Ebook Financial accounting (10th edition): Part 1 - W. Steve Albrecht

(BQ) Part 1 book Financial accounting has contents: The mechanics of accounting, completing the accounting cycle, ensuring the integrity of financial information, selling a product or a service, completing the operating cycle,...and other contents.

W STEVE ALBRECHT

PhD, CPA, CIA, CFE Brigham Young University

• EARL K STICE

PhD Brigham Young University

• JAMES D STICE

PhD Brigham Young University

PhD Brigham Young University

• JAMES D STICE

PhD Brigham Young University

FINANCIAL

ACCOUNTING

Financial Accounting, 10e

W Steve Albrecht, Earl K Stice, and James D Stice

Thomson South-Western, a part of

The Thomson Corporation Thomson,

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trademarks used herein under license

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TAKE A LOOK AT THE BEST GAME IN TOWN

SEE page iv

A STRATEGY FOR SUCCESS

Financial Accounting, 10e continues to

build upon a winning strategy designed to help

you meet the diverse needs of both accounting

majors and non-majors in your course The text’s

solid presentation of procedures blends with

a balanced emphasis on business activities.

Students learn how to effectively use and

prepare accounting information

With an emphasis on the activities of a business,

Financial Accounting, 10e demonstrates

accounting in action using a wealth of actual

examples from numerous leading companies

throughout the world Student-focused learning

features place concepts within a business

context No matter what your students’

career choices, this edition has the

coverage to make them winners

in the game of life.

THE WINNING SOLUTION – STRONGER WITH EVERY ROUND

Building on the strengths that make this a leading text, this edition takes the accounting experience to a new level The flexibility of expanded coverage, new applications in every chapter, reorganized and streamlined content, and the innovative online ThomsonNOW™

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Now It’s Your Turn.

Take a look for yourself!

Staying on top of the game in today’s competitive world means consistently looking for ways to improve, building upon existing strengths, and maximizing every opportunity.

Financial Accounting, 10e does just that to give you

and your students a competitive edge in accounting today See for yourself how proven accounting leaders Albrecht, Stice, and Stice have improved this edition to help you and your students achieve your personal best — in today’s classroom and the business world beyond.

FINANCIAL ACCOUNTING, 10E

WHERE FUTURE BUSINESS CHAMPIONS BEGIN

YOU WIN WITH FLEXIBILITY TAILORED

TO YOUR COURSE NEEDS

Always a hallmark of this text, expanded

coverage within each chapter, in

addition to solid basic coverage of essential

accounting concepts, allows you to choose how much depth you wish for exploring advanced topics The result is maximum flexibility for your class.

YOU’VE MET YOUR MATCH —

WITH ALL THE COVERAGE YOU NEED

activities, provides a solid

framework for understanding

how an organization performs

its primary business activities.

This realistic approach

makes it easier for

students to understand

accounting’s role.

STREAMLINED SOLUTIONS

ADD UP TO SUCCESS

FINANCIAL CHAPTERS LEAVE NOTHING

TO CHANCE

■ Based on your feedback, the financial

statement analysis chapter appears

as the last chapter (Ch 14) This now

serves as a capstone chapter, getting students

into analysis.

■ The unique chapter on financial

statement integrity (now Ch 5)

provides a strong ethical foundation for

students to better understand the impact

of the Sarbanes-Oxley Act and today’s

increased focus on earnings management.

MODIFIED TABLE OF CONTENTS

Based on your feedback, the table of contents has been modified to introduce topics

similar to the order they are presented on the balance sheet.

GAME ON! UNRAVEL THE PUZZLE

LEARNING FEATURES STUDENTS REALLY USE

Brief Explanations that accompany Learning Objectives at the beginning of every

chapter direct students’ attention while reading They are an ideal resource to refresh student understanding before lectures and tests.

Revised Remember This…

Summaries at the end of each

topical section of the chapter highlight the most important material within that section Bulleted lists assist with retention, while tables visually demonstrate important relationships

or connections.

Improved Chapter-Opening Exhibits place events in context,

while showing both the timeline of events for a particular business activity and the impact of these events on the financial statements These enhanced exhibits provide a clear visual aid as students begin to conceptualize the relationships between various activities of a business and the proper accounting procedures that accompany them.

FYI boxes draw examples from real business

events or situations to show students the immediate relevance of the information they are learning

Stop and Think features highlight

thought-provoking issues or concepts that reinforce the importance of developing critical-thinking skills for success in today’s competitive business world.

Caution boxes remind students of the important

points to consider when resolving more difficult situations or learning more complex concepts.

FROM NOVICE TO PROFESSIONAL

A variety of homework and assignment opportunities at the end of each chapter

provides a wealth of hands-on, focused practice.

■ Practice exercises offer quick-hit concept checks ideal

for in-class practice

■ Exercises and Problems

delve deeper into concepts, testing students’ retention of critical topics and procedures

Margin References to Learning Objectives

have been added to all exercise and problem materials for quick reference and focused practice.

Analytical Assignments,

following the problems in each chapter, provide dynamic new discussion and critical-thinking activities From discussion cases and judgment calls, to assign- ments that require the analysis of real company financial statements, this new section is a source for assignments that take learning a step beyond the typical

End-of-chapter practice exercises and problems are now available

online through the innovative ThomsonNOW™ for Financial

Accounting, 10e with instant grading and homework management capabilities!

VARIETY IS THE NAME OF THE GAME!

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sequentially or follow links from specific assignments and end-of-chapter activities for remedial review.

■ Interactive Learning Games and Assignments Reinforce Key Concepts – Multimedia games provide

a fun way to learn accounting concepts Both creative and challenging, these games reinforce core content and provide immediate feedback to help students improve knowledge and skills.

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QUALITY RESOURCES HELP SOLVE

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FULL SUITE OF INSTRUCTOR SUPPORT

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A complete selection of reliable supplements,

including PowerPoint® slides and a revised Test

Bank edited personally by the authors, ensures

consistency throughout your course and full

continuity with the text! In addition to the

innovative new technology offered with

ThomsonNOW™, Financial Accounting,

10e delivers a wealth of choices for your

teaching convenience Here are just a few

highlights from the complete package:

■ Improved Test Bank now tags questions

to AACSB and AICPA standards so you

can efficiently monitor student progress

This is particularly valuable during the

accreditation process or when your school

wants to standardize assessment Test bank

questions are also identified as easy,

moderate, and difficult to help you create

exams best suited for your individual students.

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Software allows you to easily generate

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questions for traditional or online quizzes

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■ Instructor’s Manual includes an overview

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a topical overview grid of end-of-chapter assignments with assignments classified

by level of difficulty and estimated time

of completion.

■ Companion Web Site

Find all of the resources you and your students need on the text’s companion Web site Online, password-protected access allows you to

easily download numerous valuable resources and teaching tools, including Solutions

Manual, Instructor’s Manual, PowerPoint®

slides, and Spreadsheet Solutions.

Students can easily access Student Spreadsheet Templates.They can test their understanding with interactive online quizzes and other interactive learning tools.

www.thomsonedu.com/accounting/albrecht

Content Providers:

Cameron Pratt

Brigham Young University

Jason Bond

Brigham Young University

Michael and Becky Blue

W Steve AlbrechtJames D SticeEarl K Stice

The tenth edition of Financial Accounting reflects many comments from colleagues and students, all of which

are deeply appreciated In particular we would like to thank the following:

California State University- Los AngelesMarian Boscia

Kings CollegeMary MacAuslandReading Area Community CollegeBonnie Slager

Santiago Canyon CollegeJoey Styron

Augusta State UniversityRobert HoltfreterCentral Washington UniversityDonald Raux

Siena CollegeWilliam BraberryBluefield State CollegeWilliam GoodmanBluefield State CollegeAnne Rich

Quinnipac UniversityPaul Holt

Texas A&M University- KingsvilleRalph Lindeman

Kent State UniversitySusan Minke

Indiana University- Purdue University at Fort WayneLynne Shoaf

Belmont Abbey College

A C K N O W L E D G M E N T S

In addition, we would like to thank the following content providers and verifiers for their

profes-sional services and consideration in providing a more concise, higher-quality product

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

W Steve Albrecht

W Steve Albrecht is the Associate Dean of the MarriottSchool of Management and Andersen Professor atBrigham Young University Dr Albrecht, a certified pub-lic accountant, certified internal auditor, and certifiedfraud examiner, came to BYU in 1977 after teaching atStanford and at the University of Illinois Earlier, heworked as a staff accountant for Deloitte & Touche.Prior to becoming associate dean of the MarriottSchool, Dr Albrecht served for nine years as the director

of the School of Accountancy and Information Systems

at BYU

Dr Albrecht received a bachelor’s degree in counting from Brigham Young University and his MBAand PhD degrees from the University of Wisconsin atMadison He is past President of the AmericanAccounting Association and the Association of CertifiedFraud Examiners He was a former member of the Board

ac-of Regents ac-of the Institute ac-of Internal Auditors and the Board ac-of Directors ac-of the Utah Association ac-of CPAs

He was also president of the Accounting Program Leadership Group (chairs of accounting departments andprograms) and served on the task force of the American Institute of CPAs that wrote a fraud auditing stan-dard He was a member of the Committee of Sponsoring Organizations (COSO) from 1997–2000 and is pastpresident of Beta Alpha Psi, the national accounting honors fraternity He was a member of the AICPACouncil and chaired their Pre- Certification Executive Education Committee

Dr Albrecht has done extensive research on business fraud His research has resulted in the tion of over one hundred articles in academic and professional journals He is the author or co-author ofover 20 books or monographs, several of which are on fraud His financial and principles of accountingtextbooks are in their 10th editions In 2000, he completed a major study (Accounting Education: Chartingthe Course through a Perilous Future) on the future of accounting education in the United States His fraudtextbook is currently in its second edition He is a frequent speaker on the topics of fraud examination, ac-counting education, and personal financial planning

publica-Dr Albrecht has received numerous awards and honors, including BYU’s highest faculty honor, the Karl

G Maeser Distinguished Faculty Lecturer Award for superior scholarship and teaching He has also receivedthe BYU School of Management’s Outstanding Faculty Award and the BYU Outstanding Researcher Award Hehas been recognized by Beta Alpha Psi, the Federation of Schools of Accountancy, the Auditing Section of theAmerican Association and the AICPA as Educator of the Year He has also received awards for outstandingteaching at Stanford University, the University of Illinois, and the University of Wisconsin In 1997, 2001, 2002,and 2003 he was chosen as one of the 100 most influential accounting professionals in the United States by

Accounting Todaymagazine In 1998, he received the Cressey Award from the Association of Certified FraudExaminers, the highest award given for a lifetime of achievement in fraud detection and deterrence (Past win-ners were Jane Bryant Quinn of Newsweek magazine and Rudolph Giuliani, past United States Attorney for theSouthern District of New York and past mayor of New York City.) In 2002, in honor of his contribution infighting fraud, the Association of Certified Fraud Examiners named one of the buildings at their headquartersafter Dr Albrecht And in 2001, in recognition of his contributions to BYU and to academia, an anonymousdonor endowed the W Steve Albrecht Professorship in Accounting

Dr Albrecht has consulted with numerous organizations, including a variety of Fortune 500 nies, major financial institutions, the United Nations, FBI, and other organizations, and he has been an ex-pert witness in some of the largest fraud cases in America He currently serves on the audit committeesand boards of directors of four public and three private companies Dr Albrecht is married to the formerLeAnn Christiansen, and they have six children and 10 grandchildren

compa-Earl K Stice

Earl K Stice is the PricewaterhouseCoopers Professor of Accounting in the School of Accountancy andInformation Systems at Brigham Young University where he has been on the faculty since 1998 He holdsbachelor’s and master’s degrees from Brigham Young University and a PhD from Cornell University

About the Authors xiii

Dr Stice has taught at Rice University, the University of Arizona, Cornell University, and the Hong Kong

University of Science and Technology (HKUST) He won the Phi Beta Kappa teaching award at Rice

University and was twice selected at HKUST as one of the ten best lecturers on campus Dr Stice has also

taught in a variety of executive education and corporate training programs in the United States, Hong Kong,

China, and South Africa, and he is currently on the executive MBA faculty of the China Europe International

Business School in Shanghai He has published papers in the Journal of Financial and Quantitative

Analysis, The Accounting Review, Review of Accounting Studies , Issues in Accounting Education, and

the Journal of Accounting Education, and his research on stock splits has been cited in Business Week,

Money , and Forbes Dr Stice has presented his research results at seminars in the United States, Finland,

Taiwan, Australia, and Hong Kong He is co-author of Intermediate Accounting, 16th edition and Financial

Accounting: Reporting and Analysis, 7th Edition Dr Stice and his wife, Ramona, are the parents of seven

children: Derrald, Han, Ryan Marie, Lorien, Lily, Taraz, and Kamila

James D Stice

James D Stice is the Distinguished Teaching Professor in the Marriott School of Management at Brigham

Young University He is currently the Director of the Marriott School’s MBA Program He holds bachelor’s

and master’s degrees from BYU and a PhD from the University of Washington, all in accounting Professor

Stice has been on the faculty at BYU since 1988 During that time, he has been selected by graduating

accounting students as “Teacher of the Year” on numerous occasions, he was selected by his peers in the

Marriott School at BYU to receive the “Outstanding Teaching Award” in 1995, and in 1999 he was selected

by the University to receive its highest teaching award, the Maeser Excellence in Teaching Award Professor

Stice has taught at INSEAD in France and at the China Europe International Business School in Shanghai

Professor Stice has published articles in The Journal of Accounting Research, The Accounting Review,

Decision Sciences, Issues in Accounting Education, The CPA Journal, and other academic and professional

journals In addition to this textbook, he has published two other textbooks: Financial Accounting:

Reporting and Analysis , and Intermediate Accounting In addition to his teaching and research, Dr Stice

has been involved in executive education for such companies as IBM, Bank of America, Ernst & Young,

RSM McGladrey and currently serves on the board of directors of Nutraceutical Corporation Dr Stice and

his wife, Kaye, have seven children: Crystal, J.D., Ashley, Whitney, Kara, Skyler, and Cierra and two

grandchildren

S U P P L E M E N T S

For the Instructor…….

ThomsonNOW™ for Financial Accounting, 10e

Description:

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accounting procedures and concepts with the

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effi-ciently test and automatically grade assignments with

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stan-dard lecture-based course or can serve as a strong

foundation for full distance-learning programs For

your convenience, ThomsonNOW™ is even

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For more information, visit www.thomsonedu.

com/thomsonnow.

Experience Accounting Videos

Description:

The ideal tool for launching a dynamic, interactive

lecture in your course, these new Experience

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concepts in action from Accounting, 10e Each brief

video clip, which is approximately five minutes,

features recognizable companies, such as Hard Rock

Café and BP, who are using managerial accounting to

strengthen their business performance These videos

are available in ThomsonNOW™ or standalone via

the web

Instructor’s Manual

Description:

Simplify class preparation with these detailed lecture

outlines, overview of Learning Objectives,

descrip-tions of key illustradescrip-tions and boxed items with page

references, and topical overview grid of

end-of-chapter assignments with assignments classified by

level of difficulty and estimated time of completion

Available online or on the Instructor’s Resource

CD-ROM

Instructor’s Resource CD-ROM

ISBN:0324645783

Description:

Place all of the key teaching resources you need for

a winning course at your fingertips with this

all-in-one source Find everything you need to plan, teach,

grade and assess student understanding and progress.This CD includes the Solutions Manual, Instructor’sManual, Test Bank in Word and ExamView®,PowerPoint® slides, spreadsheet solutions, and solu-tions to the Cumulative Spreadsheet Analysis assign-ments from the textbook

PowerPoint® Presentation Slides

Description:

Bring your lectures to life and clarify difficult cepts with these slides for this edition to capture andkeep your students’ attention Ideal as guides for stu-dent note-taking and study, print the slides or simplyuse with an overhead projector

con-Available online or on the Instructor’s Resource CD-Rom

Solutions ManualISBN:0324648308 Description:

Carefully verified to ensure accuracy, these solutionsand answers to all end-of-chapter materials from thetextbook help you easily plan, assign and efficientlygrade assignments

Solutions TransparenciesISBN:0324645848 Description:

Clarify learning for students with these acetate ters that detail solutions for the exercises and prob-lems from the text These are specifically created forinstructors who wish to use overheads in class.Test Bank

mas-ISBN: 0324645775 Description:

This revised test bank helps you efficiently assessyour students’ understanding with problems andquestions that are now tagged to AACSB and AICPAstandards This is particularly valuable during the ac-creditation process or when your school wants tostandardize assessment Test bank questions are alsoidentified by easy, medium or challenging level ofdifficulty for easy selection

Title: ExamView®5.0 Computerized Test Bank

Description:

This easy-to-use test-creation program for Microsoft®Windows or Macintosh contains all questions fromthe printed Test Bank with AACSB, AICPA and stan-dards and level of difficulty indicated for each ques-tion It’s simple to customize tests to your specificclass needs as you edit or create questions and store

Supplements xv

customized exams This is an ideal tool for online

testing Available on the IRCD

WebTutor™ Toolbox for Blackboard®and WebCT

ISBN: 0534272401 (Blackboard) or 053427241x

(WebCT)

Description:

Leverage the power of the Internet and bring your

course to life with this course management

pro-gram You or your students can use this wealth of

in-teractive resources with those on the text’s

companion website to supplement the classroom

ex-perience and ensure positive outcomes Use this

ef-fective resource as an integrated solution for your

distance learning or web-enhanced course Visit

Verified by the text authors to ensure accuracy and

quality consistent with the text, the working papers

for problems from the financial accounting chapters

in the textbook are provided together in one

conve-nient resource

Albrecht/Stice/Stice’s Financial Accounting, 10e

Companion Web Site

Description:

Now you and your students can reach the top of

your game in accounting with immediate access to a

rich array of teaching and learning resources at

Financial Accounting , 10e’s interactive companion

website This resource features chapter-by-chapteronline tutorial quizzes, a final exam, chapter outlinesand review, online learning games, flashcards,expanded coverage of certain topics not found in thetextbook and more! Easily download the instructorresources you need from the password-protected,instructor-only section of the site

pro-ray of learning resources at the Financial Accounting,

10einteractive companion website Designed ically for your accounting needs, this website fea-tures chapter-by-chapter online quizzes and solutions,learning games, flashcards, expanded coverage oftopics not covered in the text, and more!

specif-Working Papers t/a Financial Accounting ters 1–14)

(chap-ISBN:0324648227 Description:

The working papers for problems from the textbookare provided together in one resource for your con-venience Verified by the text authors to ensureaccuracy and consistent quality, you’ll find the toolsyou need to enhance your learning experience

TM

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◗ PART ONE: FINANCIAL REPORTING AND THE

A C C O U N T I N G C Y C L E 1

1 Accounting Information: Users and Uses 3

2 Financial Statements: An Overview 28

3 The Mechanics of Accounting 75

4 Completing the Accounting Cycle 129

5 Ensuring the Integrity of Financial Information 185

◗ PART TWO: OPERATING ACTIVITIES 223 6 Selling a Product or a Service 224

7 Inventory 282

8 Completing the Operating Cycle 341

◗ PART THREE: INVESTING AND FINANCING A C T I V I T I E S 3 8 7 9 Investments in Property, Plant, and Equipment and in Intangible Assets 388

10 Long-Term Debt Financing 453

11 Equity Financing 513

12 Investments in Debt and Equity Securities 559

◗ PART FOUR: OTHER DIMENSIONS OF FINANCIAL R E P O R T I N G 6 1 1 13 The Statement of Cash Flows 613

14 Introduction to Financial Statement Analysis 667

A P P E N D I C E S

A Wal-Mart 2006 Annual Report A-1

B Glossary B-1

C Check Figures C-1

I N D E X E S

Subject SI-1 Real World Company CI-1

B R I E F C O N T E N T S

This page intentionally left blank

◗ P A R T O N E

F I N A N C I A L R E P O R T I N G A N D T H E

A C C O U N T I N G CYC L E 1

1 ACCOUNTING INFORMATION: USERS AND USES 3

What’s the Purpose of Accounting? 5

The Relationship of Accounting to Business 7

Who Uses Accounting Information 9

Lenders 10

Investors 11

Management 11

Other Users of Financial Information 11

Within What Kind of Environment Does Accounting Operate? 13

The Significance and Development of Accounting Standards 13

The Financial Accounting Standards Board 14

Other Organizations 14

International Business 15

Ethics in Accounting 17

Technology 17

So, Why Should I Study Accounting? 20

End-of-Chapter Materials 21

2 FINANCIAL STATEMENTS: AN OVERVIEW 28

The Financial Statements 30

The Balance Sheet 31

The Income Statement 38

The Statement of Cash Flows 43

How the Financial Statements Tie Together 45

Notes to the Financial Statements 46

Summary of Significant Accounting Policies 46

Additional Information about Summary Totals 46

C O N T E N T S

xx Contents

Disclosure of Information Not Recognized 46

Supplementary Information 47

The External Audit 47

Fundamental Concepts and Assumptions 49

The Separate Entity Concept 49

The Assumption of Arm’s-Length Transactions 49

The Cost Principle 50

The Monetary Measurement Concept 50

The Going Concern Assumption 50

End-of-Chapter Materials 51

3 THE MECHANICS OF ACCOUNTING 75

How Can We Collect All This Information? 76

How Do Transactions Affect the Accounting Equation? 79

The Accounting Equation 79

Using Accounts to Categorize Transactions 80

Expanding the Accounting Equation to Include Revenues, Expenses, and Dividends 84

Why Should I Understand the Mechanics of Accounting? 84

How Do We Record the Effects of Transactions? 86

Acquiring Cash, Either from Owners or by Borrowing 87

Acquiring Other Assets 88

Selling Goods or Providing Services 91

Collecting Cash and Paying Obligations 93

A Note on Journal Entries 95

Posting Journal Entries and Preparing a Trial Balance 97

Determining Account Balances 98

Illustration of the First Three Steps in the Accounting Cycle 99

Where Do Computers Fit In All This? 104

End-of-Chapter Materials 106

4 COMPLETING THE ACCOUNTING CYCLE 129

Accrual Accounting 130

Periodic Reporting 131

Accrual- versus Cash-Basis Accounting 132

Preparing Financial Statements 143

Financial Statement Preparation 143

The Notes 145

The Audit 146

Closing the Books 148

Real and Nominal Accounts 148

Closing Entries 149

Preparing a Post-Closing Trial Balance 149

A Summary of the Accounting Cycle 151

End-of-Chapter Materials 152

5 ENSURING THE INTEGRITY OF FINANCIAL INFORMATION 185

The Types of Problems That Can Occur 187

Types of Errors in the Reporting Process 188

Disagreements in Judgment 189

Fraudulent Financial Reporting 189

Safeguards Designed to Minimize Problems 190

The Control Environment 192

Control Activities (Procedures) 192

Reasons for Earnings Management 195

Meet Internal Targets 196

Meet External Expectations 196

Income Smoothing 196

Window Dressing for an IPO or a Loan 197

The Earnings Management Continuum 197

Is Earnings Management Ethical? 199

Personal Ethics 200

The Sarbanes-Oxley Act 201

Public Company Accounting Oversight Board 201

Constraints on Auditors 201

Constraints on Management 202

xxii Contents

The Role of Auditors in the Accounting Process 202

Internal Auditors 202 External Auditors 203 What Do Auditors Do? 204 Are Outside (Independent) Auditors Independent? 206

The Securities and Exchange Commission 207

The Effect of the 1934 Act on Independent Accountants 208

End-of-Chapter Materials 209

Comprehensive Problem 1–5 220

◗ P A R T T W O

O P E R AT I N G A C T I V I T I E S 2 2 3

6 SELLING A PRODUCT OR A SERVICE 224

Major Activities of a Business 228 Recognizing Revenue 230

When Should Revenue Be Recognized? 231 Application of the Revenue Recognition Criteria 232

Cash Collection 234

Sales Discounts 234 Sales Returns and Allowances 235 Control of Cash 236

Accounting for Credit Customers Who Don’t Pay 237

Direct Write-Off Method 238 The Allowance Method 239 Real-World Illustration of Accounting for Bad Debts 243

Assessing How Well Companies Manage Their Receivables 244 Recording Warranty and Service Costs Associated

with a Sale 245

Reconciling the Bank Account 247

E X P A N D E D

material

Contents xxiii

Foreign Currency Transactions 250

Foreign Currency Transaction Example 250

End-of-Chapter Materials 253

7 INVENTORY 282

Inventory and Cost of Goods Sold 285

What is Inventory? 286

What Costs Are Included in Inventory Cost? 287

Who Owns the Inventory? 287

Ending Inventory and Cost of Goods Sold 288

Accounting for Inventory Purchases and Sales 289

Overview of Perpetual and Periodic Systems 289

Perpetual and Periodic Journal Entries 290

Counting Inventory and Calculating Cost of Goods Sold 295

Taking a Physical Count of Inventory 295

The Income Effect of an Error in Ending Inventory 296

Inventory Cost Flow Assumptions 297

Specific Identification Inventory Cost Flow 298

FIFO Cost Flow Assumption 300

LIFO Cost Flow Assumption 300

Average Cost Flow Assumption 301

A Comparison of All Inventory Costing Methods 301

Assessing How Well Companies Manage Their Inventories 303

Evaluating the Level of Inventory 303

Impact of the Inventory Cost Flow Assumption 304

Number of Days’ Purchases in Accounts Payable 304

xxiv Contents

Reporting Inventory at Amounts below Cost 311

Inventory Valued at Net Realizable Value 311 Inventory Valued at Lower of Cost or Market 311

Method of Estimating Inventories 313

The Gross Margin Method 314

End-of-Chapter Materials 315

8 COMPLETING THE OPERATING CYCLE 341

Employee Compensation 344

Payroll 345 Compensated Absences 346 Bonuses 347 Stock Options 347 Postemployment Benefits 348 Pensions 348 Postretirement Benefits Other Than Pensions 350

Taxes 351

Sales Taxes 351 Property Taxes 351 Income Taxes 352 Deferred Tax Example 353

Contingencies 355

Environmental Liabilities 356

Capitalize versus Expense 358

Research and Development 359 Advertising 359

Summarizing Operations on an Income Statement 360

Other Revenues and Expenses 360 Extraordinary Items 360 Earnings per Share 362 Differing Income Statement Formats 363

End-of-Chapter Materials 364

Comprehensive Problem 6–8 384

Contents xxv

◗ P A R T T H R E E

I N V E S T I N G A N D F I N A N C I N G

A C T I V I T I E S 3 87

9 INVESTMENTS IN PROPERTY, PLANT, AND

EQUIPMENT AND IN INTANGIBLE ASSETS 388

Nature of Long-Term Operating Assets 391

Deciding Whether to Acquire a Long-Term Operating Asset 392

Accounting for Acquisition of Property, Plant, and Equipment 393

Assets Acquired by Purchase 394

Assets Acquired by Leasing 394

Assets Acquired by Self-Construction 397

Acquisition of Several Assets at Once 397

Calculating and Recording Depreciation Expense 399

Straight-Line Method of Depreciation 400

Units-of-Production Method of Depreciation 402

A Comparison of Depreciation Methods 403

Partial-Year Depreciation Calculations 403

Units-of-Production Method with Natural Resources 404

Repairing and Improving Property, Plant, and Equipment 405

Recording Impairments of Asset Value 407

Recording Decreases in the Value of Property, Plant,

and Equipment 407

Recording Increases in the Value of Property, Plant,

and Equipment 408

Disposal of Property, Plant, and Equipment 409

Discarding Property, Plant, and Equipment 409

Selling Property, Plant, and Equipment 410

Exchanging Property, Plant, and Equipment 410

Accounting for Intangible Assets 411

Amortization of Intangible Assets 414

Impairment of Intangible Assets 415

xxvi Contents

Measuring Property, Plant, and Equipment Efficiency 416

Evaluating the Level of Property, Plant, and Equipment 416 Industry Differences in Fixed Asset Turnover 416

Accelerated Depreciation Methods 417

Declining-Balance Method of Depreciation 418 Sum-of-the-Years’-Digits Method of Depreciation 419

A Comparison of Depreciation Methods 420

Changes in Depreciation Estimates and Methods 422 End-of-Chapter Materials 423

10 LONG-TERM DEBT FINANCING 453

Measuring Long-Term Liabilities 455

Present Value and Future Value Concepts 455 Computing the Present Value of an Annuity 459

Accounting for Long-Term Liabilities 461

Interest-Bearing Notes 462 Mortgages Payable 463

Accounting for Lease Obligations 465

Operating Leases 467

The Nature of Bonds 468

Types of Bonds 468 Characteristics of Bonds 469 Determining a Bond’s Issuance Price 469 Accounting for Bonds Payable Issued at Face Value 473 Bond Retirements before Maturity 475

Using Debt-Related Financial Ratios 476

Debt Ratio and Debt-to-Equity Ratio 476 Times Interest Earned Ratio 477

E X P A N D E D

material

Contents xxvii

Bonds Issued at a Discount or at a Premium 478

Accounting for Bonds Issued at a Discount 478

Accounting for Bonds Issued at a Premium 480

Effective-Interest Amortization 481

End-of-Chapter Materials 488

11 EQUITY FINANCING 513

Raising Equity Financing 516

Difference between a Loan and an Investment 516

Proprietorships and Partnerships 517

Corporations and Corporate Stock 518

Accounting for Stock Repurchases 523

Balance Sheet Presentation 525

Retained Earnings 526

Cash Dividends 526

Dividend Payout Ratio 530

Other Equity Items 531

Equity Items That Bypass the Income Statement 531

Statement of Stockholders’ Equity 533

End-of-Chapter Materials 534

12 INVESTMENTS IN DEBT AND EQUITY SECURITIES 559

Why Companies Invest in Other Companies 561

xxviii Contents

Trading and Available-for-Sale Securities 566 Why the Different Classifications? 566

Accounting for Trading and Available-for-Sale Securities 568

Accounting for the Purchase of Securities 568 Accounting for the Return Earned on an Investment 569 Accounting for the Sale of Securities 570

Accounting for Changes in the Value of Securities 571

Changes in the Value of Trading Securities 571 Changes in the Value of Available-for-Sale Securities 571 Subsequent Changes in Value 572

Accounting for Held-to-Maturity Securities 574

Accounting for the Initial Purchase 574 Accounting for Bonds Purchased between

Interest Dates 575 Accounting for the Amortization of Bond Discounts

and Premiums 576 Accounting for the Sale or Maturity of

Bond Investments 579

Accounting for Equity Investments Using the

Equity Method 580

Illustrating the Equity Method 581

Consolidated Financial Statements 582 End-of-Chapter Materials 585

Comprehensive Problem 9–12 609

OT H E R D I M E N S I O N S O F F I N A N C I A L

R E P O R T I N G 6 1 1

13 THE STATEMENT OF CASH FLOWS 613

What’s the Purpose of a Statement of Cash Flows? 615

E X P A N D E D

material

Contents xxix

What Information Is Reported in the Statement of

Cash Flows? 616

Major Classifications of Cash Flows 616

Noncash Investing and Financing Activities 619

Cash Flow Patterns 619

Preparing a Statement of Cash Flows—A Simple Example 620

Analyzing the Other Primary Financial Statements to

Prepare a Statement of Cash Flows 623

A Six-Step Process for Preparing a Statement of

Cash Flows 625

An Illustration of the Six-Step Process 626

Using Information from the Statement of Cash Flows to

Make Decisions 635

End-of-Chapter Materials 637

14 INTRODUCTION TO FINANCIAL

STATEMENT ANALYSIS 667

The Need for Financial Statement Analysis 669

Widely Used Financial Ratios 671

More Efficiency Ratios 682

Accounts Receivable Efficiency 683

Inventory Efficiency 683

Property, Plant, and Equipment Efficiency 684

xxx Contents

More Leverage Ratios 685

Debt-to-Equity Ratio 685 Times Interest Earned Ratio 686

Cash Flow Ratios 686

Usefulness of Cash Flow Ratios 687 Cash Flow to Net Income 687 Cash Flow Adequacy 688

Potential Pitfalls 689

Financial Statements Don’t Contain All Information 689 Lack of Comparability 690 Search for the Smoking Gun 690 Anchoring, Adjustment, and Timeliness 690

TENTH EDITION

FINANCIAL

ACCOUNTING

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Financial Reporting and the Accounting Cycle

1 2 3

© DUNCAN SMITH/PHOTODISC GREEN/GETTY IMAGES INC.

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2

3 4

Accounting Information:

Users and Uses

After studying this chapter, you should be able to:

Describe the purpose of accounting

and explain its role in business and

society Accounting is the recording of the

day-to-day financial activities of a company

and the organization of that information into

summary reports used by people inside and

outside the company to make decisions.

Identify the primary users of

accounting information Among the

users of accounting information are lenders,

investors, company management, suppliers,

customers, employees, competitors,

govern-ment agencies, politicians, and the press.

Describe the environment of accounting, including the effects of generally accepted accounting principles, international business, ethical considerations, and

technology The practice of accounting involves

adherence to the established national and (increasingly) international accounting rules as well as the use of judgment Because accounting data are typically captured and summarized by computer systems, the practice of accounting requires familiarity with information technology.

Analyze the reasons for studying

accounting Every job requires you to

prepare, use, respond to, or be evaluated using accounting data Those people who better understand accounting are better able to function

in any organization.

1

4 Part 1 Financial Reporting and the Accounting Cycle

In 1913, a young CPA named Arthur Andersen

partnered with a gentleman named Clarence

DeLany to form the public accounting firm of

Andersen, DeLany & Co At the time, there

were only about 2,200 CPAs in the United

States, and at the age of 23, Mr Andersen was

one of the youngest Mr DeLany later left the

Andersen From that beginning, the company

grew to the point where in 2001, Andersen had

operations in 84 countries and over 85,000

employees Revenues for 2002 were $9.3

bil-lion Some of the companies whose financial

statements were audited by Andersen

FedEx Corp.,Hershey Foods,Hilton Hotels,

andMerck

On August 31, 2002, Arthur Andersenclosed its doors and ceased to be an auditor of

the financial statements of companies whose

stock was traded on public stock exchanges

How did this dramatic “about face” occur? In a

word—Enron Arthur Andersen was the external

auditor for a Texas-based energy company

appear as though the company was performingbetter than it actually was, Enron officials cre-ated several companies, established partner-ships with those companies, and then usedthose partnerships to hide hundreds of millions

of dollars in debt Andersen officials knew aboutthese companies and approved the accountingfor the transactions While the details of theaccounting for these transactions are far be-yond the scope of this accounting class, suffice

it to say that it was complicated

When the SEC began investigating theEnron scandal, Arthur Andersen undertook aseries of events that led to its eventual demise.Company officials ordered that documents re-lating to the Enron audit be shredded, andAndersen attorneys asked that certain internalcorrespondence with Enron officers that hadnot yet been made public be changed to hidethe firm’s knowledge of certain transactions.Investigation by the SEC into charges of ob-struction of justice by Andersen officials led tothe firm closing its doors in August of 2002

In this textbook, you will begin your study of

accounting You will learn to speak and derstand accounting, “the language of busi- ness.” Without an understanding of accounting,

un-business investments, taxes, and money

man-agement will be like a foreign language to you.

In brief, an understanding of accounting

facili-tates the interpretation of financial information,

which allows for better economic decisions.

The major objectives of this text are to vide you with a basic understanding of the

pro-language of accounting and with the ability to

interpret and use financial information prepared using accounting techniques and procedures With the knowledge you obtain from this expo- sure to accounting, you will be able to “read” the financial statements of companies, under- stand the information that is being conveyed, and use accounting information to make good business decisions Also, through discussion of the business environment in which accounting

is used, you will increase your ing of general business concepts such as corporations, leases, annuities, leverage, investments, and so forth.

understand-You will become convinced that counting is not “bean counting.” Time after time you will see that accountants must ex- ercise judgment about how to best summa- rize and report the results of business transactions This judgment was at the heart

ac-of the Enron, WorldCom, and other dals As a result, you will gain a respect for the complexity of accounting and develop a healthy skepticism about the precision of any financial reports you see.

scan-1 In addition to Enron, several other Andersen clients including WorldCom, Qwest, Sunbeam, and Waste Management also

Don’t be too concerned with all the new and

unfamiliar terms you see in the first chapter of

the book Learning a “new language” takes

time Be patient Before too long, you will be

speaking the “language of business”

(account-ing) quite fluently

C A U T I O N

Accounting Information: Users and Uses Chapter 1 5

Finally, you will see the power of

account-ing Financial statements are not just paper

re-ports that get filed away and forgotten As an

example, the misleading financial statement

numbers associated with Enron, WorldCom, and

Tyco (another financial statement fraud) resulted

in tens of thousands of employees being laid off

and investors losing billions of dollars You will

see that financial statement numbers, and, rectly, the accountants who prepare them, deter- mine who receives loans and who doesn’t, which companies attract investors and which don’t, which managers receive salary bonuses and which don’t, and which companies are praised in the financial press and which aren’t.

indi-So, let’s get started.

What’s the Purpose of Accounting?

Imagine a long distance telephone company with no system in place to documentwho calls whom and how long they talk Or a manager of a 300-unit apartmentcomplex who has forgotten to write down which tenants have and have notpaid this month’s rent Or an accounting professor who, the day before finalgrades are due, loses the only copy of the disk containing the spreadsheet ofall the homework, quiz, and exam scores Each of these scenarios illustrates

a problem with bookkeeping, the least glamorous aspect of accounting

Bookkeepingis the preservation of a systematic, quantitative record of an ity Bookkeeping systems can be very primitive—cutting notches in a stick to tallyhow many sheep you have or moving beads on a string to track the score in abilliards game But the importance of routine bookkeeping cannot be overstated;without bookkeeping, business is impossible

activ-Rudimentary bookkeeping is ancient, probably predating both language andmoney The modern system of double-entry bookkeeping still in use today(described in Chapter 3) was developed in the 1300s–1400s in Italy by the mer-chants in the trading and banking centers of Florence, Venice, and Genoa The keydevelopment in accounting in the last 500 years has been the use of the bookkeeping data,not just to keep track of things, but to evaluate the performance and health of a business.This use of bookkeeping data as an evaluation tool may seem obvious to you, but it

is a step that is often not taken Let’s consider a bookkeeping system with which most of

us are familiar—a checking account Your checking account involves (or should involve)careful recording of the dates and amounts of all checks written and all deposits made,the maintenance of a running account total, and reconciliations with the monthly bankstatement Now, assume that you have a perfect checking account bookkeeping system.Will the system answer the following questions?

• Are you spending more for groceries this year than you did last year?

• What proportion of your monthly expenditures are fixed, meaning that you can’tchange them except through a drastic change in lifestyle?

• You plan to study abroad next year; will you be able to save enough between now and then to pay for it?

In order to answer these kinds of evaluation questions, each check must beanalyzed to determine the type of expenditure, your checks must then be coded

by type of expenditure, the data must be boiled down into summary reports, andpast data must be used to forecast future patterns How many of us use ourchecking account data like this? Not many We do the bookkeeping (usually), but

we don’t structure the information to be used for evaluation

In summary, an accounting system is used by a business to (1) analyzetransactions, (2) handle routine bookkeeping tasks, and (3) structure information

so it can be used to evaluate the performance and health of the business Exhibit 1illustrates the three functions of the accounting system

used to evaluate the

performance and health

of the business

Making good decisions is critical for success in any business enterprise When an portant decision must be made, it is essential to use a rational decision-making process.The process is basically the same no matter how complex the issue First, the issue orquestion must be clearly identified Next, the facts surrounding the situation must be gath-ered and analyzed Then, several alternative courses of action should be identified andconsidered before a decision is finally reached This decision-making process is summa-rized in Exhibit 2.

im-2 Statement of the Accounting Principles Board No 4, “Basic Concepts and Accounting Principles Underlying Financial

EXHIBIT 1 Functions of an Accounting System

Accountingis formally defined as a system for providing “quantitative formation, primarily financial in nature, about economic entities that is in-tended to be useful in making economic decisions.”2The key components

in-of this definition are:

• Quantitative Accounting relates to numbers This is a strength

be-cause numbers can be easily tabulated and summarized It is a ness because some important business events, such as a toxic wastespill and the associated lawsuits and countersuits, cannot be easily de-scribed by one or two numbers

weak-• Financial The health and performance of a business are affected by

and reflected in many dimensions—financial, personal relationships,community and environmental impact, and public image Accountingfocuses on just the financial dimension

• Useful The practice of accounting is supported by a long tradition of

theory U.S accounting rules have a theoretical conceptual framework.Some people actually make a living as accounting theorists However,

in spite of its theoretical beauty, accounting exists only because it isuseful

• Decisions Although accounting is the structured reporting of what has

already occurred, this past information can only be useful if it impactsdecisions about the future

accounting

A system for providing

quantitative, financial

information about

economic entities that is

useful for making sound

economic decisions

Accounting is often called

the “language of business”

because it provides the

means of recording and

communicating business

activities and the results

of those activities

Select the option that will most likely result

in the desired objective.

Identify alternatives.

Identify the issue.

Accounting plays a vital role in the decision-making process An accountingsystem provides information in a form that can be used to make knowledgeablefinancial decisions The information supplied by accounting is in the form ofquantitative data, primarily financial in nature, and relates to specific economicentities An economic entity may be an individual, a business enterprise, or a non-profit organization A business, such as a grocery store or a car dealership, is op-erated with the objective of making a profit for its owners The goal of a nonprofit organization, such as a city government or a university, is to provide services

in an effective and efficient manner Every entity, regardless of its size or pose, must have a way to keep track of its economic activities and measure howwell it is accomplishing its goals Accounting provides the means for tracking ac-tivities and measuring results

pur-The Relationship of Accounting to Business

Business is the general term applied to the activities involved in the production and tribution of goods and services Accounting is used to record and report the financialeffects of business activities Thus, as mentioned earlier, accounting is often called the

dis-“language of business.” It provides the means of recording and communicating the cesses and failures of business organizations Without accounting information, many im-portant financial decisions would be made blindly Investors, for example, would have noway to distinguish between a profitable company and one that is on the verge of failure;bankers could not evaluate the riskiness of potential loans; corporate managers wouldhave no basis for controlling costs, setting prices, or investing the company’s resources;and governments would have no basis for taxing income

suc-All business enterprises have some activities in common As shown in Exhibit 3, onecommon activity is the acquisition of monetary resources These resources, often re-ferred to as “capital,” come from three sources: (1) investors (owners), (2) creditors(lenders), and (3) the business itself in the form of earnings that have been retained.Once resources are obtained, they are used to buy land, buildings, and equipment; topurchase materials and supplies; to pay employees; and to meet any other operating ex-penses involved in the production and marketing of goods or services When the prod-uct or service is sold, additional monetary resources (revenues) are generated Theseresources can be used to pay loans, to pay taxes, and to buy new materials, equipment,

Accounting Information: Users and Uses Chapter 1 7

EXHIBIT 2 The Decision-Making Process

One must be careful to make a distinction between a good decision and a good come Often, many factors outside the control of the decision maker affect the out-come of a decision The decision-making process does not guarantee a certain result;

out-it only ensures that a good decision is made The outcome always has an element ofchance Part of business is learning how to protect yourself against bad outcomes Thefirst step in achieving a favorable outcome begins with making a good decision

business

An organization operated

with the objective of

making a profit from the

sale of goods or services

nonprofit

organization

An entity without a profit

objective, oriented toward

providing services

efficiently and effectively