c Financial Accounting

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1 c Financial Accounting A Business Process Approach Rollins College^ Crummer Graduate School of Business THIRP-- EDITION Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

2 Contents Chapter 1 Business: What's It All About? 1 Purpose and Organization of a Business 2 What Is a Business All About? 3 The Nature of Business Operations 3 Ownership Structure of a Business 4 Sole Proprietorships 4 Partnerships 5 Corporations 6 Limited Liability Partnerships (LLP) and Corporations (LLC) 8 Business Activities and the Flow of Goods and Services 8 Information Needs for Decision Making in Business 10 Who Needs Information about Transactions of the Business? 11 Setting Guidelines 11 International Financial Reporting Standards 11 Other Users of Accounting Information 12 Accounting Information: A Part of the Firm's Information System 13 Overview of the Financial Statements 13 Balance Sheet 13 Income Statement 17 The Difference between the Balance Sheet and the Income Statement 18 Statement of Changes in Shareholders' Equity 19 Statement of Cash Flows 20 Flow of Information and the Financial Statements 23 Real Company Financial Statements 23 Business Risk, Control, and Ethics 26 Chapter Summary Points 28 Chapter Summary Problems 28 Key Terms for Chapter 1 29 Answers to YOUR-TURN Questions 30 Financial Statement Analysis 47 Critical Thinking Problems 49 Internet Exercise: Disney Corporation 49 Chapter 2 Qualities of Accounting Information 51 Information for Decision Making 52 Characteristics of Accounting Information 53 What Makes Information Useful? 53 Relevant 53 Reliable 53 Comparable 53 Consistent 54 Assumptions Underlying Financial Reporting 54 Principles Underlying Financial Reporting 55 Elements of the Financial Statements 56 Transactions for the Second Month of Business 56 Assets 62 Liabilities 62 Shareholders' Equity 64 Measurement and Recognition in Financial Statements 64 Measuring Assets 64 Recognizing Revenues and Expenses 65 Accruals and Deferrals 66 Accrual Basis Accounting 66 VII

3 VIII CONTENTS Chapter 3 Chapter 4 Cash Basis versus Accrual Basis Accounting 66 Accounting Periods and Cutoff Issues 67 How Investors Owners and Creditors Use Accrual Accounting Information 67 An Example to Illustrate the Information Financial Statements Provide 68 Putting It All Together The Objectives of Financial Statements 72 Real Company Financial Statements 73 Applying Your Knowledge: Ratio Analysis 75 Business Risk, Control, and Ethics 75 Internal Controls Definition and Objectives 76 Special Internal Control Issues Related to Financial Statements 76 Preventive Controls 76 Detective Controls 76 Corrective Controls 77 Chapter Summary Points 77 Chapter Summary Problems 77 Key Terms for Chapter 2 81 <> Answers to YOUR TURN Questions 81 Financial Statement Analysis 94 Critical Thinking Problems 96 Internet Exercise: MSN Money and Merck 96 Accruals and Deferrals: Timing Is Everything in Accounting Measuring Income 98 The Income Statement 98 Accruals 99 Accrued Revenue 99 Accrued Expenses 101 Reporting Interest Expense 102 Other Accrued Expenses 102 Deferrals 104 Deferred Revenue 104 Subscriptions 105 Gift Cards 105 Deferred Expenses 106 Insurance 106 Rent 107 Supplies 108 Equipment 109 Effects of Accruals and Deferrals on Financial Statements 112 Team Shirts Transactions for March 112 Adjustments to the Accounting Records 115 Preparing the Financial Statements 116 Accruals and Deferrals on Real Firms' Financial Statements 119 Applying Your Knowledge: Ratio Analysis 121 Profit Margin on Sales Ratio 121 Business Risk, Control, and Ethics 122 Errors in Recording and Updating the Accounting Records 123 Unauthorized Access to the Accounting Information 123 Loss or Destruction of Accounting Data 123 Chapter Summary Points 124 Chapter Summary Problems Chapter Answers to YOUR TURN Questions Key Terms for Financial Statement Analysis 150 Critical Thinking Problems 152 Internet Exercise: Darden 152 Payment for Goods and Services: Cash and Accounts Receivable 153 Controlling Cash 154 Safeguarding Cash 154 Assignment of Responsibilities for Cash 154 Bank Reconciliations 154 Steps in the Reconciliation 156 Reconciling Items 156 An Example of a Bank Reconciliation and the Adjustments 159 Reporting Cash 160 Cash Equivalents 160 The Statement of Cash Flows 160

4 CONTENTS ix Accounts Receivable and Bad Debts Expense 161 Extending Credit 161 Recording Uncollectible Accounts 162 Methods of Estimating Bad Debts Expense 162 Allowance Method Percentage of Sales Method 162 Allowance Method Accounts Receivable Method 163 Writing Off a Specific Account 165 The Direct Write-Off Method 168 Credit Card Sales 169 NEWSFLASH 170 Notes Receivable 170 Team Shirts for April 171 Applying Your Knowledge: Ratio Analysis 175 Business Risk, Control, and Ethics 177 Clear Assignment of Responsibility 177 Specific Procedures for Documentation 177 > Independent Internal Verification of Data 178 Chapter Summary Points 178 Chapter Summary Problem 179 Key Terms for Chapter4 181 Answers to YOUR TURN Questions 181 Financial Statement Analysis 198 Critical Thinking Problems 199 Internet Exercise: Intel Corporation 200 Chapter 5 The Purchase and Sale of Inventory 201 Acquiring and Selling Merchandise 202 An Operating Cycle 202 Acquiring Merchandise for Sale 202 Acquisition Process for Inventory 203 Recording Purchases 204 Who Pays the Freight Costs to Obtain Inventory? 204 Purchase Returns and Allowances 205 Purchase Discounts 206 Summary of PurchaseS'for Quality Lawn Mowers 207 Selling Merchandise '207 Sales Process 208 Recording Sales 208 Sales Returns and Allowances 209 Sales Discounts and Shipping Terms 209 Summary of Purchases and Sales for Quality Lawn Mowers 210 Sales Taxes 210 Recording Inventory: Perpetual Versus Periodic Record Keeping 211 Differences between Perpetual and Periodic Inventory Systems 211 Inventory Cost Flow Assumptions 211 Specific Identification 212 Weighted Average Cost 213 First-ln, First-Out Method (FIFO) 214 Last-In, First-Out Method (LIFO) 215 How Inventory Cost Flow Assumptions Affect the Financial Statements 217 Differences in Reported Inventory and Cost of Goods Sold under Different Cost Flow Assumptions 217 Conclusions about Inventory Cost Flow Assumptions 222 Income Tax Effects of LIFO and FIFO 222 How Do Firms Choose an Inventory Cost Flow Method? 223 NEWS FLASH: IFRS in the News 225 Applying Inventory Assumptions to Team Shirts 225 Complications in Valuing Inventory: Lower-of-Cost-or-Market Rule 230 Financial Statement Analysis 231 Gross Profit Ratio 231 Inventory Turnover Ratio 232 Business Risk, Control, and Ethics 233 Obsolescence 234 The Ethics of Inventory Losses 234

5 CONTENTS Chapter Summary Points 234 Chapter Summary Problem 235 Key Terms for Chapter Answers to YOUR TURN Questions 238 * Financial Statement Analysis 259 Critical Thinking Problems 260 Internet Exercise: Gap 260 Appendix 5A: Inventory Errors 262 Appendix 5B: Gross Profit Method of Estimating Ending Inventory 265 Chapter 6 Acquisition and Use of Long-Term Assets 267 Acquiring Long-Term Assets 268 Types of Long-Lived Assets: Tangible and Intangible 268 Acquisition Costs 268 Basket Purchase Allocation 270 Using Long-Term Tangible Assets: Depreciation and Depletion 270 Straight-Line Depreciation 272 Activity (Units-of-Production) Depreciation 274 Declining Balance Depreciation 276 Depletion 278 Using Intangible Assets: Amortization 279 Copyrights 279 Patents 279 Trademarks 280 Franchises 280 Goodwill 280 Research and Development Costs 280 Changes after the Purchase of the Asset 281 Asset Impairment 281 Expenditures to Improve an Asset or Extend Its Useful Life 281 Revising Estimates of Useful Life and Salvage Value 282 Selling Long-Term Assets 283 Presentation of Long-Term Assets on the Financial Statements 285 Reporting Long-Term Assets 285 NEWS FLASH: IFRS and Long-Lived Assets 286 Preparing Statements for Team Shirts 286 Applying Your Knowledge Ratio Analysis 289 Return on Assets 289 Asset Turnover Ratio 290 Business Risk, Control, and Ethics 291 Chapter Summary Points 291 Chapter Summary Problems 292 Key Terms for Chapter Answers to YOUR TURN Questions 295 Financial Statement Analysis 314 Critical Thinking Problems 314 Internet Exercise: Best Buy 315 Appendix 6: Depreciation and Taxes 316 Chapter 7 Accounting for Liabilities 317 Types of Liabilities 318 Definitely Determinable Liabilities 318 Payroll 318 Other Short-Term Liabilities: Using a Line of Credit 321 Estimated Liabilities 321 Warranties 321 Long-Term Notes Payable and Mortgages 323 Long-Term Liabilities: Raising Money by Issuing Bonds 325 What Is a Bond? 325 Issuing Bonds Payable: Getting the Money 326 Recording the Bond Issue 327 Bonds Issued at a Discount 328 Bonds Issued at a Premium 329 Paying the Bondholders 329 Amortizing Bond Discounts and Premiums: Effective Interest Method 329 Straight-Line Amortization of Bond Discounts and Premiums 332 Team Shirts for July 333 Applying Your Knowledge: Financial Statement Analysis 338 Business Risk, Control, and Ethics 339

6 CONTENTS xi Chapter Summary Points 340 Chapter Summary Problems 340 -Key Terms for Chapter Answers to YOUR TURN Questions 343 Financial Statement Analysis 357 Critical Thinking Problems 359 Internet Exercise: Starbucks 360 Appendix 7: Time Value of Money 361 Chapter 8 Accounting for Shareholders' Equity 371 Components of Shareholders' Equity in a Corporation Contributed Capital 372 Stock Authorized, Issued, and Outstanding 372 Common Stock 373 Preferred Stock 376 Cash Dividends 376 Important Dates Related to Dividends 376 Declaration Date 376 Date of Record 377 Payment Date 377 Distribution of Dividends between Common and Preferred Shareholders 377 An Example of a Dividend Payment 378 Treasury Stock 379 Why Do Firms Buy Their Own Stock? 379 Accounting for the Purchase 380 Selling Treasury Stock 380 Reporting Treasury Stock 381 Stock Dividends and Stock Splits 382 Stock Dividends 382 Stock Splits 383 Retained Earnings 383 Team Shirts Issues New Stock 384 Applying Your Knowledge: Ratio Analysis 388 Return on Equity 388 Earnings Per Share 389 Business Risk, Control, and Ethics 391 Risks Faced by Owners j 391 Chapter Summary Points 391 Chapter Summary Problems 392 Key Terms forchapters 393 Answers to YOUR TURN Questions 394 Financial Statement Analysis 411 Critical Thinking Problems 412 Internet Exercise: Hershey Foods Corporation 412 Chapter 9 Preparing and Analyzing the Statement of Cash Flows 415 The Importance of the Statement of Cash Flows 416 Two Methods of Preparing and Presenting the Statement of Cash Flows 417 Accrual Accounting versus Cash Basis Accounting 418 Sales versus Cash Collected from Customers 418 Salary Expense versus Cash Paid to Employees 419 Preparing the Statement of Cash Flows: Direct Method 420 Revenue -> Cash Collected from Customers 420 Cost of Goods Sold -> Cash Paid to Vendors 421 Other Expenses -> Cash Paid for Other Expenses 422 Summary of Direct Method 422 Preparing the Statement of Cash Flows: Indirect Method 423 Start with Net Income 423 Examine Current Asset and Current Liability Accounts 423 Comparing the Direct and Indirect Methods 425 Cash from Investing and Financing Activities 425 Investing Activities 425 Financing Activities 425 Putting It All Together 426 Summary of Direct and Indirect Methods 427 Applying Your Knowledge: Financial Statement Analysis 427 Cash from Operating Activities AutoZone 427 Cash from Investing Activities AutoZone 427 Cash from Financing Activities AutoZone 428

7 XII CONTENTS Other Characteristics of the Statement of Cash Flows 429 Free Cash Flow 429 Business Risk, Control, and Ethics 430 Chapter Summary Points 430 Chapter Summary Problems 431 Key Terms for Chapter Answers to YOUR TURN Questions 434» Financial Statement Analysis 456 Critical Thinking Problems 459 Internet Exercise: Carnival Corporation 459 Chapter 10 Using Financial Statement Analysis to Evaluate Firm Performance 461 A Closer Look at the Income Statement 462 Discontinued Operations 462 Extraordinary Items 463 Horizontal and Vertical Analysis of Financial Information 463 Horizontal Analysis 464 Vertical Analysis 465 Ratio Analysis 466 A Review of All Ratios 466 Liquidity Ratio with Cash Flows 467 Market Indicator Ratios 468 Understanding Ratios 469 Using Ratio Analysis 470 Liquidity Ratios 470 Current Ratio 470 Cash from Operations to Current Liabilities Ratio 471 Inventory Turnover Ratio 472 Accounts Receivable Turnover Ratio 472 Profitability Ratios 474 Financial Statement Analysis More than Numbers 474 Business Risk, Control, and Ethics 475 NEWS FLASH 475 Chapter Summary Points 476 Chapter Summary Problems 476 Key Terms for Chapter Answers to YOUR TURN Questions 480 Critical Thinking Problems 503 Internet Exercise: Papa John's International 504 Appendix 10A: Comprehensive Income 505 Appendix 10B: Investments in Securities 507 Chapter 11 Quality of Earnings, Corporate Governance, and IFRS 511 Why Are Earnings Important? 512 The Quality of Earnings 512 Common Ways to Manipulate Earnings 513 Big Bath Charges 513 Cookie Jar Reserves 514 Revenue Recognition 515 What We Learned from the Business Scandals of the Early 2000s 515 The Sarbanes-Oxley Act of Key Players in Corporate Governance 517 NEWS FLASH 519 Outlook for the Future 519 Evaluating Corporate Governance 520 Defining and Measuring Good Corporate Governance 520 How Can We Evaluate a Firm's Corporate Governance? 520 International Financial Reporting Standards (IFRS) 521 You Have Come a Long Way 524 Chapter Summary Points 524 Key Terms for Chapter Answers to YOUR TURN Questions 524 Internet Exercises 527 Appendix A: Selection from Books-A-Million 2009 Annual Report Appendix B: The Mechanics of an Accounting System 563 Glossary 609 Index

FINANCIAL ACCOUNTING. Jeffrey Waybright. Robert Kemp. Spokane Community College. University of Virginia

FINANCIAL ACCOUNTING. Jeffrey Waybright. Robert Kemp. Spokane Community College. University of Virginia FINANCIAL ACCOUNTING Jeffrey Waybright Spokane Community College Robert Kemp University of Virginia Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London