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Accounting Principles: A Business Perspective Volume 1 Financial Accounting Accounting Principles: A Business Perspective First Global Text Edition, Volume 1 Financial Accounting James Don Edwards, PhD, D.H.C. J.M. Tull Professor Emeritus of Accounting Terry College of Business University of Georgia Roger H. Hermanson, PhD Regents Professor Emeritus of Accounting Ernst & Young-J. W. Holloway Memorial Professor Emeritus Georgia State University Funding for the first Global Text edition was provided by Endeavour International Corporation, Houston, Texas, USA. The Global Text Project is funded by the Jacobs Foundation, Zurich, Switzerland. This book is licensed under a Creative Commons Attribution 3.0 License Acknowledgments for the Global Text First Edition: Revision Editor: Donald J. McCubbrey, PhD Clinical Professor, Daniels College of Business University of Denver Life member, American Institute of Certified Public Accountants Revision Assistants Emily Anderson Kyle Block Assistant Editor Jackie Sharman Associate Editor Marisa Drexel Conversion Specialist Varun Sharma This book is licensed under a Creative Commons Attribution 3.0 License Table of Contents Accounting principles:A business perspective.................................................................................................6 The accounting environment..........................................................................................................................18 Accounting defined.........................................................................................................................................19 Financial accounting versus managerial accounting.....................................................................................23 Development of financial accounting standards............................................................................................25 Ethical behavior of accountants.....................................................................................................................27 1. Accounting and its use in business decisions.......................................................................30 Forms of business organizations....................................................................................................................31 Types of activities performed by business organizations..............................................................................33 Financial statements of business organizations............................................................................................33 The financial accounting process...................................................................................................................37 Analyzing and using the financial results—the equity ratio...........................................................................47 2. Recording business transactions..........................................................................................68 The account and rules of debit and credit......................................................................................................69 The accounting cycle.......................................................................................................................................75 The journal......................................................................................................................................................76 The ledger........................................................................................................................................................79 The accounting process in operation.............................................................................................................80 3. Adjustments for financial reporting....................................................................................123 Cash versus accrual basis accounting...........................................................................................................124 Classes and types of adjusting entries..........................................................................................................127 Adjustments for deferred items....................................................................................................................129 Adjustments for accrued items.....................................................................................................................137 4. Completing the accounting cycle.........................................................................................159 The accounting cycle summarized................................................................................................................160 The work sheet..............................................................................................................................................160 Preparing financial statements from the work sheet...................................................................................166 Journalizing adjusting entries......................................................................................................................167 The closing process.......................................................................................................................................168 Accounting systems: From manual to computerized...................................................................................174 A classified balance sheet..............................................................................................................................179 Analyzing and using the financial results — the current ratio.....................................................................185 5. Accounting theory................................................................................................................210 Traditional accounting theory.......................................................................................................................211 Other basic concepts.....................................................................................................................................213 The measurement process in accounting.....................................................................................................214 The major principles.....................................................................................................................................215 Modifying conventions (or constraints).......................................................................................................221 The financial accounting standards board's conceptual framework project...............................................224 Objectives of financial reporting..................................................................................................................224 Qualitative characteristics............................................................................................................................226 Recognition and measurement in financial statements...............................................................................231 6. Merchandising transactions................................................................................................250 Introduction to inventories and the classified income statement...............................................................250 Two income statements compared— Service company and merchandising company...............................251 Accounting Principles: A Business Perspective 4 A Global Text Sales revenues...............................................................................................................................................252 Cost of goods sold.........................................................................................................................................258 Classified income statement.........................................................................................................................267 Analyzing and using the financial results—Gross margin percentage.........................................................271 7. Measuring and reporting inventories.................................................................................296 Inventories and cost of goods sold...............................................................................................................297 Determining inventory cost.........................................................................................................................300 Departures from cost basis of inventory measurement..............................................................................320 Analyzing and using financial results—inventory turnover ratio................................................................325 8. Control of cash.....................................................................................................................353 Internal control.............................................................................................................................................354 Controlling cash............................................................................................................................................361 The bank checking account..........................................................................................................................364 Bank reconciliation.......................................................................................................................................369 Petty cash funds............................................................................................................................................374 Analyzing and using the financial results—The quick ratio.........................................................................377 9. Receivables and payables....................................................................................................395 Accounts receivable......................................................................................................................................396 Current liabilities..........................................................................................................................................405 Notes receivable and notes payable..............................................................................................................412 Short-term financing through notes payable...............................................................................................417 Analyzing and using the financial results—Accounts receivable turnover and number of days' sales in accounts receivable............................................................................................................................................420 10. Property, plant, and equipment........................................................................................437 Nature of plant assets...................................................................................................................................438 Initial recording of plant assets....................................................................................................................439 Depreciation of plant assets.........................................................................................................................443 Subsequent expenditures (capital and revenue) on assets..........................................................................456 Subsidiary records used to control plant assets...........................................................................................459 Analyzing and using the financial results—Rate of return on operating assets..........................................461 11. Plant asset disposals, natural resources, and intangible assets........................................478 Disposal of plant assets................................................................................................................................479 Intangible assets............................................................................................................................................491 Analyzing and using the financial results—Total assets turnover...............................................................499 12. Stockholders' equity: Classes of capital stock....................................................................519 The corporation............................................................................................................................................520 Documents, books, and records relating to capital stock............................................................................524 Par value and no-par capital stock...............................................................................................................525 Other values commonly associated with capital stock.................................................................................526 Capital stock authorized and outstanding....................................................................................................527 Classes of capital stock.................................................................................................................................528 Types of preferred stock...............................................................................................................................528 Balance sheet presentation of stock..............................................................................................................531 Stock issuances for cash...............................................................................................................................532 Capital stock issued for property or services................................................................................................533 Balance sheet presentation of paid-in capital in excess of par (or stated) value—Common or preferred..534 Analyzing and using the financial results—Return on average common stockholders' equity..................536 5 This book is licensed under a Creative Commons Attribution 3.0 License 13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock............557 Paid-in (or contributed) capital....................................................................................................................558 Retained earnings.........................................................................................................................................559 Paid-in capital and retained earnings on the balance sheet........................................................................559 Retained earnings appropriations................................................................................................................567 Statement of retained earnings....................................................................................................................568 Statement of stockholders' equity................................................................................................................569 Treasury stock...............................................................................................................................................569 Net income inclusions and exclusions..........................................................................................................573 Analyzing and using the financial results—Earnings per share and price-earnings ratio...........................577 14. Stock investments..............................................................................................................598 Cost and equity methods..............................................................................................................................599 Consolidated balance sheet at time of acquisition.......................................................................................607 Accounting for income, losses, and dividends of a subsidiary.....................................................................611 Consolidated financial statements at a date after acquisition.....................................................................612 Uses and limitations of consolidated statements.........................................................................................615 Analyzing and using the financial results—Dividend yield on common stock and payout ratios...............616 15. Long-term financing: Bonds..............................................................................................633 Bonds payable...............................................................................................................................................634 Bond prices and interest rates.....................................................................................................................640 Analyzing and using the financial results—Times interest earned ratio.....................................................652 16. Analysis using the statement of cash flows.......................................................................673 Purposes of the statement of cash flows.......................................................................................................674 Uses of the statement of cash flows..............................................................................................................675 Information in the statement of cash flows..................................................................................................675 Cash flows from operating activities.............................................................................................................677 Steps in preparing statement of cash flows..................................................................................................679 Analysis of the statement of cash flows........................................................................................................685 Analyzing and using the financial results—Cash flow per share of common stock, cash flow margin, and cash flow liquidity ratios............................................................................................................................................691 Appendix: Use of a working paper to prepare a statement of cash flows....................................................693 17. Analysis and interpretation of financial statements..........................................................721 Objectives of financial statement analysis...................................................................................................722 Sources of information.................................................................................................................................724 Horizontal analysis and vertical analysis: An illustration...........................................................................725 Trend percentages........................................................................................................................................729 Ratio analysis................................................................................................................................................730 18. Managerial accounting concepts/job costing....................................................................777 Compare managerial accounting with financial accounting........................................................................778 Merchandiser and manufacturer accounting: Differences in cost concepts...............................................779 Financial reporting by manufacturing companies.......................................................................................782 The general cost accumulation model..........................................................................................................786 Job costing....................................................................................................................................................787 Predetermined overhead rates.....................................................................................................................793 Accounting Principles: A Business Perspective 6 A Global Text This book is licensed under a Creative Commons Attribution 3.0 License Accounting principles:A business perspective Eighth edition Roger H. Hermanson, PhD, CPA (Georgia State University, USA) James D. Edwards, PhD, D.H.C., CPA (The University of Georgia, USA) Michael W. Maher, PhD, CPA (University of Notre Dame, USA) About the authors Professor Roger H. Hermanson, PhD, CPA Regents Professor Emeritus of Accounting and Ernst & Young-J. W. Holloway Memorial Professor Emeritus at Georgia State University. He received his doctorate at Michigan State University in 1963 and is a CPA in Georgia. Professor Hermanson taught and later served as chairperson of the Division of Accounting at the University of Maryland. He has authored or coauthored approximately one-hundred articles for professional and scholarly journals and has coauthored numerous editions of several textbooks, including Accounting Principles, Financial Accounting, Survey of Financial and Managerial Accounting, Auditing Theory and Practice, Principles of Financial and Managerial Accounting, and Computerized Accounting with Peachtree Complete III. He also has served on the editorial boards of the Journal of Accounting Education, New Accountant, Accounting Horizons, and Management Accounting. Professor Hermanson has served as co-editor of the Trends in Accounting Education column for Management Accounting. He has held the office of vice president of the American Accounting Association and served on its Executive Committee. He was also a member of the Institute of Management Accountants, the American Institute of Certified Public Accountants, and the Financial Executives Institute. Professor Hermanson has been awarded two excellence in teaching awards, a doctoral fellow's award, and a Distinguished Alumni Professor award; and he was selected as the Outstanding Faculty Member for 1985 by the Federation of Schools of Accountancy. He has served as a consultant to many companies and organizations. In 1990, Professor Hermanson was named Accounting Educator of the Year by the Georgia Society of CPAs. His wife's name is Dianne, and he has two children, Dana and Susan, both of whom are accounting professors. Professor James D. Edwards, PhD, DHC, CPA J. M. Tull Professor Emeritus of Accounting in the Terry College of Business at the University of Georgia. He is a graduate of Louisiana State University and has been inducted into the Louisiana State University Alumni Federation's Hall of Distinction. He received his MBA from the University of Denver and his PhD from the University of Texas and is a CPA in Texas and Georgia. He has served as a professor and chairman of the Department of Accounting and Financial Administration at Michigan State University, a professor and dean of the Graduate School of Business Administration at the University of Minnesota, and a Visiting Scholar at Oxford University in Oxford, England. Professor Edwards is a past president of the American Accounting Association and a past national vice president and executive committee member of the Institute of Management Accountants. He has served on the board of directors of the American Institute of Certified Public Accountants and as chairman of the Georgia State Board of Accountancy. He was an original trustee of the Financial Accounting Foundation, the parent organization of the FASB, and a member of the Public Review Board of Arthur Andersen & Co. Accounting Principles: A Business Perspective 7 A Global Text Accounting principles:A business perspective He has published in The Accounting Review, The Journal of Accountancy, The Journal of Accounting Research, Management Accounting, and The Harvard Business History Review. He is also the author of History of Public Accounting in the United States. He has served on various American Institute of Certified Public Accountants committees and boards, including the Objectives of Financial Statements Committee, Standards of Professional Conduct Committee, and the CPA Board of Examiners. He was the managing editor of the centennial issue of The Journal of Accountancy. In 1974, Beta Alpha Psi, the National Accounting Fraternity, selected Professor Edwards for its first annual Outstanding Accountant of the Year award. This selection is made from industry, government, and educational leaders. In 1975, he was selected by the American Accounting Association as its Outstanding Educator. He has served the AICPA as president of the Benevolent Fund, chairman of the Awards Committee, member of the Professional Ethics Committee and Program for World Congress of Accountants. He was on the Education Standards Committee of the International Federation of Accountants and the Committee on Planning for the Institute of Management Accountants. He was the director of the Seminar for Management Accountants-Financial Reporting for the American Accounting Association. He is also a member of the Financial Executives Institute. He received the 1993 AICPA Gold Medal Award, the highest award given by the Institute. A Doctor Honoris Causa (Honorary Doctorate) from the University of Paris was awarded to him in 1994. He is the first accountant to receive this distinction in France. The Academy of Accounting Historians awarded him the 1994 Hourglass Award which is the highest international honor in the field of Accounting History. He was inducted into the Ohio State University Accounting Hall of Fame in 2001. His wife's name is Clara, and he has one son, Jim. Professor Michael W. Maher, PhD, CPA Professor of management at the University of California at Davis. He is a graduate of Gonzaga University (BBA) and the University of Washington (MBA, PhD). Before going to the University of California at Davis, he taught at the University of Michigan and the University of Chicago. He also worked on the audit staff at Arthur Andersen & Co. and was a self-employed financial consultant for small businesses while attending graduate school. Professor Maher is the coauthor of two leading textbooks, Cost Accounting and Managerial Accounting. He has coauthored several additional books and monographs, including Internal Controls in US Corporations (Financial Executives Research Foundation, 1980); and Management Incentive Compensation Plans (National Association of Accountants, 1986). His articles have appeared in Management Accounting, The Journal of Accountancy, The Accounting Review, The Journal of Accounting Research, Financial Executive, and The Wall Street Journal, among others. For his research on internal controls, Professor Maher was awarded the American Accounting Association Competitive Manuscript Award and the AICPA Notable Contribution in Literature Award. He has also been awarded the American Tax Association Manuscript Award. From the students at the Graduate School of Management, University of California, Davis, he has received the Annual Outstanding Teacher Award three times and twice received a special award for outstanding service. In 1989, Gonzaga University honored Maher with its Outstanding Alumni Merit Award. 8 This book is licensed under a Creative Commons Attribution 3.0 License Preface Philosophy and purpose Imagine that you have graduated from college without taking an accounting course. You are employed by a company as a sales person, and you eventually become the sales manager of a territory. While attending a sales managers' meeting, financial results are reviewed by the Vice President of Sales and terms such as gross margin percentage, cash flows from operating activities, and LIFO inventory methods are being discussed. The Vice President eventually asks you to discuss these topics as they relate to your territory. You try to do so, but it is obvious to everyone in the meeting that you do not know what you are talking about. Accounting principles courses teach you the "language of business" so you understand terms and concepts used in business decisions. If you understand how accounting information is prepared, you will be in an even stronger position when faced with a management decision based on accounting information. The importance of transactions analysis and proper recording of transactions has clearly been demonstrated in some of the recent business failures that have been reported in the press. If the financial statements of an enterprise are to properly represent the results of operations and the financial condition of the company, the transactions must be analyzed and recorded in the accounts following generally accepted accounting principles. The debits and credits are important not only to accounting majors but also to those entering or engaged in a business career to become managers because the ultimate effects of these journal entries are reflected in the financial statements. If expenses are reported as assets, liabilities and their related expenses are omitted from the financial statements, or reported revenues are recorded prematurely or do not really exist, the financial statements are misleading. The financial statements are only useful and meaningful if they are fair and clearly represent the business events of the company. We wrote this text to give you an understanding of how to use accounting information to analyze business performance and make business decisions. The text takes a business perspective. We use the annual reports of real companies to illustrate many of the accounting concepts. You are familiar with many of the companies we use, such as The Limited, The Home Depot, and Coca-Cola Company. Gaining an understanding of accounting terminology and concepts, however, is not enough to ensure your success. You also need to be able to find information on the Internet, analyze various business situations, work effectively as a member of a team, and communicate your ideas clearly. This text was developed to help you develop these skills. Curriculum concerns Significant changes have been recommended for accounting education. Some parties have expressed concern that recent accounting graduates do not possess the necessary set of skills to succeed in an accounting career. The typical accounting graduate seems unable to successfully deal with complex and unstructured "real world" accounting problems and generally lacks communication and interpersonal skills. One recommendation is the greater use of active learning techniques in a re-energized classroom environment. The traditional lecture and structured problem solving method approach would be supplemented or replaced with a more informal classroom setting dealing with cases, simulations, and group projects. Both inside and outside the classroom, there would be two-way communication between (1) professor and student and (2) student and student. Study groups would be Accounting Principles: A Business Perspective 9 A Global Text Accounting principles:A business perspective formed so that students could tutor other students. The purposes of these recommendations include enhancing students' critical thinking skills, written and oral communication skills, and interpersonal skills. One of the most important benefits you can obtain from a college education is that you "learn how to learn". The concept that you gain all of your learning in school and then spend the rest of your life applying that knowledge is not valid. Change is occurring at an increasingly rapid pace. You will probably hold many different jobs during your career, and you will probably work for many different companies. Much of the information you learn in college will be obsolete in just a few years. Therefore, you will be expected to engage in life-long learning. Memorizing is much less important than learning how to think critically. With this changing environment in mind, we have developed a text that will lend itself to developing the skills that will lead to success in your future career in business. The section at the end of each chapter titled, "Beyond the numbers—Critical thinking", provides the opportunity for you to address unstructured case situations, the analysis of real companies' financial situations, ethics cases, and team projects. Each chapter also includes one or two Internet projects in the section titled "Using the Internet—A view of the real world". For many of these items, you will use written and oral communication skills in presenting your results. Objectives and overall approach of the eighth edition The Accounting Education Change Commission (AECC) made specific recommendations regarding teaching materials and methods used in the first-year accounting course. As a result, significant changes have taken place in that course at many universities. The AECC states: The first course in accounting can significantly benefit those who enter business, government, and other organizations, where decision-makers use accounting information. These individuals will be better prepared for their responsibilities if they understand the role of accounting information in decision-making by managers, investors, government regulators, and others. All organizations have accountability responsibilities to their constituents, and accounting, properly used, is a powerful tool in creating information to improve the decisions that affect those constituents.1 One of the purposes of the first course should be to recruit accounting majors. To help accomplish this, the text has a section preceding each chapter entitled, "Careers in accounting". We retained a solid coverage of accounting that serves business students well regardless of the majors they select. Those who choose not to major in accounting, which is a majority of those taking this course, will become better users of accounting information because they will know something about the preparation of that information. Approach and organization Business emphasis Without actual business experience, business students sometimes lack a frame of reference in attempting to apply accounting concepts to business transactions. We seek to involve the business student more in real world business applications as we introduce and explain the subject matter. 1 Accounting Education Change Commission, Position Statement No. Two, “The First Course in Account” (Torrance, CA, June 1992), pp. 1-2. 10