1 Financial Accounting and Its Economic Context 2
PART 1 AN OVERVIEW OF FINANCIAL ACCOUNTING 2
1 FINANCIAL ACCOUNTING AND ITS ECONOMIC CONTEXT 2
PART 1 AN OVERVIEW OF FINANCIAL ACCOUNTING 2
Consumption and Investment 4
THE DEMAND FOR FINANCIAL INFORMATION: A USER S ORIENTATION 4
The Demand for Documentation 5
Where to Invest? 5
The Auditor s Report,the Management Letter,and the Financial Statements 6
Martin and the CPA:Different Perspectives 6
The Demand for an Independent Audit 6
The Financial Statements: Definitions and Preliminary Analysis 10
What Form of Investment: Debt or Equity? 12
A Decision Is Made but Important Questions Still Remain 13
Financial Accounting Information: More Than the Financial Statements 14
THE ENVIRONMENT OF FINANCIAL ACCOUNTING 14
Providers of Capital:Investors and Creditors 16
Companies (Managers) 16
Independent Auditors 17
Contracts 17
Legal Liability 18
Relationships Among the Capital Providers,Management,and the Independent Auditor 18
Ethics and Professional Reputation 20
ECONOMIC CONSEQUENCES: MANAGEMENT S PERSPECTIVE 21
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES 22
The Securities and Exchange Commission 22
ACCOUNTING STANDARD SETTING: A POLITICAL PROCESS 23
The Financial Accounting Standards Board 23
Reactions to Economic Consequences: Lobbying Accounting Numbers 24
INTERNATIONAL PERSPECTIVE: ACCOUNTING PRACTICES AND STANDARDS THROUGHOUT THE WORLD 25
British-American-Dutch Model 25
Continental Model 26
South American Model 26
Communist Model 26
International Accounting Standard Setting 26
Appendix 1A Three Other Kinds of Accounting 30
NOT-FOR-PROFIT ACCOUNTING 30
MANAGERIAL ACCOUNTING 30
TAX ACCOUNTING 30
COMPARING THE FOUR KINDS OF ACCOUNTING 31
The Role of the Accounting Profession 33
2 THE FINANCIAL STATEMENTS 37
2 The Financial Statements 37
BUSINESSES ARE LIKE FRUIT TREES 38
Three Activities of a Business 39
Businesses 39
Fruit Trees 39
THE CLASSIFIED BALANCE SHEET 40
A Photograph of Financial Condition 40
Balance Sheet Classifications 42
Assets 42
Liabilities 46
Stockholders Equity 47
THE INCOME STATEMENT 49
Revenues 49
Expenses 50
THE STATEMENT OF RETAINED EARNINGS 51
THE STATEMENT OF CASH FLOWS 52
Cash Flows From Operating Activities 52
Cash Flows From Financing Activities 54
Cash Flows From Investing Activities 54
RELATIONSHIPS AMONG THE FINANCIAL STATEMENTS 54
INTERNATIONAL PERSPECTIVE: FINANCIAL STATEMENTS AND ANALYSES IN OTHER COUNTRIES 56
3 Using Financial Statement Information 76
PART 2 USE,MEASUREMENT,AND MECHANICS OF FINANCIAL STATEMENTS 76
3 USING FINANCIAL STATEMENT INFORMATION 76
PART 2 USE,MEASUREMENT AND MECHANICS OF FINANCIAL STATEMENTS 76
PREDICTION AND CONTROL 77
Financial Accounting Numbers as Prediction Aids 77
Financial Accounting Numbers and Management Control 78
The Audit Report 79
ASSESSING EARNING POWER AND SOLVENCY 79
Significant Transactions 80
The Credit Rating 81
Analyzing the Financial Statements 82
Solvency Assessment 95
LIMITATIONS OF FINANCIAL ACCOUNTING INFORMATION 96
Management Biases 97
Inherent GAAP Limitations 99
INTERNATIONAL PERSPECTIVE: FINANCIAL STATEMENT ANALYSIS IN AN INTERNATIONAL SETTING 101
ANALYZING THE FINANCIAL STATEMENTS OF ALBERTSONS AND SAFEWAY 102
A Word of Caution 104
ASSUMPTIONS OF FINANCIAL ACCOUNTING 132
Economic Entity Assumption 132
4 THE MEASUREMENT FUNDAMENTALS OF FINANCIAL ACCOUNTING 132
4 The Measurement Fundamentals of Financial Accounting 132
Fiscal Period Assumption 133
Going Concern Assumption 134
Stable Dollar Assumption 134
VALUATIONS ON THE BALANCE SHEET 136
Four Alternative Valuation Bases 137
Valuation Bases Used on the Balance Sheet 138
THE PRINCIPLES OF FINANCIAL ACCOUNTING MEASUREMENT 140
The Principle of Objectivity 140
The Principles of Matching and Revenue Recognition 142
The Principle of Consistency 144
TWO EXCEPTIONS TO THE BASIC PRINCIPLES: MATERIALITY AND CONSERVATISM 146
Materiality 146
Conservatism 147
INTERNATIONAL PERSPECTIVE: AN EXTREME FORM OF CONSERVATISM THAT ENCOURAGES INCOME MANIPULATION 149
Appendix 4A The Time Value of Money 152
INTEREST: THE PRICE OF MONEY 152
TIME VALUE 153
Size of Time Value 153
Inflation 153
TIME VALUE COMPUTATIONS 154
Future Value 154
Present Value 158
An Illustration 159
PRESENT VALUE AND FINANCIAL ACCOUNTING 163
5 THE MECHANICS OF FINANCIAL ACCOUNTING 182
5 The Mechanics of Financial Accounting 182
ECONOMIC EVENTS 183
Relevant Events 183
Objectivity 183
THE FUNDAMENTAL ACCOUNTING EQUATION 184
Assets 184
Stockholders Equity 185
BUSINESS TRANSACTIONS,THE ACCOUNTING EQUATION,AND THE FINANCIAL STATEMENTS 185
Liabilities 185
Transactions and the Accounting Equation 186
The Accounting Equation and the Financial Statements 187
THE JOURNAL ENTRY 190
RECOGNIZING GAINS AND LOSSES 196
PERIODIC ADJUSTMENTS 197
Accruals 197
Cost Expirations 200
Revaluation Adjustments 206
FINANCIAL STATEMENT PRESENTATION IN A MULTINATIONAL ENVIRONMENT 207
Appendix 5A The Accounting Cycle: An Overview 215
The Journal 216
The Ledger 217
The Work Sheet 218
Preparation of the Financial Statements 224
A COMPREHENSIVE EXAMPLE OF THE ACCOUNTING CYCLE 226
Appendix 5B Mechanics: A User s Perspective 230
PART 3 ASSETS: A CLOSER LOOK 258
6 THE CURRENT ASSET CLASSIFICATION,CASH,AND ACCOUNTS RECEIVABLE 258
6 The Current Asset Classification,Cash,and Accounts Receivable 258
PART 3 ASSETS:A CLOSER LOOK 258
THE CURRENT ASSET CLASSIFICATION 259
The Relative Size of Current Assets Across Industries 260
Measures Using Current Assets: Working Capital,Current Ratio,and Quick Ratio 260
The Economic Consequences of Working Capital,the Current Ratio,and the Quick Ratio 262
Limitations of the Current Asset Classification 263
CASH 264
Restrictions on the Use of Cash 265
Proper Management of Cash 266
Control of Cash 267
ACCOUNTS RECEIVABLE 267
Importance of Accounts Receivable 268
Net Realizable Value: The Valuation Base for Accounts Receivable 269
Cash Discounts 270
Accounting for Uncollectibles (Bad Debts) 272
Accounting for Sales Returns 278
ACCOUNTS RECEIVABLE FROM A USER S PERSPECTIVE 278
When Should a Receivable Be Recorded? 278
Balance Sheet Valuation of Receivables 280
THE COLLECTION PERIOD FOR ACCOUNTS RECEIVABLE 281
Appendix 6A Short-Term Notes Receivable 286
ACCOUNTING FOR SHORT-TERM NOTES RECEIVABLE 286
Example: Housing Finance Company 287
Methods 1 and 2 Compared 288
Financial Institutions and Uncollectible Loans 288
Appendix 6B 289
Accounting for Receivables and Payables Expressed in Foreign Currencies 289
Exchange Rates Among Currencies 290
Receivables and Payables Held in Other Currencies 291
Hedging and the Economic Consequences of Fluctuating Exchange Rates 293
7 MERCHANDISE INYENTORY 311
7 Merchandise Inventory 311
THE RELATIVE SIZE OF INVENTORIES 312
ACCOUNTING FOR INVENTORY: FOUR IMPORTANT ISSUES 312
ACQUIRING INVENTORY: WHAT COSTS TO CAPITALIZE? 313
What Items or Units to Include? 314
Determining the Costs of Manufacturing Inventories 316
CARRYING INVENTORY: THE PERPETUAL OR PERIODIC METHOD? 317
Perpetual and Periodic Methods: Costs and Benefits 319
Errors in the Inventory Count 321
SELLING INVENTORY: WHICH COST FLOW ASSUMPTION? 322
Specific Identification 323
Three Inventory Cost Flow Assumptions: Averaging,FIFO,and LIFO 324
Inventory Cost Flow Assumptions:Effects on the Financial Statements 326
Inventory Cost Flow Assumptions: Effects on Federal Income Taxes 327
Choosing an Inventory Cost Flow Assumption: Trade-Offs 328
ENDING INVENTORY: APPLYING THE LOWER-OF-COST-OR-MARKET RULE 332
The Lower-of-Cost-or-Market Rule and Hidden Reserves 333
INTERNATIONAL PERSPECTIVE: JAPANESE BUSINESS AND INVENTORY ACCOUNTING 334
Appendix 7A 339
Determining Market Values for Inventories and Applying the Lower-of-Cost-or-Market Rule 339
8 INVESTMENTS IN EQUITY SECURITIES 355
8 Investments in Equity Securities 355
EQUITY SECURITIES CLASSIFIED AS CURRENT 356
The Intention to Convert: Another Area of Subjectivity 357
The Existence of a Ready Market 357
TRADING AND AVAILABLE-FOR-SALE SECURITIES 358
Declaration and Receipt of Cash Dividends 359
Purchasing Trading and Available-for-Sale Securities 359
Price Changes of Securities on Hand at the End of the Accounting Period 360
Sale of Securities 360
Discussion of Mark-to-Market Accounting 363
Reclassifications and Permanent Market Value Declines 363
Accounting for Long-Term Equity Investments 364
LONG-TERM EQUITY INVESTMENTS 364
The Cost Method 365
The Equity Method 366
Some Cautions to Financial Statement Users About the Equity Method 368
Business Acquisitions,Mergers,and Consolidated Financial Statements 369
The Equity Method or Consolidated Statements? 371
Accounting for Equity Investments: A Summary 372
GOODWILL ACCOUNTING: CONTROVERSY AND INTERNATIONAL IMPLICATIONS 374
Appendix 8A 379
Consolidated Financial Statements 379
Accounting for Business Acquisitions and Mergers: The Purchase Method 380
Preparing Consolidated Financial Statement for Multinational 391
Quality of Earnings Cases A Comprehensive Review 409
CASE 1: LIBERTY MANUFACTURING 409
CASE 2: MICROLINE CORPORATION 412
CASE 3: TECHNIC ENTERPRISES AND SONAR-SUN INC. 416
9 Long-Lived Assets 423
9 LONG-LIVED ASSETS 423
THE RELATIVE SIZE OF LONG-LIVED ASSETS 424
LONG-LIVED ASSET ACCOUNTING: GENERAL ISSUES AND FINANCIAL STATEMENT EFFECTS 425
AN OVERVIEW OF LONG-LIVED ASSET ACCOUNTING 428
ACQUISITION: WHAT COSTS TO CAPITALIZE? 428
The Acquisition of Land 429
Lump-Sum Purchases 429
Construction of Long-Lived Assets 430
POSTACQUISITION EXPENDITURES: BETTERMENTS OR MAINTENANCE? 431
COST ALLOCATION: AMORTIZING CAPITALIZED COSTS 432
Estimating the Useful Life and Salvage Value 432
Revising the Useful-Life Estimate 433
Cost Allocation (Depreciation) Methods 434
Cost Allocation Methods and the Matching Principle 440
How Does Management Choose an Acceptable Cost Allocation Method? 440
Depreciation Methods for Income Tax Purposes 441
DISPOSAL: RETIREMENTS,SALES,AND TRADE-INS 443
Retirement of Long-Lived Assets 443
Trade-Ins of Long-Lived Assets 444
Sale of Long-Lived Assets 444
INTERNATIONAL PERSPECTIVE: LONG-LIVED ASSETS AND CURRENT VALUES 446
Appendix 9A 450
Intangible Assets and Deferred Costs 450
COPYRIGHTS,PATENTS,AND TRADEMARKS 451
THE COSTS OF DEVELOPING COMPUTER SOFTWARE 451
GOODWILL 452
ORGANIZATIONAL COSTS 453
RESEARCH AND DEVELOPMENT COSTS 453
Appendix 9B 454
Accounting for Long-Lived Assets—A Review and Critique 454
PROBLEMS WITH HISTORICAL COST 454
PROBLEMS WITH COST ALLOCATION 455
MISCONCEPTIONS ABOUT COST ALLOCATION 455
PART 4 LIABILITIES AND STOCKHOLDERS EQUITY:A CLOSER LOOK 474
10 Introduction to Liabilities:Economic Consequences,Current Liabilities,and Contingencies 474
10 INTRODUCTION TO LIABILITIES: ECONOMIC CONSEQUENCES,CURRENT LIABILITIES,AND CONTINGENCIES 474
PART 4 LIABILITIES AND STOCKHOLDERS EQUITY: A CLOSER LOOK 475
WHAT IS A LIABILITY? 475
THE RELATIVE SIZE OF LIABILITIES ON THE BALANCE SHEET 475
REPORTING LIABILITIES ON THE BALANCE SHEET: ECONOMIC CONSEQUENCES 476
Stockholders and Investors 476
Creditors 477
Management 477
Auditors 478
CURRENT LIABILITIES 479
The Relative Size of Current Liabilities on the Balance Sheet 479
Valuing Current Liabilities on the Balance Sheet 480
Reporting Current Liabilities: An Economic Consequence 480
ACCOUNTING FOR CURRENT LIABILITIES 481
Determinable Current Liabilities 481
Contingent Liabilities: A Scenario 489
CONTINGENCIES AND CONTINENT LIABILITIES 489
Accounting for Contingencies 491
INTERNATIONAL PERSPECTIVE: EXECUTIVE COMPENSATION AND U.S.BUSINESS IN THE GLOBAL MARKETPLACE 495
Appendix 10A 501
Retirement Costs: Pensions and Postretirement Health Care and Insurance 501
PENSIONS 501
Defined-Contribution Plan 501
Defined-Benefit Plan 502
POSTRETIREMENT HEALTH CARE AND INSURANCE COSTS 504
Deferred Income Taxes 505
THE CONCEPT OF DEFERRED INCOME TAXES 505
Appendix 10B 505
ACCOUNTING ENTRIES FOR DEFERRED INCOME TAXES 506
DEFERRED INCOME TAXES: ADDITIONAL ISSUES 507
THE CONSERVATISM RATIO 509
11 Long-Term Liabilities: Notes,Bonds,and Leases 527
11 LONG-TERM LIABILITIES: NOTES,BONDS,AND LEASES 527
THE RELATIVE SIZE OF LONG-TERM LIABILITIES 528
THE ECONOMIC CONSEQUENCES OF REPORTING LONG-TERM LIABILITIES 530
BASIC DEFINITIONS AND DIFFERENT CONTRACTUAL FORMS 531
EFFECTIVE INTEREST RATE 532
Installment and Non-Interest-Bearing Obligations 532
Interest-Bearing Obligations 533
ACCOUNTING FOR LONG-TERM OBLIGATIONS: THE EFFECTIVE INTEREST METHOD 534
ACCOUNTING FOR LONG-TERM NOTES PAYABLE 535
Equipment Exchanged for a Non-Interest-Bearing Note 535
BONDS PAYABLE 537
Bond Terminology 537
The Price of a Bond 539
The Effective Rate and the Stated Rate 540
Accounting for Bonds Payable 541
The Effective Interest Method and Changing Interest Rates 546
Bond Redemptions 547
Financial Instruments and Off-Balance-Sheet Risks 548
LEASES 549
Operating Leases 550
Capital Leases 550
Operating Leases,Capital Leases,and Off Balance-Sheet Financing 552
INTERNATIONAL PERSPECTIVE: THE IMPORTANCE OF DEBT FINANCING IN OTHER COUNTRIES 554
Appendix 11A 559
Accounting for Long-Term Investments in Debt Securities 559
Long-Term Notes Receivable 559
Accounting for Long-Term Notes Receivable 560
Investments in Corporate Bonds 561
Accounting for Investments in Corporate Bonds 562
The Determination of Bond Prices 564
Appendix 11B 564
Determine the Effective (Actual)Rate of Return 565
Determine the Required Rate of Return 565
Compare the Effective Rate to the Required Rate 566
Factors Determining Bond Prices 566
12 Stockholders Equity 585
12 STOCKHOLDERS EQUITY 585
THE RELATIVE IMPORTANCE OF LIABILITIES,CONTRIBUTED CAPITAL,AND EARNED CAPITAL 586
Characteristics of Debt 587
DEBT AND EQUITY DISTINGUISHED 587
Characteristics of Equity 588
Why Is It Important to Distinguish Debt From Equity 588
THE ECONOMIC CONSEQUENCES ASSOCIATED WITH ACCOUNTING FOR STOCKHOLDERS EQUITY 591
ACCOUNTING FOR STOCKHOLDERS EQUITY 592
Preferred Stock 593
Common Stock 596
Treasury Stock 598
Stock Options 602
Retained Earnings 603
THE STATEMENT OF STOCKHOLDERS EQUITY 609
INTERNATIONAL PERSPECTIVE: THE RISE OF INTERNATIONAL EQUITY MARKETS 610
Appendix 12A 617
Forms of Business 617
THE CORPORATE FORM OF ORGANIZATION 617
Corporate Income Taxes 618
Stockholder Returns: Capital Appreciation and Dividends 618
Limited Liability 618
PROPRIETORSHIPS AND PARTNERSHIPS 619
Legal Liability of Partners: Unlimited 619
Income Taxes: Personal Rates and Unaffected by Withdrawals 619
Returns to Partners: Limited Markets but Relatively Free Withdrawals 620
CHOOSING A FORM OF BUSINESS: A SUMMARY 620
PART 5 INCOME AND FLOWS 642
13 The Complete Income Statement 642
13 THE COMPLETE INCOME STATEMENT 642
PART 5 INCOME AND FLOWS 642
THE ECONOMIC CONSEQUENCES ASSOCIATED WITH INCOME MEASUREMENT AND DISCLOSURE 643
THE MEASUREMENT OF INCOME: DIFFERENT MEASURES FOR DIFFERENT OBJECTIVES 644
Capital and Operating Transactions: A Framework 646
Classifying Operating Transactions 648
A COMPLETE INCOME STATEMENT DISCLOSURE AND PRESENTATION 649
(1)Operating Revenues and Expenses: Usual and Frequent 651
(2)Other Revenues and Expenses: Unusual or Infrequent 651
(3)Disposal of a Business Segment 652
(4)Extraordinary Items: Unusual and Infrequent 654
(5)Changes in Accounting Principles 654
EARNINGS-PER-SHARE DISCLOSURE 656
INTRAPERIOD TAX ALLOCATIOIN 658
INCOME STATEMENT CATEGORIES: USEFUL FOR DECISIONS BUT SUBJECTIVE 659
RETAINED EARNINGS AND PRIOR ADJUSTMENTS 661
INTERNATIONAL PERSPECTIVE: INVESTMENTS AND INCOME STATEMENT DISCLOSURE 661
14 THE STATEMENT OF CASH FLOWS 682
14 The Statement of Cash Flows 682
THE DEFINITON OF CASH 683
A GENERAL DESCRIPTION OF THE STATEMENT OF CASH FLOWS 684
Cash Provided (Used) by Operating Activities 685
Cash Provided (Used)by Investing Activities 686
Cash Provided (Used)by Financing Activities 686
HOW THE STATEMENT OF CASH FLOWS COMPLEMENTS THE INCOME STATEMENT AND BALANCE SHEET 688
HOW THE STATEMENT OF CASH FLOWS CAN BE USED 689
Analyzing the Statement of Cash Flows 689
The Importance of Cash From Operating Activities 690
The Importance of Significant Noncash Transactions 691
THE STATEMENT OF CASH FLOWS: ECONOMIC CONSEQUENCES 692
THE MECHANICS OF PREPARING THE STATEMENT OF CASH FLOWS 693
A Conceptual Description of the Statement of Cash Flows 693
Deriving Cash Flow From Accrual Financial Statements, 695
Cash Provided (Used)by Operating Activities, 696
Cash Provided (Used)by Investing Activities 701
Cash Provided (Used)by Financing Activities 702
THE COMPLETE STATEMENT OF CASH FLOWS 704
The Direct Method 704
The Indirect Method 704
The Direct and Indirect Methods: A Reconciliation 706
ANALYZING THE STATEMENT OF CASH FLOWS: AN APPLICATION 707
Explaining the Changes in the Cash Balance 707
Summarizing the Cash Effects of Operating Transactions 707
INTERNATIONAL PRESPECTIVE: THE STATEMENT OF CASH FLOWS 708
Summarizing the Cash Effect of Investing and Financing Transactions 708
Quality of Earnings Cases 734
A Comprehensive Review 734
CASE 1: AVERY CORPORATION 734
CASE 2: ZENITH SERVICES 739
CASE 3: PIERCE AND SNOWDEN 743
APPENDICES 753
A CONVERTING ACCRUAL NUMBERS TO CASH FLOWS: THE DIRECT AND INDIRECT FORMS OF PRESENTATION 753
APPENDICES 753
A Converting Accrual Numbers to Cash Flows:The Direct and Indirect Forms of Presentation 753
PRESENTING THE OPERATING SECTION OF THE STATEMENT OF CASH FLOWS: DIRECT AND INDIRECT METHODS 756
T-ACCOUNT ANALYSIS: ANOTHER METHOD TO CONVERT ACCRUAL NUMBERS TO CASH FLOWS 756
B FINANCIAL ACCOUNTING SIMULATION PROJECT 764
B Financial Accounting Simulation Project 764
C THE ANNUAL REPORT OF MCI CORPORATION 783
C The Annual Report of MCI Corporation 783