SEVENTH EDITION FINANCIAL ACCOUNTING Robert Libby Cornell University Patricia A. Libby Ithaca College Daniel G. Short Texas Christian University McGraw-Hill Irwin
I Chapter One Financial Statements and Business Decisions 2 Maxidrive Corporation 3 Management Responsibility and the Demand for Auditing 20 Using Financial Statements to Determine Maxidrive's Value 21 Ethics, Reputation, and Legal Liability 21 Understanding the Business 3, The Players 3 The Business Operations 4 I The Accounting System 4 The Four Basic Financial Statements: An Overview 6 The Balance Sheet 7 Interpreting Assets, Liabilities, and Stockholders' Equity on the Balance Sheet 9 Pause for Feedback and Self-Study Quiz 9 The Income Statement 10 Analyzing the Income Statement: Beyond the Bottom Line 12 Pause for Feedback and Self-Study Quiz 12 Statement of Retained Earnings 12 Interpreting Retained Earnings 13 * Pause for Feedback and Self-Study Quiz 14 Statement of Cash Flows 14 EPILOGUE 22 Demonstration Case 23 CHAPTER SUPPLEMENT A: TYPES OF BUSINESS ENTITIES 24 CHAPTER SUPPLEMENT B: EMPLOYMENT IN THE ACCOUNTING PROFESSION TODAY 25 Chapter Take-Aways 26 Finding Financial Information 27 Key Terms 27 Questions 27 Multiple-Choice Questions 28 Mini-Exercises 29 Exercises 30 Problems 35 Alternate Problems 37 Cases and Projects 39 Annual Report Cases 39 Financial Reporting and Analysis Cases 40 Critical Thinking Cases 40 Financial Reporting and Analysis Team Project 41 Interpreting the Cash Flow Statement 15 Pause for Feedback and Self-Study Quiz 16 Relationships Among the Statements 16 Notes 16 Management Uses of Financial Statements 17 Summary of the Four Basic Financial Statements 18 Responsibilities for the Accounting Communication Process 18 Generally Accepted Accounting Principles 18 The International Accounting Standards Board and Global Convergence of Accounting Standards 19 Chapter Two Investing and Financing Decisions and the Balance Sheet 42 Papa John's International 43 Understanding the Business 44 Overview of Accounting Concepts 45 Concepts Emphasized in Chapter 2 45 Reconsidering the Conceptual Framework 46 Unrecorded but Valuable Assets 47 XXVII
XXVIII CONTENTS Environmental Liabilities: The "Greening of GAAP" 49 Pause for Feedback and Self-Study Quiz 49 What Business Activities Cause Changes in Financial Statement Amounts? 50 Nature of Business Transactions 50 Accounts 51 How Do Transactions Affect Accounts? 52 Principles of Transaction Analysis 52 Analyzing Papa John's Transactions 54 Pause for Feedback and Self-Study Quiz 56 How Do Companies Keep Track of Account Balances? 57 The Direction of Transaction Effects 58 Pause for Feedback and Self-Study Quiz 59 Analytical Tools 59 Inferring Business Activities from T-Accounts 62 Transaction Analysis Illustrated 62 Pause for Feedback and Self-Study Quiz 65 How Is the Balance Sheet Prepared and Analyzed? 66 Classified Balance Sheet 66 Understanding Foreign Financial Statements 67 Current Ratio 68 Pause for Feedback and Self-Study Quiz 69 Investing and Financing Activities 70 Pause for Feedback and Self-Study Quiz 71 Demonstration Case 72 Chapter Take-Aways 75 Key Ratio 77 Finding Financial Information 77 Key Terms 77 Questions 78 Multiple-Choice Questions 78 Mini-Exercises 79 Exercises 82 Problems 89 Alternate Problems 92 Cases and Projects 94 Annual Report Cases 94 Financial Reporting and Analysis Cases 95 Critical Thinking Cases 97 Financial Reporting and Analysis Team Project 99 Chapter Three Operating Decisions and the Income Statement 100 Papa John's International 101 Understanding the Business 102 How Do Business Activities Affect the Income Statement? 103 The Operating Cycle 103 Elements on the Income Statement 104 Income Statement Differences 107 How Are Operating Activities Recognized and Measured? 107 Accrual Accounting 108 Pause for Feedback and Self-Study Quiz 110 Pause for Feedback and Self-Study Quiz 112 Management's Incentives to Violate Accounting Rules 113 The Expanded Transaction Analysis Model 113 Transaction Analysis Rules 113 Analyzing Papa John's Transactions 116 Pause for Feedback and Self-Study Quiz 120 How are Financial Statements Prepared and Analyzed? 122 Classified Income Statement 123 Statement of Stockholders' Equity 123 Classified Balance Sheet 124 Reporting More Detailed Financial Information in the Notes 125 Operating Activities 125 Pause for Feedback and Self-Study Quiz 126 Total Asset Turnover Ratio 127 Demonstration Case 128 Chapter Take-Aways 133 Key Ratio 134 Finding Financial Information 134 Key Terms 135 Questions 135 Multiple-Choice Questions 136 Mini-Exercises 137 Exercises 140 Problems 148 Alternate Problems 153 Cases and Projects 156
CONTENTS XXIX Annual Report Cases 156 Financial Reporting and Analysis Cases 157 Critical Thinking Cases 158 Financial Reporting and Analysis Team Project 160 Annual Report Cases 219 Financial Reporting and Analysis Cases 220 Critical Thinking Cases 225 Financial Reporting and Analysis Team Project 226 Chapter Four Adjustments, Financial Statements, and the Quality of Earnings 162 Papa John's International 163 Understanding the Business 164 Adjusting Revenues and Expenses 165 The Accounting Cycle 165 Unadjusted Trial Balance 165 Purpose of Adjustments 167 Types of Adjustments 167 Adjustment Process 168 Adjustments and Incentives 175 Pause for Feedback and Self-Study Quiz 176 Preparing Financial Statements 177 Income Statement 179 Statement of Stockholders' Equity 180 Balance Sheet 180 Cash Flows from Operations, Net Income, and the Quality of Earnings 181 ' Net Profit Margin 182 Closing the Books 183 End of the Accounting Cycle 183 Pause for Feedback and Self-Study Quiz 185 Post-Closing Trial Balance 186 Demonstration Case 186 Chapter Take-Aways 192 Key Ratio 193 Finding Financial Information 194 Key Terms 194 Questions 194 Multiple-Choice Questions 195 Mini-Exercises 196 Exercises 199 Problems 209 Alternate Problems 212 Comprehensive Problems (Chapters 1-4) 217 Cases and Projects 219 Chapter Five Communicating and Interpreting Accounting Information 228 Callaway Golf 229 Understanding the Business 230 Players in the Accounting Communication Process 231 Regulators (SEC, FASB, PCAOB, Stock Exchanges) 231 Managers (CEO, CFO, and Accounting Staff) 232 Board of Directors (Audit Committee) 233 Auditors 233 Information Intermediaries: Financial Analysts and Information Services 233 Information Services and Your Job Search 235 Users: Institutional and Private Investors, Creditors, and Others 236 Guiding Principles for Communicating Useful Information 236 Differences in Accounting Methods Acceptable under IFRS and U.S. GAAP 237 Pause for Feedback and Self-Study Quiz 237 The Disclosure Process 238 Press Releases 238 How Does the Stock Market React to Earnings Announcements? 238 Annual Reports 239 Quarterly Reports 240 SEC Reports 10-K, 10-Q, 8-K 240 A Closer Look at Financial Statement Formats and Notes 240 Classified Balance Sheet 240 Classified Income Statement 242 Statement of Comprehensive Income 244 Pause for Feedback and Self-Study Quiz 244 Statement of Stockholders' Equity 245 Statement of Cash Flows 245 s Operating Activities (Indirect Method) 245 Notes to Financial Statements 246 Alternative Accounting Methods and GAAP 247
XXX CONTENTS Voluntary Disclosures 249 Accounting and Sustainable Development 249 Return on Assets Analysis: A Framework for Evaluating Company Performance 249 Return on Assets (ROA) 250 ROA Profit Driver Analysis 251 Profit Drivers and Business Strategy 251 Pause for Feedback and Self-Study Quiz 252 EPILOGUE 253 Demonstration Case 253 CHAPTER SUPPLEMENT: NONRECURRING ITEMS 255 Chapter Take-Aways 256 Key Ratio 256 Finding Financial Information 257 Key Terms 257 Questions 257 Multiple-Choice Questions 258 Mini-Exercises 259 Exercises 260 Problems 266 Alternate Problems 271 Cases and Projects 273 Annual Report Cases 273 Financial Reporting and Analysis Case 274 Critical Thinking Cases 275 Financial Reporting and Analysis Team Project 277 Chapter Six Reporting and Interpreting Sales Revenue, Receivables, and Cash 278 Deckers Outdoor Corporation 279 Understanding the Business 279 Accounting for Sales Revenue 280 Credit Card Sales to Consumers 281 Sales Discounts to Businesses 282 To Take or Not to Take the Discount, That Is the Question 283 Sales Returns and Allowances 283 Reporting Net Sales 283 Gross Profit Percentage 284 Pause for Feedback and Self-Study Quiz 285 Measuring and Reporting Receivables 286 Classifying Receivables 286 Foreign Currency Receivables 286 Accounting for Bad Debts 286 Reporting Accounts Receivable and Bad Debts 288 Pause for Feedback and Self-Study Quiz 289 Estimating Bad Debts 290 Control Over Accounts Receivable 292 Receivables Turnover Ratio 292 Accounts Receivable 293 Pause for Feedback and Self-Study Quiz 294 Reporting and Safeguarding Cash 295 Cash and Cash Equivalents Defined 295 Cash Management 296 Internal Control of Cash 296 Ethics and the Need for Internal Control 297 Reconciliation of the Cash Accounts and the Bank Statements 297 Pause for Feedback and Self-Study Quiz 301 EPILOGUE 302 Demonstration Case A 302 Demonstration Case 6 303 CHAPTER SUPPLEMENT: RECORDING DISCOUNTS AND RETURNS 304 Chapter Take-Aways 305 Key Ratios 306 Finding Financial Information 306 Key Terms 306 Questions 306 Multiple-Choice Questions 307 Mini-Exercises 308 Exercises 310 Problems 318 Alternate Problems 322 Cases and Projects 326
CONTENTS XXXI Annual Report Cases 326 Financial Reporting and Analysis Cases 326 Critical Thinking Cases 327 Financial Reporting and Analysis Team Project 328 Chapter Seven Reporting and Interpreting Cost of Goods Sold and Inventory 330 Harley-Davidson, Inc. 331 Understanding the Business 331 Nature of Inventory and Cost of Goods Sold 333 Items Included in Inventory 333 Costs Included in Inventory Purchases 334 Applying the Materiality Constraint in Practice 335 Flow of Inventory Costs 335 Managing Inventory During an Economic Downturn 336 Nature of Cost of Goods Sold 336 Pause for Feedback and Self-Study Quiz 337 Inventory Costing Methods 338 Specific Identification Method 339 Cost Flow Assumptions 339 LIFO and International Comparisons 342 Financial Statement Effects of Inventory Methods 342 Managers' Choice of Inventory Methods 343 Pause for Feedback and Self-Study Quiz 352 Control of Inventory 353 Internal Control of Inventory 353 Perpetual and Periodic Inventory Systems 353 Errors in Measuring Ending Inventory 354 Pause for Feedback and Self-Study Quiz 355 Demonstration Case 356 CHAPTER SUPPLEMENT A: LIFO LIQUIDATIONS 357 CHAPTER SUPPLEMENT B: ADDITIONAL ISSUES IN MEASURING PURCHASES 358 CHAPTER SUPPLEMENT C: COMPARISON OF PERPETUAL AND PERIODIC INVENTORY SYSTEMS 359 Chapter Take-Aways 361 Key Ratio 362 Finding Financial Information 362 Key Terms 362 Questions 363 Multiple-Choice Questions 363 Mini-Exercises 364 Exercises 366 Problems 373 Alternate Problems 379 Cases and Projects 381 Annual Report Cases 381 Financial Reporting and Analysis Cases 381 Critical Thinking Cases 382 Financial Reporting and Analysis Team Project 383 LIFO and Conflicts between Managers' and Owners' Interests 344 Pause for Feedback and Self-Study Quiz 345 Valuation at Lower of Cost or Market 346 Evaluating Inventory Management 347 Measuring Efficiency in Inventory Management 347 Inventory Turnover 347 Inventory and Cash Flows 348 Inventory 348 Pause for Feedback and Self-Study Quiz 350 Inventory Methods and Financial Statement Analysis 350 LIFO and Inventory Turnover Ratio 352 Chapter Eight Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles 386 Southwest Airlines 387 Understanding the Business 387 Acquisition and Maintenance of Plant and Equipment 389 Classifying Long-Lived Assets 389 Measuring and Recording Acquisition Cost 389 Fixed Asset Turnover 390 Pause for Feedback and Self-Study Quiz 393 Repairs, Maintenance, and Additions 394
XXXII CONTENTS WorldCom: Hiding Billions in Expenses through Capitalization 395 Pause for Feedback and Self-Study Quiz 395 Use, Impairment, and Disposal of Plant and Equipment 396 Depreciation Concepts 396 Book Value as an Approximation of Remaining Life 397 Differences in Estimated Lives within a Single Industry 398 Alternative Depreciation Methods 398 Finding Financial Information 421 Key Terms 422 Questions 422 Multiple-Choice Questions 422 Mini-Exercises 424 Exercises 426 Problems 433 Alternate Problems 440 Comprehensive Problems (Chapters 6-8) 444 Cases and Projects 446 Annual Report Cases 446 Financial Reporting and Analysis Cases 447 Critical Thinking Cases 448 Financial Reporting and Analysis Team Project 451 Impact of Alternative Depreciation Methods 403 Pause for Feedback and Self-Study Quiz 404 Increased Profitability Due to an Accounting Adjustment? Reading the Notes 404 How Managers Choose 404 Measurement Basis for Property, Plant, and Equipment 405 Two Sets of Books 405 Measuring Asset Impairment 406 Disposal of Property, Plant, and Equipment 408 Pause for Feedback and Self-Study Quiz 409 Natural Resources and Intangible Assets 409 Acquisition and Depletion of Natural Resources 409 Acquisition and Amortization of Intangible Assets 411 Standards in Process 414 Productive Assets and Depreciation 414 A Misinterpretation 415 Demonstration Case 416 CHAPTER SUPPLEMENT: CHANGES IN DEPRECIATION ESTIMATES 418 Pause for Feedback and Self-Study Quiz 419 Chapter Take-Aways 420 Key Ratio 421 Chapter Nine Reporting and Interpreting Liabilities 454 Starbucks 455 Understanding the Business 455 Liabilities Defined and Classified 457 Quick Ratio 458 Current Liabilities 459 Accounts Payable 459 Accounts Payable Turnover 460 Accrued Liabilities 460 Notes Payable. 463 Current Portion of Long-Term Debt 464 Refinanced Debt: Current or Noncurrent? 464 Deferred Revenues 465, Estimated Liabilities Reported on the Balance Sheet 465 Estimated Liabilities Reported in the Notes 465 It's a Matter of Degree 466 Working Capital Management 467 Working Capital and Cash Flows 467 r Pause for Feedback and Self-Study Quiz 469
CONTENTS XXXIII Long-Term Liabilities 469 Long-Term Notes Payable and Bonds 469 Borrowing in Foreign Currencies 470 Lease Liabilities 470 Present Value Concepts 471 Present Value of a Single Amount 472 Pause for Feedback and Self-Study Quiz 473 Present Value of an Annuity 473 Truth in Advertising 474 Accounting Applications of Present Values 475 Demonstration Case 477 CHAPTER SUPPLEMENT A: PRESENT VALUE COMPUTATIONS USING EXCEL 478 CHAPTER SUPPLEMENT B: DEFERRED TAXES 480 CHAPTER SUPPLEMENT C: FUTURE VALUE CONCEPTS 481 Chapter Take-Aways 483 Key Ratios 484 Finding Financial Information 484 Key Terms 485 Questions 485 Multiple-Choice Questions 485 Mini-Exercises 487 Exercises 488 Problems 494 Alternate Problems 499 Cases and Projects 501 Annual Report Cases 501 Financial Reporting and Analysis Case 502 Critical Thinking Cases 502 Financial Reporting and Analysis Team Project 503 Chapter Ten Reporting and Interpreting Bonds 504 Burlington Northern Santa Fe 505 Understanding the Business 505 Characteristics of Bonds Payable 507 Bond Information from the Business Press 509 Reporting Bond Transactions 509 Pause for Feedback and Self-Study Quiz 511 Bonds Issued at Par 511 Pause for Feedback and Self-Study Quiz 512 Times Interest Earned 513 Bonds Issued at a Discount 514 Pause for Feedback and Self-Study Quiz 516 Pause for Feedback and Self-Study Quiz 518 Zero Coupon Bonds 518 Bonds Issued at a Premium 519 Pause for Feedback and Self-Study Quiz 520 Pause for Feedback and Self.Study Quiz 522 Debt-to-Equity 522 Early Retirement of Debt 523 Pause for Feedback and Self-Study Quiz 524 Bonds Payable 524 Demonstration Case 525 CHAPTER SUPPLEMENT A: BOND CALCULATIONS USING EXCEL 526 CHAPTER SUPPLEMENT B: BONDS ISSUED AT A DISCOUNT 527 Pause for Feedback and Self-Study Quiz 529 Zero Coupon Bonds 530 Pause for Feedback and Self-Study Quiz 532 Chapter Take-Aways 532 Key Ratios 533 Finding Financial Information 533 Key Terms 534 Questions 534 Multiple-Choice Questions 534 Mini-Exercises 535 Exercises 537 Problems 541 Alternate Problems 546 Cases and Projects 548 Annual Reporting Cases 548 Critical Thinking Cases 548 Financial Reporting and Analysis Team Project 549
XXXIV CONTENTS Chapter Eleven Reporting and Interpreting Owners' Equity 550 The Kroger Co. 551 Understanding the Business 551 Ownership of a Corporation 553 Benefits of Stock Ownership 553 Authorized, Issued, and Outstanding Shares 554 Earnings Per Share (EPS) 556 Common Stock Transactions 556 Initial Sale of Stock 557 Sale of Stock in Secondary Markets 557 Stock Issued for Employee Compensation 558 Repurchase of Stock 558 Pause for Feedback and Self-Study Quiz 559 Dividends on Common Stock 560 Dividend Yield 560 Impact of Dividends on Stock Price 562. Pause for Feedback and Self-Study Quiz' 562 Stock Dividends and Stock Splits 563 Stock Dividends 563 Stock Splits 564 Pause for Feedback and Self-Study Quiz 564 Preferred Stock 565 What's in a Name? 565 Dividends on Preferred Stock 565 Restrictions on the Payment of Dividends 566 Financing Activities 567 Demonstration Case 568 CHAPTER SUPPLEMENT: ACCOUNTING FOR OWNERS' EQUITY FOR SOLE PROPRIETORSHIPS AND PARTNERSHIPS 569 Chapter Take-Aways 572 Key Ratios 573 Finding Financial Information 574 Key Terms 574 Questions 574 Multiple-Choice Questions 575 Mini-Exercises 576 Exercises 577 Problems 585 Alternate Problems 590 Comprehensive Problems (Chapters 9-11) 591 Cases and Projects 592 Annual Report Cases 592 Financial Reporting and Analysis Case 593 Critical Thinking Cases 594 Financial Reporting and Analysis Team Project 594 Chapter Twelve Reporting and Interpreting Investments in Other Corporations 596 The Washington Post Company 597 Understanding the Business 597 Types of Investments and Accounting Methods 599 Passive Investments in Debt and Equity Securities 599 Investments in Stock for Significant Influence 599 Investments in Stock for Control 600 Debt Held to Maturity: Amortized Cost Method 600 Bond Purchases 600 Interest Earned 601 Principal at Maturity 601 Passive Investments: The Fair Value Method 601 Classifying Passive Investments at Fair Value 602 Securities Available for Sale 602 Comparing Trading and Available-for-Sale Securities 606 Reporting the Fair Value of Investments 607 Pause for Feedback and Self-Study Quiz 608 Economic Return from Investing 609 Investments for Significant Influence: Equity Method 609 Recording Investments under the Equity Method 610 Reporting Investments under the Equity Method 612 Pause for Feedback and Self-Study Quiz 612 Transaction Structuring: Selecting Accounting Methods for Minority Investments 613 Investments 613 Controlling Interests: Mergers and Acquisitions 614
CONTENTS XXXV Recording a Merger 614 Reporting for the Combined Companies 615 Pause for Feedback and Self-Study Quiz 616 Demonstration Case A 616 Demonstration Case B 617 Demonstration Case C 618 Chapter Take-Aways 618 Key Ratio 619 Finding Financial Information 620 Key Terms 620 Questions 620 Multiple-Choice Questions 621 Mini-Exercises 622 Exercises 624 Problems 626 Alternate Problems 631 Cases and Projects 633 Annual Report Cases 633 Financial Reporting and Analysis Cases 634 Critical Thinking Cases 635 Financial Reporting and Analysis Team Project 635 Chapter Thirteen Statement of Cash Flows 636 National Beverage Corp. 637 Understanding the Business 637 "Classifications of the Statement of Cash Flows 638 Cash Flows from Operating Activities 639 Cash Flows from Investing Activities 641 Cash Flows from Financing Activities 641 Net Increase (Decrease) in Cash 641 Pause for Feedback and Self-Study Quiz 642 Relationships to the Balance Sheet and Income Statement 642 Reporting and Interpreting Cash Flows from Operating Activities 645 Reporting Cash Flows from Operating Activities Indirect Method 645 Classification of Interest on the Cash Flow Statement 649 Pause for Feedback and Self-Study Quiz 650 Interpreting Cash Flows from Operating Activities 650 Quality of Income Ratio 651 Fraud and Cash Flows from Operations 652 Reporting and Interpreting Cash Flows from Investing Activities 652 Reporting Cash Flows from Investing Activities 652 Interpreting Cash Flows from Investing Activities 653 Capital Acquisitions Ratio 654 Free Cash Flow 654 Reporting and Interpreting Cash Flows from Financing Activities 655 Reporting Cash Flows from Financing Activities 655 Interpreting Cash Flows from Financing Activities 656 Pause for Feedback and Self-Study Quiz 657 Completing the Statement and Additional Disclosures 657 Statement Structure 657 Noncash Investing and Financing Activities 658 Supplemental Cash Flow Information 659 EPILOGUE 659 Demonstration Case 659 CHAPTER SUPPLEMENT A: REPORTING CASH FLOWS FROM OPERATING ACTIVITIES DIRECT METHOD 660 Pause for Feedback and Self-Study Quiz 663 CHAPTER SUPPLEMENT B: ADJUSTMENT FOR GAINS AND LOSSES ON SALE OF LONG-TERM ASSETS INDIRECT METHOD 664 CHAPTER SUPPLEMENT C: USING A SPREADSHEET TO PREPARE THE STATEMENT OF CASH FLOWS- INDIRECT METHOD 665 Chapter Take-Aways 667 Key Ratios 668 Finding Financial Information 668 Key Terms 669 Questions 669 Multiple-Choice Questions 669 Mini-Exercises 670 Exercises 672 Problems 680 Alternate Problems 684 Cases and Projects 686 Annual Report Cases 686 Financial Reporting and Analysis Cases 687 Critical Thinking Case 688 Financial Reporting and Analysis Team Project 689
XXXVI CONTENTS Chapter Fourteen Analyzing Financial Statements 690 The Home Depot 691 Understanding the Business 691 The Investment Decision 696 Understanding a Company's Strategy 697 Financial Statement Analysis 698 Ratio and Percentage Analysis 700 Component Percentages 700 Tests of Profitability 702 Pause for Feedback and Self-Study Quiz 707 Tests of Liquidity 707 Pause for Feedback and Self-Study Quiz 711 Tests of Solvency 712 Market Tests 713 Pause for Feedback and Self-Study Quiz 714 Interpreting Ratios and Other Analytical Considerations 714 Other Financial Information 715 Insider Information 716 Information in an Efficient Market 717 Chapter Take-Aways 717 Finding Financial Information 718 Key Terms 718 Questions 718 Multiple-Choice Questions 719 Mini-Exercises 720 Exercises 721 Problems 726 Alternate Problems 731 Cases and Projects 736 Annual Report Cases 736 Financial Reporting and Analysis Cases 736 Critical Thinking Case 737 Financial Reporting and Analysis Team Project 737 Appendix A: Present and Future Value Tables A-1 Appendix B: American Eagle Outfitters Form 10-K Annual Report B-0 Appendix C: Urban Outfitters, Inc. Form 10-K Annual Report C-1 Appendix D: Industry Ratio Report D-0 Glossary G-1 Credits CR-1 Index 1-1