Financial Accounting

Financial Accounting Roger H. Hermanson, Ph.D., CPA Regents' Professor of Accounting Ernst & Whinney Professor School of Accountancy Georgia State University James Don Edwards^ Ph.D., CPA J. M. Tull Professor of Accounting J. M. Tull School of Accounting University of Georgia L. Gayle Rayburn, Ph.D., CPA, CIA, CMA Professor of Accounting School of Accountancy Memphis State University Fourth Edition 1989 IRWIN Homewood, IL 60430 Boston, MA 02116

Contents Introduction: The Accounting Environment 1 Learning Objectives, 1 Accounting Defined, 2 Employment Opportunities in Accounting, 4 Public Accounting. Private or Industrial Accounting. Governmental and Other Not-for-Profit Accounting. Financial Accounting versus Managerial Accounting, 6 Financial Accounting. Managerial Accounting. Development of Financial Accounting Standards, 8 American Institute of Certified Public Accountants (AICPA). Financial Accounting Standards Board (FASB). Governmental Accounting Standards Board (GASB). Securities and Exchange Commission (SEC). American Accounting Association (AAA). Summary, 9 New Terms, 10 Questions, 11 PART1 The Basic Accounting Model 13 1 Accounting and Its Use in Business Decisions 14 Learning Objectives, 14 Forms of Business Organizations, 15 Single Proprietorship. Partnership. Corporation. Types of Business Activities Performed by Business Organizations, 16 Financial Statements of Business Organizations, 17 The Balance Sheet. The Income Statement. The Statement of Retained Earnings. The Financial Accounting Process, 20 The Accounting Equation. Accounting Assumptions. Analysis of Transactions. Summary, 30 New Terms, 31 Demonstration Problem, 32 Questions, 35 Exercises, 35 Problems (A), 37 (B), 40 Business Decision Problems, 43 2 Recording Business Transactions 45 Learning Objectives, 45 The Account, 46 The T-Account. Debits and Credits. Double-Entry Procedure. Determining the Balance of an Account. Rules of Debit and Credit Summarized. The Ledger, 52 The Accounting Process in Operation, 52 The Effects of Transactions on the Accounts. The Journal, 59 The General Journal. Journalizing. Posting. Cross-Indexing. Compound Journal Entries. Summary of Functions and Advantages of a Journal. Posting and Cross-Indexing An Illustration. The Trial Balance, 69 Summary, 70 New Terms, 71 Demonstration Problem, 72 Questions, 77 Exercises, 78 Problems (A), 80 (B), 84 Business Decision Problem, 87 xiii

Xj v Contents Adjusting the Accounts 89 Learning Objectives, 89 The Need for Adjusting Entries, 90 Cash versus Accrual Basis Accounting. Classes and Types of Adjusting Entries, 92 Adjustments for Deferred Items, 94 Asset/Expense Adjustments Prepaid Expenses and Depreciation. Liability I Revenue Adjustments Unearned Revenues. Adjustments for Accrued Items, 103 Asset/Revenue Adjustments Accrued Assets. Liability!Expense Adjustments Accrued Liabilities. Effects of Failing to Prepare Adjusting Entries, 107 SummaryT 107 New Terms, 108 Demonstration Problem, 109 Questions, 111 Exercises, 111 Problems (A), 113 (B), 116 Business Decision Problems, 119 Completing the Accounting Cycle: Work Sheet, Closing Entries, and Classified Balance Sheet 121 ^--^ Learning Objectives, 121 The Accounting Cycle Summarized, 122 The Work Sheet, 123 The Trial Balance Columns. The Adjustments Columns. The Adjusted Trial Balance Columns. The Income Statement Columns. The Statement of Retained Earnings Columns. The Balance Sheet Columns. Preparing Financial Statements from the Work Sheet, 133 Income Statement. Statement of Retained Earnings. Balance Sheet. Journalizing Adjusting Entries, 134 The Closing Process, 136 Step 1: Closing the Revenue Account(s). Step 2: Closing the Expense Account(s). Step 3: Closing the Income Summary Account. Step 4: Closing the Dividends Account. The Closing Process Summarized. Post-Closing Trial Balance. The Classified Balance Sheet, 143 Current Assets. Long-Term Investments. Property, Plant, and Equipment. Intangible Assets. Current Liabilities. Long-term Liabilities. Stockholders' Equity. Summary, 147 Appendix 4-A: Reversing Entries, 148 Appendix 4-B: Ledger Accounts after Closing Process Completed, 151 New Terms, 156 Demonstration Problem, 158 Questions, 160 Exercises, 161 Problems (A), 164 (B), 170 Business Decision Problem, 174 Comprehensive Review Problem, 176 Merchandising Transactions, Introduction to Inventories, and Classified Income Statement 178 Learning Objectives, 178 Two Income Statements Compared Service Company and Merchandising Company, 179 Sales Revenues, 180 Recording Gross Sales. Recording Deductions from Gross Sales. Reporting Net Sales in the Income Statement. Cost of Goods Sold, 185 Two Procedures for Accounting for Inventories. Purchases of Merchandise. Deductions from Purchases. Transportation Costs. Merchandise Inventories. Determining Cost of Goods Sold. Lack of Control under Periodic Inventory Procedure. Classified Income Statement, 194 Important Relationships in the Income Statement. The Work Sheet for a Merchandising Company, 197 Completing the Work Sheet. Financial Statements for a Merchandising Company. Closing Entries. Summary, 204 Appendix: Alternative Closing Procedure, 204 New Terms, 207 Demonstration Problems, 209 Questions, 216 Exercises, 217 Problems (A), 219 (B), 224 Business Decision Problems, 228

Contents 6 Measuring and Reporting Inventories 231 Learning Objectives, 231 Inventories and Cost of Goods Sold, 232 Taking a Physical Inventory. Importance of Proper Inventory Valuation. Determining Inventory Cost, 235 Costs Included in Inventory Cost. Inventory Valuation under Changing Prices. Methods of Determining Inventory Cost. Differences in Cost Methods Summarized. Departures from Cost Basis of Inventory Measurement, 244 Net Realizable Value. Lower-of- Co$t-or-Market Method. Changing Inventory Methods. Estimating Inventory. Perpetual Inventory Procedure, 249 Perpetual Inventory Records. Journal Entries under Perpetual Procedure. Summary, 251 New Terms, 252 Demonstration Problems, 253 Questions, 256 Exercises, 256 Problems (A), 259 (B), 262 Business Decision Problems, 266 7 Accounting Systems and Special Journals 267 Learning Objectives, 267 The Processing of Data Manual System, 268 Control Accounts and Subsidiary Ledgers, 269 Special Journals, 270 Sales Journal. Cash Receipts Journal. Combined Sales and Cash Receipts Journal. The Purchases Journal. Cash Disbursements Journal. A Combined Purchases and Cash Disbursements Journal. General Ledger Illustrated. The General Journal. Alternative Methods of Processing Data, 290 Manual System. Bookkeeping Machine System. Microcomputers and Minicomputers. Service Bureaus. Time-Sharing Terminals. Mainframe In-House Computer. Summary, 291 Appendix 7-A: The Use of the Microcomputer in Accounting, 292 Appendix 7-B: The Computer Basic Concepts, 301 New Terms, 303 Demonstration Problems, 304 Questions, 307 Exercises, 307 Problems (A), 309 (B), 314 Business Decision Problems, 318 Comprehensive Review Problem, 319 PART 2 Accounting for Assets, Liabilities, and Stockholders' Equity 323 8 Control of Cash 324 Learning Objectives, 324 Internal Control, 325 Protection of Assets. Compliance with Company Policies and Federal Law. Evaluation of Personnel Performance. Accuracy of Accounting Reports. Internal Control in a Computer Environment. Controlling Cash, 329 Controlling Cash Receipts. Controlling Cash Disbursements. The Bank Checking Account, 333 The Signature Card. Deposit Ticket. Check. Bank Statement. Bank Reconciliation Statement, 337 Certified and Cashier's Checks. Petty Cash Funds, 341 Establishing a Fund. Operating the Fund. Replenishing the Fund. Cash Short and Over. Net Price Method, 343 The Voucher System, 345 Procedures for Preparing a Voucher. Special Journals Used. Procedures for Paying a Voucher. Files Maintained in a Voucher System. Summary, 350 New Terms, 351 Demonstration Problems, 353 Questions, 358 Exercises, 359 Problems (A), 362 (B), 366 Business Decision Problems, 372

xvj Contents 9 Receivables and Payables 375 Learning Objectives, 375 Accounts Receivable, 376 The Allowance Method for Recording Uncollectible Accounts. The Direct Write-Off Method for Recording Uncollectible Accounts. Credit Cards. Notes Receivable and Notes Payable, 384 Interest Calculation. Determination of Maturity Date. Accounting for Notes in Normal Business Transactions. Dishonored Notes. Accruing Interest. Discounting (Selling) Notes Receivable. Short-Term Financing through Notes Payable. Long-Term Mortgage"Notes Payable. Summary, 395 New Terms, 396 Demonstration Problem, 397 Questions, 399 Exercises, 400 Problems (A), 401 (B), 403 Business Decision Problems, 405 10 Plant Assets; Natural Resources; Intangibles 407 Learning Objectives, 407 Plant Assets, 408 Initial Recording of Plant Assets. Subsidiary Plant Asset Records. Depreciation of Plant Assets. Depreciation Methods, 414 Straight-Line Depreciation. Units-Of-Production (Output) Method. Accelerated Depreciation Methods. Partial- Year Depreciation. Changes in Estimates. Depreciation and Financial Reporting. Capital and Revenue Expenditures. Disposal of Plant Assets, 424 Sale of Plant Assets. Retirement of Plant Assets without Sale. Destruction of Plant Assets. Exchanges of Dissimilar Plant Assets. Exchanges of Similar Plant Assets. Removal Costs. Natural Resources, 431 Depletion. Intangible Assets, 434 Acquisition of Intangible Assets. Amortization of Intangible Assets. Patents. Copyrights. Franchises. Trademarks; Trade Names. Leases. Leasehold Improvements. Goodwill. Reporting Amortization. Summary, 441 New Terms, 443 Demonstration Problems, 444 Questions, 446 Exercises, 447 Problems (A), 450 (B), 453 Business Decision Problems, 457 11 Accounting Theory and International Accounting 460 Learning Objectives, 460 Underlying Assumptions, 461 Entity. Going Concern (Continuity). Money Measurement. Periodicity (Time Periods). Other Basic Concepts, 463 General-Purpose Financial Statements. Substance over Form. Consistency. Double Entry. Articulation. Measurement in Accounting, 464 Measuring Assets and Liabilities. Measuring Changes in Assets and Liabilities. The Major Principles, 465 Exchange- Price (or Cost) Principle. Matching Principle. Revenue Recognition Principle. Expense and Loss Recognition Principle. Full Disclosure Principle. Modifying Conventions (or Constraints), 471 The Conceptual Framework Project, 472 Objectives of Financial Reporting. Qualitative Characteristics. The Basic Elements of Financial Statements. Summary, 480 Appendix: International Accounting, 481 New Terms, 490 Demonstration Problem, 492 Questions, 493 Exercises, 494 Problems (A), 495 (B), 498 Business Decision Problem, 500 12 Measurement and Reporting of Stockholders' Equity Paid-in Capital and Retained Earnings 501 Learning Objectives, 501 The Corporation, 502 Advantages of the Corporation Form of Organization. Disadvantages of the Corporation. Incor-

Contents xyii porating. Articles of Incorporation. Bylaws. Organization Costs. Directing the Corporation. Documents, Books, and Records Relating to Capital Stock, 506 Stockholders' Ledger. The Minutes Book. Stockholders' Equity Paid-in Capital and Retained Earnings, 508 Paid-in Capital, 509 Capital Stock Authorized and Outstanding. Par Value and No-Par Capital Stock. Other Values Commonly Associated with Capital Stock. Classes of Capital Stock. Types of Preferred Stock. Stock Issuances of Cash. Recording Capital Stock Issued by Subscription. Capital Stock Issued for Property or Services. Other Sources of Paid-in Capital. Retained Earnings, 523 Dividends. Retained Earnings^Appropriations. The Statement of Retained Earnings. Treasury Stock, 531 Acquisition and Reis- suance of Treasury Stock. Treasury Stock in the Balance Sheet. The Statement of Stockholders' Equity. Book Value, 534 Net Income Inclusions and Exclusions, 536 Extraordinary Items. Changes in Accounting Principle. Prior Period Adjustments. Accounting for Tax Effects. Earnings Per Share, 541 Summary of Illustrative Financial Statements. Summary, 542 New Terms, 544 Demonstration Problems, 547 Questions, 549 Exercises, 551 Problems (A), 553 (B), 560 Business Decision Problems, 567 13 Bonds Payable and Bond Investments 572 Learning Objectives, 572 Bonds Payable, 573 Comparison with Stock. Selling (Issuing) Bonds. Characteristics of Bonds. Advantages of Issuing Debt. Disadvantages of Issuing Debt. Accounting for Bonds. Bond Prices and Interest Rates. Computing Bond Prices. Discount/Premium Amortization. Redeeming Bonds Payable. Serial Bonds. Bond Redemption or Sinking Funds. Convertible Bonds. Bond Investments, 589 Short-Term Bond Investments. Long-Term Bond Investments. Sale of Bond Investments. Valuation of Bond Investments. Summary, 593 Appendix: Future Value and Present Value, 595 New Terms, 599 Demonstration Problems, 600 Questions, 602 Exercises, 603 Problems (A), 604 (B), 607 Business Decision Problems, 609 14 Stock Investments Cost, Equity, and Consolidations 610 Learning Objectives, 610 Cost and Equity Methods, 611 Accounting for Short-Term Stock Investments and for Long-Term Stock Investments of Less than 50%, 611 Cost Method for Short-Term Investments and for Long-Term Investments of Less than 20%. Subsequent Valuation of Stock Investments under the Cost Method. The Equity Method for Long-Term Investments of Between 20% and 50%, 617 Reporting for Stock Investments of More than 50%, 618 Parent and Subsidiary Corporations. Eliminations. Consolidated Balance Sheet at Time of Acquisition, 620 Acquisition of Subsidiary at Book Value. Acquisition of Subsidiary at a Cost above or below Book Value. Acquisition of Less than 100 Percent of Subsidiary. Accounting for Income, Losses, and Dividends of a Subsidiary, 626 Cost Method for Investments in Subsidiaries. Equity Method for Investments in Subsidiaries. Consolidated Financial Statements at a Date after Acquisition, 628 Purchase versus Pooling of Interests, 632 Uses and Limitations of Consolidated Statements, 633 Summary, 633 New

xvjjj Contents Terms, 635 Demonstration Problems, 636 Questions, 641 Exercises, 642 Problems (A), 645 (B), 648 Business Decision Problem, 651 PART 3 Analysis of Financial Statements and Cash Flows 653 15 Analysis and Interpretation of Financial Statements 654 Learning Objectives, 654 Objectives of Financial Statement Analysis, 655 Financial Statement Analysis, 655 Horizontal and Vertical Analysis: An Illustration, 658 Analysis of Balance Sheet. Analysis of Statement of Income and Retained Earnings. Trend Percentages, 660 Ratio Analysis, 661 Liquidity Ratios. Equity, or Long-Term Solvency, Ratios. Profitability Tests. Market Tests. Final Considerations in Financial Statement Analysis, 675 Need for Comparable Data. Influence of External Factors. Impact of Inflation. Need for Comparative Standards. Summary, 678 New Terms, 678 Demonstration Problems, 680 Questions, 683 Exercises, 684 Problems (A), 686 (B), 692 Business Decision Problems, 698 16 Statement of Cash Flows 700 Learning Objectives, 700 Purpose of the Statement of Cash Flows, 700 Uses of the Statement of Cash Flows, 701 Management Uses. Investor and Creditor Uses. Information in the Statement of Cash Flows, 702 Cash Flows from Operating Activities, 703 Statement of Cash Flows, 705 Step 1: Determining Cash Flows from Operating Activities. Step 2: Analyzing the Noncurrent Accounts. Step 3: Arranging Information into Statement of Cash Flows. Comprehensive Illustration, 711 Completing the Working Paper. Preparing the Statement of Cash Flows. Working Capital or Cash Flows, 721 The Shift toward Cash Flows. Summary, 722 New Terms, 723 Demonstration Problem, 723 Questions, 729 Exercises, 729 Problems (A), 731 (B), 736 Business Decision Problems, 742 PART 4 Special Topics 745 17 Single Proprietorships and Partnerships 746 Learning Objectives, 746 Owner's Equity Accounts, 747 Single Proprietorships, 747 Financial Statements for a Single Proprietorship, 749 Partnerships and the Partnership Agreement, 750 Characteristics of a Partnership, 751 Voluntary Association. Mutual Agency. Limited Life. Unlimited Liability. Advantages of a Partnership, 752 Disadvantages of a Partnership, 752 Unique Features of Partnership Accounting,-752 The Partners' Capital'Accounts. Partners' Drawing Accounts. End-of-Period

Contents Xj x Entries. Division of Partnership Income or Loss, 757 Illustrations of Distribution of Partnership Income. Financial Statements of a Partnership, 761 Partnership Income Statement. Statement of Partner's Capital. Partnership Balance Sheet. Changes in Partnership Personnel, 763 Admission of a New Partner. Retirement of a Partner. Liquidation of a Partnership, 769 Partnership Liquidation Illustrated. Summary, 773 New.Terms, 775 Demonstration Problems, 775 Questions, 777 Exercises, 777 ^Problems (A), 780 (B), 784 Business Decision Problems, 789 18 Payroll and Federal Income Taxes 791 Learning Objectives, 791 Payroll Accounting, 792 Internal Control over Payroll, 792 Payroll Fraud. Gross Earnings of Employees, 793 Computing Gross Earnings. Payroll Taxes and Deductions, 795 Federal and State Income Taxes. FICA (Social Security) Taxes. Other Payroll Deductions. Employee Earnings Record, 799 Payroll Journal, 800 Payroll Checking Account, 801 Employer Payroll Taxes,,, 803 FICA (Social Security) Taxes. Federal Unemployment Tax. State Unemployment Tax. Recording Employer Payroll Taxes. Remitting Withholding, Taxes, and Deductions. 804 Taxes Withheld. Unemployment Taxes. Other Payroll Deductions. End-of-Period Accruals, 806 Wages and Payroll Taxes. Vacation Pay. More Efficient Methods of Payroll Accounting, 807 Corporate Federal Income Taxation, 808 Income before Taxes versus Taxable Income, 808 Tax Rates. Loss Carryback and Carryforward. Accounting Methods Used for Tax Purposes. Income Tax Allocation, 812 Permanent Differences. Temporary Differences. The Need for Tax Planning, 816 Summary, 816 Appendix: Personal Federal Income Taxes, 817 New Terms, 825 Demonstration Problems, 827 Questions, 830 Exercises, 831 Problems (A), 833 (B), 835 Business Decision Problems, 837 Appendix A Inflation Accounting 839 Appendix B An Introduction to Governmental and Nonprofit Accounting 857 Appendix C Georgia-Pacific Corporation A Set of Consolidated Financial Statements and Other Financial Data 869 Appendix D Compound Interest and Annuity Tables 889 Appendix E AICPA Code of Professional Conduct and NAA Standards of Ethical Conduct for Management Accountants 911 Index 927