FINANCIAL ACCOUNTING Tools for Business Decision Making

FINANCIAL ACCOUNTING Tools for Business Decision Making






The following is a sample chart of accounts. It does not represent a comprehensive chart of all the accounts used in this textbook but rather those accounts that are commonly used. This sample chart of accounts is for a company that generates both service revenue as well as sales revenue. It uses the perpetual approach to inventory. If a periodic system was used, the following temporary accounts would be needed to record inventory purchases: Purchases, Freight-In, Purchase Returns and Allowances, and Purchase Discounts.

Assets Cash

Accounts Receivable

Allowance for Doubtful Accounts

Interest Receivable



Prepaid Insurance

Prepaid Rent



Accumulated Depreciation— Equipment


Accumulated Depreciation— Buildings




Liabilities Notes Payable

Accounts Payable

Unearned Service Revenue

Salaries and Wages Payable

Interest Payable

Dividends Payable

Income Taxes Payable

Bonds Payable

Discount on Bonds Payable

Premium on Bonds Payable

Mortgage Payable

Stockholders’ Equity Common Stock

Paid-in Capital in Excess of Par Value—Common Stock

Preferred Stock

Paid-in Capital in Excess of Par Value—Preferred Stock

Treasury Stock

Retained Earnings


Income Summary

Revenues Service Revenue

Sales Revenue

Sales Discounts

Sales Returns and Allowances

Interest Revenue

Gain on Disposal of Plant Assets

Expenses Administrative Expenses

Amortization Expense

Bad Debt Expense

Cost of Goods Sold

Depreciation Expense


Income Tax Expense

Insurance Expense

Interest Expense

Loss on Disposal of Plant Assets

Maintenance and Repairs Expense

Rent Expense

Salaries and Wages Expense

Selling Expenses

Supplies Expense

Utilities Expense





Account Title Classification Financial Statement Normal Balance

A Accounts Payable Current Liability Balance Sheet Credit

Accounts Receivable Current Asset Balance Sheet Debit

Accumulated Depreciation—Buildings Plant Asset—Contra Balance Sheet Credit

Accumulated Depreciation—Equipment Plant Asset—Contra Balance Sheet Credit

Administrative Expenses Operating Expense Income Statement Debit

Allowance for Doubtful Accounts Current Asset—Contra Balance Sheet Credit

Amortization Expense Operating Expense Income Statement Debit

B Bad Debt Expense Operating Expense Income Statement Debit

Bonds Payable Long-Term Liability Balance Sheet Credit

Buildings Plant Asset Balance Sheet Debit

C Cash Current Asset Balance Sheet Debit

Common Stock Stockholders’ Equity Balance Sheet Credit

Copyrights Intangible Asset Balance Sheet Debit

Cost of Goods Sold Cost of Goods Sold Income Statement Debit

D Debt Investments Current Asset/

Long-Term Investment Balance Sheet Debit

Depreciation Expense Operating Expense Income Statement Debit

Discount on Bonds Payable Long-Term Liability—Contra Balance Sheet Debit

Dividend Revenue Other Income Income Statement Credit Dividends Temporary account closed

to Retained Earnings Retained Earnings Statement


Dividends Payable Current Liability Balance Sheet Credit

E Equipment Plant Asset Balance Sheet Debit

F Freight-Out Operating Expense Income Statement Debit

G Gain on Disposal of Plant Assets Other Income Income Statement Credit

Goodwill Intangible Asset Balance Sheet Debit

I Income Summary Temporary account closed

to Retained Earnings Not Applicable (1)

Income Tax Expense Income Tax Expense Income Statement Debit

Income Taxes Payable Current Liability Balance Sheet Credit

Insurance Expense Operating Expense Income Statement Debit

Interest Expense Other Expense Income Statement Debit

Interest Payable Current Liability Balance Sheet Credit

Interest Receivable Current Asset Balance Sheet Debit

Interest Revenue Other Income Income Statement Credit

Inventory Current Asset Balance Sheet (2) Debit



Account Title Classification Financial Statement Normal Balance

L Land Plant Asset Balance Sheet Debit

Loss on Disposal of Plant Assets Other Expense Income Statement Debit

M Maintenance and Repairs Expense Operating Expense Income Statement Debit

Mortgage Payable Long-Term Liability Balance Sheet Credit

N Notes Payable Current Liability/

Long-Term Liability Balance Sheet Credit

P Patents Intangible Asset Balance Sheet Debit

Paid-in Capital in Excess of Par Value—Common Stock

Stockholders’ Equity Balance Sheet Credit

Paid-in Capital in Excess of Par Value—Preferred Stock

Stockholders’ Equity Balance Sheet Credit

Preferred Stock Stockholders’ Equity Balance Sheet Credit

Premium on Bonds Payable Long-Term Liability—Contra Balance Sheet Credit

Prepaid Insurance Current Asset Balance Sheet Debit

Prepaid Rent Current Asset Balance Sheet Debit

R Rent Expense Operating Expense Income Statement Debit Retained Earnings Stockholders’ Equity Balance Sheet and Retained

Earnings Statement Credit

S Salaries and Wages Expense Operating Expense Income Statement Debit

Salaries and Wages Payable Current Liability Balance Sheet Credit

Sales Discounts Revenue—Contra Income Statement Debit

Sales Returns and Allowances Revenue—Contra Income Statement Debit

Sales Revenue Revenue Income Statement Credit

Selling Expenses Operating Expense Income Statement Debit

Service Revenue Revenue Income Statement Credit

Stock Investments Current Asset/Long-Term Investment

Balance Sheet Debit

Supplies Current Asset Balance Sheet Debit

Supplies Expense Operating Expense Income Statement Debit

T Treasury Stock Stockholders’ Equity Balance Sheet Debit

U Unearned Service Revenue Current Liability Balance Sheet Credit

Utilities Expense Operating Expense Income Statement Debit

(1) The normal balance for Income Summary will be credit when there is a net income, debit when there is a net loss. The Income Summary account does not appear on any financial statement.

(2) If a periodic system is used, Inventory also appears on the income statement in the calculation of cost of goods sold.



FINANCIAL ACCOUNTING Tools for Business Decision Making


Paul D. Kimmel PhD, CPA University of Wisconsin—Milwaukee

Milwaukee, Wisconsin

Jerry J. Weygandt PhD, CPA University of Wisconsin—Madison

Madison, Wisconsin

Donald E. Kieso PhD, CPA Northern Illinois University

DeKalb, Illinois



Vice President and Director George Hoffman Executive Editor Michael McDonald Development Editor Ed Brislin Editorial Supervisor Terry Ann Tatro Editorial Associate Margaret Thompson Senior Content Manager Dorothy Sinclair Senior Production Editor Suzie Pfister Executive Marketing Manager Karolina Zarychta Hons Product Design Manager Allison Morris Product Designer Matt Origoni Media Specialist Elena Santa Maria Design Director Harry Nolan Cover Design Maureen Eide Interior Design Maureen Eide Senior Photo Editor Mary Ann Price Market Solutions Assistant Elizabeth Kearns Cover Credit Susanna Price/Getty Images, Inc.

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1 Introduction to Financial Statements 2 2 A Further Look at Financial Statements 44 3 The Accounting Information System 90 4 Accrual Accounting Concepts 150 5 Merchandising Operations and the

Multiple-Step Income Statement 214 6 Reporting and Analyzing Inventory 266 7 Fraud, Internal Control, and Cash 316 8 Reporting and Analyzing Receivables 374 9 Reporting and Analyzing Long-Lived Assets 422 10 Reporting and Analyzing Liabilities 478 11 Reporting and Analyzing Stockholders’

Equity 536 12 Statement of Cash Flows 590 13 Financial Analysis: The Big Picture 646

APPENDICES A Specimen Financial Statements:

Apple Inc. A-1 B Specimen Financial Statements:

Columbia Sportswear Company B-1 C Specimen Financial Statements:

VF Corporation C-1 D Specimen Financial Statements:, Inc. D-1 E Specimen Financial Statements: Wal-Mart Stores, Inc. E-1 F Specimen Financial Statements: Louis Vuitton F-1 G Time Value of Money G-1 H Reporting and Analyzing Investments H-1



Brief Contents




Dear Student,

Why This Course? Remember your biology course in high school? Did you have one of those “invisible man” models (or maybe something more high-tech than that) that gave you the opportunity to look “inside” the human body? This accounting course offers something similar. To understand a business, you have to understand the financial insides of a business organization. A financial accounting course will help you understand the essential financial components of businesses. Whether you are looking at a large multinational company like Apple or Starbucks or a single- owner software consulting business or coffee shop, knowing the fundamentals of financial accounting will help you understand what is happening. As an employee, a manager, an investor,a business owner, or a director of your own personal finances—any of which roles you will have at some point in your life—you will make better decisions for having taken this course.

Why This Book? Hundreds of thousands of students have used this textbook. Your instructor has chosen it for you because of its trusted reputation. The authors have worked hard to keep the book fresh, timely, and accurate.

How to Succeed? We’ve asked many students and many instructors whether there is a secret for success in this course. The nearly unanimous answer turns out to be not much of a secret: “Do the homework.” This is one course where doing is learn- ing. The more time you spend on the homework assignments—using the various tools that this textbook provides—the more likely you are to learn the essential concepts, techniques, and methods of accounting. Besides the textbook itself, WileyPLUS and the book’s companion website also offer various support resources.

Good luck in this course. We hope you enjoy the experience and that you put to good use throughout a lifetime of success the knowledge you obtain in this course. We are sure you will not be disappointed.

Paul D. Kimmel Jerry J. Weygandt

Donald E. Kieso

“Whether you are looking at a large multinational company like Apple or Starbucks or a single-owner software consulting business or coffee shop, knowing the fundamentals of financial accounting will help you understand what is happening.”

From the Authors



Jerry Weygandt JERRY J. WEYGANDT, PhD, CPA, is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin— Madison. He holds a Ph.D. in accounting from the University of Illinois. Articles by Professor Weygandt have appeared in the Accounting Review, Journal of Accounting Research, Accounting Horizons, Journal of Accountancy, and other academic and professional journals. These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports. Professor Weygandt is author of other accounting and financial reporting books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Wisconsin Society of Certified Public Accountants. He has served on numerous committees of the American Accounting Association and as a member of the editorial board of the Accounting Review; he also has served as President and Secretary-Treasurer of the American Accounting Association. In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Standards Executive Committee (AcSEC) of that organization. He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accounting Foundation. Professor Weygandt has received the Chancellor’s Award for Excellence in Teaching and the Beta Gamma Sigma Dean’s Teaching Award. He is on the board of directors of M & I Bank of Southern Wisconsin. He is the recipient of the Wisconsin Institute of CPA’s Outstanding Educator’s Award and the Lifetime Achievement Award. In 2001 he received the American Accounting Association’s Outstanding Educator Award.

Paul Kimmel PAUL D. KIMMEL, PhD, CPA, received his bachelor’s degree from the University of Minnesota and his doctorate in account- ing from the University of Wisconsin. He is an Associate Professor at the University of Wisconsin—Milwaukee, and has pub- lic accounting experience with Deloitte & Touche (Minneapolis). He was the recipient of the UWM School of Business Advisory Council Teaching Award, the Reggie Taite Excellence in Teaching Award and a three-time winner of the Outstanding Teaching Assistant Award at the University of Wisconsin. He is also a recipient of the Elijah Watts Sells Award for Honorary Distinction for his results on the CPA exam. He is a member of the American Accounting Association and the Institute of Management Accountants and has published articles in Accounting Review, Accounting Horizons, Advances in Management Accounting, Managerial Finance, Issues in Accounting Education, Journal of Accounting Education, as well as other journals. His research interests include accounting for financial instruments and innovation in accounting education. He has published papers and given numerous talks on incorporating critical thinking into accounting education, and helped prepare a catalog of critical thinking resources for the Federated Schools of Accountancy.

Don Kieso DONALD E. KIESO, PhD, CPA, received his bachelor’s degree from Aurora University and his doctorate in accounting from the University of Illinois. He has served as chair- man of the Department of Accountancy and is currently the KPMG Emeritus Professor of Accountancy at Northern Illinois University. He has public accounting experience with Price Waterhouse & Co. (San Francisco and Chicago) and Arthur Andersen & Co. (Chicago) and research experience with the Research Division of the American Institute of Certified Public Accountants (New York). He has done postdoctoral work as a Visiting Scholar at the University of California at Berkeley and is a recipient of NIU’s Teaching Excellence Award and four Golden Apple Teaching Awards. Professor Kieso is the author of other accounting and business books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Illinois CPA Society. He has served as a member of the Board of Directors of the Illinois CPA Society, then AACSB’s Accounting Accreditation Committees, the State of Illinois Comptroller’s Commission, as Secretary- Treasurer of the Federation of Schools of Accountancy, and as Secretary-Treasurer of the American Accounting Association. Professor Kieso is currently serving on the Board of Trustees and Executive Committee of Aurora University, as a member of the Board of Directors of Kishwaukee Community Hospital, and as Treasurer and Director of Valley West Community Hospital. From 1989 to 1993 he served as a charter member of the national Accounting Education Change Commission. He is the recipient of the Outstanding Accounting Educator Award from the Illinois CPA Society, the FSA’s Joseph A. Silvoso Award of Merit, the NIU Foundation’s Humanitarian Award for Service to Higher Education, a Distinguished Service Award from the Illinois CPA Society, and in 2003 an honorary doctorate from Aurora University.

Author Commitment



Quickly identify areas of strength and weakness before the first exam, and use the information to build a learning path to success.

A little time with ORION goes a long way. Based on usage data, students who engage in ORION adaptive practice—just a few minutes per week—get better outcomes. In fact, students who used ORION five or more times over the course of a semester reported the following results:



Developing effective problem solving skills requires practice, relevant feedback, and insightful examples.

Solutions to practice multiple-choice questions, exercises, and problems are now available at the end of each chapter.



1 Discuss how to classify and determine inventory. Merchandisers need only one inventory classifi cation, merchandise inventory, to describe the different items that make up total inventory. Manufacturers, on the other hand, usually classify inventory into three catego- ries: fi nished goods, work in process, and raw materi- als. To determine inventory quantities, manufactur- ers (1) take a physical inventory of goods on hand and (2) determine the ownership of goods in transit or on consignment.

2 Apply inventory cost fl ow methods and discuss their fi nancial effects. The primary basis of accounting for inventories is cost. Cost includes all expenditures neces- sary to acquire goods and place them in a condition ready for sale. Cost of goods available for sale includes (a) cost of beginning inventory and (b) cost of goods purchased. The inventory cost fl ow methods are specifi c identifi cation and three assumed cost fl ow methods—FIFO, LIFO, and average-cost. The cost of goods available for sale may be allocated to cost of goods sold and ending inventory by specifi c identifi cation or by a method based on an assumed cost fl ow. When prices are rising, the fi rst-in, fi rst-out (FIFO) method results in lower cost of goods sold and higher net income than the average-cost and the last-in, fi rst-out (LIFO) methods. The reverse is true when prices are fall- ing. In the balance sheet, FIFO results in an ending inven- tory that is closest to current value, whereas the inven- tory under LIFO is the farthest from current value. LIFO

lt i th l t i t (b f l t

Inventory turnover is calculated as cost of goods sold divided by average inventory. It can be converted to average days in inventory by dividing 365 days by the inventory turnover. A higher inventory turnover or lower average days in inventory suggests that management is trying to keep inventory levels low relative to its sales level. The LIFO reserve represents the difference between ending inventory using LIFO and ending inventory if FIFO were employed instead. For some companies this differ- ence can be signifi cant, and ignoring it can lead to inappro- priate conclusions when using the current ratio or inven- tory turnover.

*4 Apply inventory cost fl ow methods to perpetual inven- tory records. Under FIFO, the cost of the earliest goods on hand prior to each sale is charged to cost of goods sold. Under LIFO, the cost of the most recent purchase prior to sale is charged to cost of goods sold. Under the average- cost method, a new average cost is computed after each purchase.

*5 Indicate the effects of inventory errors on the fi nan- cial statements. In the income statement of the current year: (1) An error in beginning inventory will have a reverse effect on net income (e.g., overstatement of inventory results in understatement of net income, and vice versa). (2) An error in ending inventory will have a similar effect on net income (e.g., overstatement of inventory results in overstatement of net income). If ending inventory errors are not corrected in the follow-

c06ReportingAndAnalyzingInventory.indd Page 291 01/06/15 8:11 PM f-0161 /202/WB01539/9781118552551/ch06/text_s


1. Ending inventory—as reported $650,000

1. Subtract from inventory: The goods belong to Bosnia Corporation. Sergei is merely holding them for Bosnia. (200,000)

2. Add to inventory: The goods belong to Sergei when they were shipped. 40,000

3. Subtract from inventory: Offi ce supplies should be carried in a separate account. They are not considered inventory held for resale. (15,000)

4. Add to inventory: The goods belong to Sergei until they are shipped (Jan. 1). 30,000

p p


Prepare a schedule to determine the correct inventory amount. Provide explanations for each item above, saying why you did or did not make an adjustment for each item.

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SOLUTIONS 1. (d) A physical inventory is usually taken when a limited number of goods are being sold or received, and at the end

of the company’s fi scal year. Choice (a) is incorrect because a physical inventory count is usually taken when the com- pany has the least, not greatest, amount of inventory. Choices (b) and (c) are correct, but (d) is the better answer.

2. (a) Goods held on consignment should not be included because another company has title (ownership) to the goods. The other choices are incorrect because (b) goods shipped on consignment to another company and (c) goods in transit from another company shipped FOB shipping point should be included in a company’s ending inventory. Choice (d) is incorrect because (a) is not included in the physical inventory.

3. (b) The inventory held on consignment by Rogers should be included in Railway’s inventory balance at cost ($35,000). The purchased goods of $13,000 should not be included in inventory until January 3 because the goods are shipped FOB destination. Therefore, the correct amount of inventory is $215,000 ($180,000 + $35,000), not (a) $230,000, (c) $228,000, or (d) $193,000.

4. (c) Under FIFO, ending inventory will consist of 5,000 units from the Nov. 8 purchase and 4,000 units from the June 19 purchase. Therefore, ending inventory is (5,000 × $13) + (4,000 × $12) = $113,000, not (a) $99,000, (b) $108,000, or (d) $117,000.

5. (d) Under LIFO, ending inventory will consist of 8,000 units from the inventory at Jan. 1 and 1,000 units from the June 19 purchase. Therefore, ending inventory is (8,000 × $11) + (1,000 × $12) = $100,000, not (a) $113,000, (b) $108,000, or (c) $99,000.

6 (d) Under the average-cost method total cost of goods available for sale needs to be calculated in order to deter-

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S l ti t ti lti l




• DO IT! Exercises


All new practice questions provide

assessment, helping students see what

they understand and where they can


Algorithmic versions of the questions

allow students to revisit practice

questions until they understand a

topic completely.



Focus on the Accounting Cycle To help students master accounting cycle concepts, we added (1) new, recurring illustrations that show students the big picture of the accounting cycle, (2) new comprehensive accounting cycle exercises and problems, and (3) new accounting cycle questions in the Test Bank and .

Student Practice and Solutions New practice opportunities with solutions are integrated throughout the textbook and WileyPLUS course. Each textbook chapter now provides students with a Review and Practice section that includes learning objective sum- maries, multiple-choice questions with feedback for each answer choice, practice exercises with solutions, and a prac- tice problem with a solution. Also, all learning objective modules in the textbook are followed by a DO IT! exercise with an accompanying solution.

In WileyPLUS, two brief exercises, two DO IT! exercises, two exercises, and a new problem are available for practice with each chapter. All of the new practice questions are algorithmic, providing students with multiple opportunities for advanced practice. WileyPLUS assessment now includes new narrative student feedback.

Over 3,500 questions, including new medium-level, computational, and accounting-cycle-based questions, are avail- able for practice and review. is an adaptive study and practice tool that helps students build proficiency in course topics.

Updated Content and Design We scrutinized all content to find new ways to engage students and help them learn accounting concepts. A new learning objective structure helps students practice their understanding of concepts with DO IT! exercises before they move on to different topics in other learning objectives. Coupled with a new interior design, revised infographics, and the newly designed interactive chapter tutorials, the new outcomes-oriented approach motivates students and helps them make the best use of their time.

WileyPLUS Videos Over 150 videos are available in WileyPLUS. More than 80 of the videos are new to the Eighth Edition. The videos walk students through relevant homework problems and solutions, review important concepts, provide overviews of Excel skills, and explore topics in a real-world context.

Real World Context: Feature Stories and Comprehensive Problems New feature stories frame chapter topics in a real-world company example. Also, the feature stories now closely cor- relate with the Using Decision Tools problem at the end of each chapter. In WileyPLUS, real-world Insight boxes now have questions that can be assigned as homework.

More information about the Eighth Edition is available on the book’s website at


What’s New?



2Introduction to FinancialStatements1

Knowing the Numbers 3 LO 1: Study the forms of business organization and

the uses of accounting information. 4 Forms of Business Organization 4 Users and Uses of Financial Information 5 Ethics in Financial Reporting 7

LO 2: Explain the three principal types of business activity. 8

Financing Activities 9 Investing Activities 9 Operating Activities 9

LO 3: Describe the four financial statements and how they are prepared. 11

Income Statement 11 Retained Earnings Statement 12 Balance Sheet 13 Statement of Cash Flows 14 Interrelationships of Statements 15 Other Elements of an Annual Report 18

A Look at IFRS 42

46A Further Look at Financial Statements2

Just Fooling Around? 45 LO 1: Identity the sections of a classified

balance sheet. 46 Current Assets 46 Long-Term Investments 48 Property, Plant, and Equipment 48 Intangible Assets 48 Current Liabilities 50 Long-Term Liabilities 50 Stockholders’ Equity 50

LO 2: Use ratios to evaluate a company’s profitability, liquidity, and solvency. 51

Ratio Analysis 51 Using the Income Statement 52 Using a Classified Balance Sheet 53 Using the Statement of Cash Flows 57

LO 3: Discuss financial reporting concepts. 58 The Standard-Setting Environment 58 Qualities of Useful Information 59 Assumptions in Financial Reporting 60 Principles in Financial Reporting 61 Cost Constraint 62

A Look at IFRS 87

90The Accounting InformationSystem 3

Accidents Happen 91 LO 1: Analyze the effect of business transactions

on the basic accounting equation. 92 Accounting Transactions 92 Analyzing Transactions 93 Summary of Transactions 99

LO 2: Explain how accounts, debits, and credits are used to record business transactions. 100

Debits and Credits 101 Debit and Credit Procedures 101 Stockholders’ Equity Relationships 104 Summary of Debit/Credit Rules 105

LO 3: Indicate how a journal is used in the recording process. 106

The Recording Process 106 The Journal 106

LO 4: Explain how a ledger and posting help in the recording process. 109

The Ledger 109 Chart of Accounts 109 Posting 110 The Recording Process Illustrated 111 Summary Illustration of Journalizing and

Posting 117 LO 5: Prepare a trial balance. 119

Limitations of a Trial Balance 119 A Look at IFRS 148

46Accrual Accounting Concepts4 Keeping Track of Groupons 151 LO 1: Explain the accrual basis of accounting and

the reasons for adjusting entries. 152 The Revenue Recognition Principle 152 The Expense Recognition Principle 152 Accrual versus Cash Basis of Accounting 153 The Need for Adjusting Entries 154 Types of Adjusting Entries 155

LO 2: Prepare adjusting entries for deferrals. 156 Prepaid Expenses 156 Unearned Revenues 160

LO 3: Prepare adjusting entries for accruals. 163 Accrued Revenues 163 Accrued Expenses 164 Summary of Basic Relationships 167


Table of Contents



LO 4: Prepare an adjusted trial balance and closing entries. 170

Preparing the Adjusted Trial Balance 170 Preparing Financial Statements 171 Quality of Earnings 172 Closing the Books 175 Summary of the Accounting Cycle 177

LO *5: APPENDIX 4A: Describe the purpose and the basic form of a worksheet. 182

A Look at IFRS 212

150 Merchandising Operations and the Multiple-Step Income Statement


Buy Now, Vote Later 215 LO 1: Describe merchandising operations and

inventory systems. 216 Operating Cycles 216 Flow of Costs 217

LO 2: Record purchases under a perpetual inventory system. 219

Freight Costs 221 Purchase Returns and Allowances 221 Purchase Discounts 222 Summary of Purchasing Transactions 223

LO 3: Record sales under a perpetual inventory system. 224

Sales Returns and Allowances 225 Sales Discounts 226

LO 4: Prepare a multiple-step income statement and a comprehensive income statement. 227

Single-Step Income Statement 227 Multiple-Step Income Statement 228 Comprehensive Income Statement 231

LO 5: Determine cost of goods sold under a periodic inventory system. 233

LO 6: Compute and analyze gross profit rate and profit margin. 234

Gross Profit Rate 234 Profit Margin 235

LO *7: APPENDIX 5A: Record purchases and sales of inventory under a periodic inventory system. 239

Recording Merchandise Transactions 239 Recording Purchases of Merchandise 239 Freight Costs 240 Recording Sales of Merchandise 240 Comparison of Entries—Perpetual vs.

Periodic 241 A Look at IFRS 264

266Reporting and Analyzing Inventory6

“Where Is That Spare Bulldozer Blade?” 267 LO 1: Discuss how to classify and

determine inventory. 268 Classifying Inventory 268 Determining Inventory Quantities 269

LO 2: Apply inventory cost flow methods and discuss their financial effects. 271

Specific Identification 272 Cost Flow Assumptions 273 Financial Statement and Tax Effects of Cost Flow

Methods 277 Using Inventory Cost Flow Methods

Consistently 280 LO 3: Explain the statement presentation and

analysis of inventory. 281 Presentation 281 Lower-of-Cost-or-Market 281 Analysis 283 Analysts’ Adjustments for LIFO Reserve 284

LO *4: APPENDIX 6A: Apply inventory cost flow methods to perpetual inventory records. 287

First-In, First-Out (FIFO) 287 Last-In, First-Out (LIFO) 288 Average-Cost 289

LO *5: APPENDIX 6B: Indicate the effects of inventory errors on the financial statements. 289

Income Statement Effects 289 Balance Sheet Effects 290

A Look at IFRS 314

316Fraud, Internal Control, and Cash7

Minding the Money in Madison 317 LO 1: Define fraud and the principles of

internal control. 318 Fraud 318 The Sarbanes-Oxley Act 318 Internal Control 319 Principles of Internal Control Activities 320 Limitations of Internal Control 326

LO 2: Apply internal control principles to cash. 327

Cash Receipts Controls 328 Cash Disbursements Controls 330

LO 3: Apply the control features of a bank account. 333

Electronic Funds Transfer (EFT) System 333 Bank Statements 333 Reconciling the Bank Account 334




LO 4: Explain the reporting of cash and the basic principles of cash management. 340

Reporting Cash 340 Managing and Monitoring Cash 341 Cash Budgeting 344

LO *5: APPENDIX 7A: Explain the operation of a petty cash fund. 347

Establishing the Petty Cash Fund 347 Making Payments from Petty Cash 347 Replenishing the Petty Cash Fund 348

A Look at IFRS 371

374Reporting and Analyzing Receivables8

What’s Cooking? 375 LO 1: Explain how companies recognize

accounts receivable. 376 Types of Receivables 376 Recognizing Accounts Receivable 376

LO 2: Describe how companies value accounts receivable and record their disposition. 378

Valuing Accounts Receivable 378 Disposing of Accounts Receivable 385

LO 3: Explain how companies recognize, value, and dispose of notes receivable. 387

Determining the Maturity Date 388 Computing Interest 388 Recognizing Notes Receivable 388 Valuing Notes Receivable 389 Disposing of Notes Receivable 389

LO 4: Describe the statement presentation of receivables and the principles of receivables management. 391

Financial Statement Presentation of Receivables 391

Managing Receivables 392 Evaluating Liquidity of Receivables 394 Accelerating Cash Receipts 396

A Look at IFRS 419

422Reporting and Analyzing Long-Lived Assets9

A Tale of Two Airlines 423 LO 1: Explain the accounting for plant

asset expenditures. 424 Determining the Cost of Plant Assets 424 Expenditures During Useful Life 427 To Buy or Lease? 428

LO 2: Apply depreciation methods to plant assets. 429

Factors in Computing Depreciation 430 Depreciation Methods 430

Revising Periodic Depreciation 435 Impairments 436

LO 3: Explain how to account for the disposal of plant assets. 437

Sale of Plant Assets 437 Retirement of Plant Assets 438

LO 4: Identity the basic issues related to reporting intangible assets. 439

Accounting for Intangible Assets 440 Types of Intangible Assets 440

LO 5: Discuss how long-lived assets are reported and analyzed. 443

Presentation 443 Analysis 444

LO *6: APPENDIX 9A: Compute periodic depreciation using the declining-balance method and the units-of-activity method. 449

Declining-Balance Method 449 Units-of-Activity Method 450

A Look at IFRS 475

478Reporting and Analyzing Liabilities10

And Then There Were Two 479 LO 1: Explain how to account for current

liabilities. 480 What Is a Current Liability? 480 Notes Payable 480 Sales Taxes Payable 481 Unearned Revenues 481 Current Maturities of Long-Term Debt 482 Payroll and Payroll Taxes Payable 483

LO 2: Describe the major characteristics of bonds. 485

Types of Bonds 486 Issuing Procedures 486 Determining the Market Price of Bonds 486

LO 3: Explain how to account for bond transactions. 489

Issuing Bonds at Face Value 489 Discount or Premium on Bonds 489 Issuing Bonds at a Discount 490 Issuing Bonds at a Premium 492 Redeeming Bonds at Maturity 493 Redeeming Bonds before Maturity 493

LO 4: Discuss how liabilities are reported and analyzed. 495

Presentation 495 Analysis 496

LO *5: APPENDIX 10A: Apply the straight-line method of amortizing bond discount and bond premium. 502

Amortizing Bond Discount 502 Amortizing Bond Premium 503




LO *6: APPENDIX 10B: Apply the effective-interest method of amortizing bond discount and bond premium. 504

Amortizing Bond Discount 505 Amortizing Bond Premium 506

LO *7: APPENDIX 10C: Describe the accounting for long-term notes payable. 507

A Look at IFRS 534

536Reporting and Analyzing Stockholders’ Equity11

Oh Well, I Guess I’ll Get Rich 537 LO 1: Discuss the major characteristics of a

corporation. 538 Characteristics of a Corporation 538 Forming a Corporation 541 Stockholder Rights 541 Stock Issue Considerations 542 Corporate Capital 544

LO 2: Explain how to account for the issuance of common and preferred stock, and the purchase of treasury stock. 545

Accounting for Common Stock 545 Accounting for Preferred Stock 546 Treasury Stock 547

LO 3: Explain how to account for cash dividends and describe the effect of stock dividends and stock splits. 549

Cash Dividends 549 Dividend Preferences 552 Stock Dividends 553 Stock Splits 555

LO 4: Discuss how stockholders’ equity is reported and analyzed. 557

Retained Earnings 557 Retained Earnings Restrictions 558 Balance Sheet Presentation of Stockholders’

Equity 558 Analysis of Stockholders’ Equity 560 Debt versus Equity Decision 562

LO *5: APPENDIX 11A: Prepare entries for stock dividends. 565

A Look at IFRS 587

590Statement of Cash Flows12 Got Cash? 591 LO 1: Discuss the usefulness and format of the

statement of cash flows. 592 Usefulness of the Statement of Cash Flows 592 Classification of Cash Flows 592

Significant Noncash Activities 593 Format of the Statement of

Cash Flows 594 LO 2: Prepare a statement of cash flows using

the indirect method. 595 Indirect and Direct Methods 596 Indirect Method—Computer Services

Company 596 Step 1: Operating Activities 598 Summary of Conversion to Net Cash

Provided by Operating Activities– Indirect Method 601

Step 2: Investing and Financing Activities 603

Step 3: Net Change in Cash 604 LO 3: Use the statement of cash flows to

evaluate a company. 607 The Corporate Life Cycle 607 Free Cash Flow 609

LO *4: APPENDIX 12A: Prepare a statement of cash flows using the direct method. 611

Step 1: Operating Activities 613 Step 2: Investing and Financing Activities 617 Step 3: Net Change in Cash 618

LO *5: APPENDIX 12B: Use the T-account approach to prepare a statement of cash flows. 618

A Look at IFRS 643

646Financial Analysis: The Big Picture13

It Pays to Be Patient 647 LO 1: Apply the concept of sustainable income

and quality of earnings. 648 Sustainable Income 648 Quality of Earnings 652

LO 2: Apply horizontal analysis and vertical analysis. 654

Horizontal Analysis 655 Vertical Analysis 657

LO 3: Analyze a company’s performance using ratio analysis. 660

Price-Earnings Ratio 660 Liquidity Ratios 660 Solvency Ratios 661 Profitability Ratios 661

LO *4: APPENDIX 13A: Evaluate a company comprehensively using ratio analysis. 666

Liquidity Ratios 668 Solvency Ratios 670 Profitability Ratios 672

A Look at IFRS 699




A-1Specimen Financial Statements: Apple Inc.A

B-1 Specimen Financial Statements: Columbia Sportswear Company


C-1 Specimen Financial Statements: VF Corporation


D-1 Specimen Financial Statements:, Inc.


E-1 Specimen Financial Statements: Wal-Mart Stores, Inc.


F-1Specimen Financial Statements: Louis VuittonF

G-1Time Value of MoneyG LO 1: Compute interest and future values. G-1

Nature of Interest G-1 Future Value of a Single Amount G-3 Future Value of an Annuity G-4

LO 2: Compute present values. G-7 Present Value Variables G-7

Present Value of a Single Amount G-7 Present Value of an Annuity G-9 Time Periods and Discounting G-11 Present Value of a Long-Term Note or Bond G-11

LO 3: Use a financial calculator to solve time value of money problems. G-13

Present Value of a Single Sum G-14 Present Value of an Annuity G-15 Useful Applications of the Financial

Calculator G-15

H-1Reporting and Analyzing InvestmentsH

LO 1: Explain how to account for debt investments. H-1

Why Corporations Invest H-1 Accounting for Debt Investments H-3

LO 2: Explain how to account for stock investments. H-4

Holdings of Less than 20% H-4 Holdings Between 20% and 50% H-5 Holdings of More than 50% H-6

LO 3: Discuss how debt and stock investments are reported in the financial statements. H-7

Categories of Securities H-7 Balance Sheet Presentation H-10 Presentation of Realized and Unrealized Gain

or Loss H-11 Statement of Cash Flows Presentation H-12

Company Index I-1 Subject Index I-5




Eighth Edition

Dennis Avola Northeastern University Thomas Bednarcik Robert Morris University Illinois Martin Blaine Columbus State Community College Bradley Blaylock Oklahoma State University Gary Bower Community College of Rhode Island Robert Braun Southeastern Louisiana University Lou Bravo North Lake College Myra Bruegger Southeastern Community College Barry Buchoff Towson University Matthew Calderisi Fairleigh Dickinson University Julia Camp Providence College Marian Canada Ivy Tech Community College at Franklin Bea Chiang The College of New Jersey Colleen Chung Miami Dade College Shifei Chung Rowan University Tony Cioffi Lorain County Community College Leslie Cohen University of Arizona Jim Coughlin Robert Morris University Patricia Crenny Villanova University Dori Danko Grand Valley State University Mingcherng Deng Baruch College Kathy Dunne Rider University Barbara Durham University of Central Florida David Emerson Salisbury University Caroline Falconetti Nassau Community College

Nancy Fan California State Polytechnic University, Pomona Magdy Farag California State Polytechnic University, Pomona Linda Flaming Monmouth University Joseph Fournier University of Rhode Island Amy Geile University of Arizona Alan Glaser Franklin & Marshall College J. D. Golub Northeastern University Rita Grant Grand Valley State University Steve Groves Ivy Tech Community College Konrad Gunderson Missouri Western State University Marcye Hampton University of Central Florida Qian Hao Wilkes University Huong Higgins Worcester Polytechnic Institute Yongtao Hong North Dakota State University Robert Hurst Franklin University Wayne Ingalls University of Maine Jennifer Joe University of Delaware James B. Johnson Community College of Philadelphia Patricia Johnson Canisius College Jordan Kanter University of Rhode Island Ann Galligan Kelley Providence College Robert Kenny The College of New Jersey Emil Koren Saint Leo University Faith Lamprey Providence College Gary Laycock Ivy Tech Community College

Charles Leflar University of Arkansas Jennifer LeSure Ivy Tech Community College Claudia Lubaski Lorain County Community College Yuanyuan Ma University of Minnesota Don McFall Hiram College Allison McLeod University of North Texas Maha Mitrelis Providence College Louella Moore Washburn University Sia Nassiripour William Paterson University Joseph Nesi Monmouth University Glenn Pate Palm Beach State College Suzy Pearse Clemson University Rachel Pernia Essex County College George Psaras Aurora University Patrick Reihing Nassau Community College John Ribezzo Community College of Rhode Island Vernon Richardson University of Arkansas Patrick Rogan Consumnes River College Juan Roman Saint Leo University John Rude Bloomsburg University Martin Rudnick William Paterson University August Saibeni Consumnes River College Barbara Sandler Queens College Barbara Scofield Washburn University Chris Severson Franklin University Suzanne Seymoure Saint Leo University


Acknowledgments Financial Accounting has benefitted greatly from the input of focus group participants, manuscript reviewers, those who have sent comments by letter or e-mail, ancillary authors, and proofers. We greatly appreciate the constructive suggestions and innovative ideas of reviewers and the creativity and accuracy of the ancillary authors and checkers.




Abdus Shahid The College of New Jersey Mike Shapeero Bloomsburg University Todd Shawver Bloomsburg University Eileen Shifflett James Madison University Ladd Simms Mississippi Valley State University

Doug Stives Monmouth University Karen Tower Ivy Tech Community College Daniel Tschopp Saint Leo University Mark Ulrich St. John’s University Nancy Wilburn Northern Arizona University

Wayne W. Williams Community College of Philadelphia Hannah Wong William Paterson University Kenneth Zheng University at Buffalo

Prior Editions

Thanks to the following reviewers and focus group participants of prior editions of Financial Accounting: Dawn Addington, Central New Mexico Community College; Gilda Agacer, Monmouth University; Solochidi Ahiarah, Buffalo State College; C. Richard Aldridge, Western Kentucky University; Sylvia Allen, Los Angeles Valley College; Sheila Ammons, Austin Community College; Thomas G. Amyot, College of Santa Rose; Juanita Ardavany, Los Angeles Valley College; Brian Baick, Montgomery College; Timothy Baker, California State University—Fresno; Cheryl Bartlett, Central New Mexico Community College; Benjamin Bean, Utah Valley State College.

Victoria Beard, University of North Dakota; Angela H. Bell, Jacksonville State University; Charles Bokemeier, Michigan State University; John A. Booker, Tennessee Technological University; Duane Brandon, Auburn University; Gary Braun, University of Texas—El Paso; Jerold K. Braun, Daytona State College; Robert L. Braun, Southeastern Louisiana University; Daniel Brickner, Eastern Michigan University; Evangelie Brodie, North Carolina State University; Sarah Ruth Brown, University of North Alabama; Charles Bunn, Wake Technical Community College; Thane Butt, Champlain College; Sandra Byrd, Missouri State University; James Byrne, Oregon State University.

Judy Cadle, Tarleton State University; Julia Camp, University of Massachusetts—Boston; David Carr, Austin Community College; Jack Cathey, University of North Carolina—Charlotte; Andy Chen, Northeast Illinois University; Jim Christianson, Austin Community College; Siu Chung, Los Angeles Valley College; Laura Claus, Louisiana State University; Leslie A. Cohen, University of Arizona; Teresa L. Conover, University of North Texas; Rita Kingery Cook, University of Delaware; Cheryl Corke, Genesee Community College; Sue Counte, St. Louis Community College—Meramec; Janet Courts, San Bernardino Valley College; Samantha Cox, Wake Technical Community College; Cheryl Crespi, Central Connecticut State University; Dori Danko, Grand Valley State University; Brent W. Darwin, Allan Hancock College; Helen Davis, Johnson and Wales University; Paquita Davis-Friday, Baruch College; Michael Deschamps, Mira Costa College; Cheryl Dickerson, Western Washington University; Gadis Dillon, Oakland University; George M. Dow, Valencia Community College—West; Kathy J. Dow, Salem State College; Lola Dudley, Eastern Illinois University.

Mary Emery, St. Olaf College; Martin L. Epstein, Central New Mexico Community College; Ann Escaro, McHenry County College; Larry R. Falcetto, Emporia State University; Alan Falcon, Loyola Marymount University; Scott Fargason, Louisiana State University; Janet Farler, Pima Community College; Lance Fisher, Oklahoma State University; Sheila D. Foster, The Citadel; Jessica J. Frazier, Eastern Kentucky University; Roger Gee, San Diego Mesa College; Lisa Gillespie, Loyola University—Chicago; Hubert Glover, Drexel University; Norman H. Godwin, Auburn University; David Gotlob, Indiana University—Purdue University—Fort Wayne; Lisa Gray, Seminole State College and Valencia Community College; Emmett Griner, Georgia State University; Leon J. Hanouille, Syracuse University; Hassan Hefzi, California State PolyTech University— Pomona; Kenneth M. Hiltebeitel, Villanova University; Harry Hooper, Santa Fe Community College; Judith A. Hora, University of San Diego; Carol Olson Houston, San Diego State University; Ryan Huldah, Iona College; Sam Isley, Wake Technical Community College.

Norma Jacobs, Austin Community College; Marianne L. James, California State University—Los Angeles; Stanley Jenne, University of Montana; Christopher Jones, George Washington University; Siriyama Kanthi Herath, Georgia Institute of Technology; Jane Kaplan, Drexel University; John E. Karayan, California State University—Pomona; Susan Kattelus, Eastern Michigan University; Ann Kelly, Providence College; Dawn Kelly, Texas Tech University; Robert Kenny, The College of New Jersey; Cindi Khanlarian, University of North Carolina—Greensboro; Robert Kiddoo, California State University—Northridge; Marinilka Kimbro, Gonzaga University; Robert J. Kirsch, Southern Connecticut State University; Frank Korman, Mountain View College; Jerry G. Kreuze, Western Michigan University.

John Lacey, California State University—Long Beach; Joseph Larkin, Saint Joseph’s University; Doulas Larson, Salem State College; Doug Laufer, Metropolitan State College of Denver; Keith Leeseberg, Manatee Community College; Glenda Levendowski, Arizona State University; Seth Levine, DeVry University; Lihon Liang, Syracuse University; James Lukawitz, University of Memphis; Nancy Lynch, West Virginia University; P. Merle Maddocks, University of Alabama—Huntsville; Janice Mardon, Green River Community College; Sal Marino, Westchester Community College; John Marts, University of North Carolina—Wilmington; Alan Mayer- Sommer, Georgetown University; Florence McGovern, Bergen Community College; Noel McKeon, Florida Community College at Jacksonville; Sara Melendy, Gonzaga University; Barbara Merino, University of North Texas; Paul Mihalek, Central Connecticut State University; Jeanne Miller, Cypress College; Robert Miller, California State University—Fullerton; Elizabeth Minbiole, Northwood University; Sherry Mirbod, Montgomery College; Andrew Morgret, University of Memphis; Michelle Moshier, SUNY Albany; Marguerite Muise, Santa Ana College; Kathy Munter, Pima Community College; William J. Nealon, Schenectady County Community College; James Neurath, Central Michigan University; Gale E. Newell, Western Michigan University; Garth Novack, Utah State University; Rosemary Nurre, San Mateo Community College.




Suzanne Ogilby, Sacramento State University; Sarah N. Palmer, University of North Carolina—Charlotte; Patricia Parker, Columbus State Community College; Terry Patton, Midwestern State University; Charles Pier, Appalachian State University; Ronald Pierno, Florida State University; Janice Pitera, Broome Community College; Franklin J. Plewa, Idaho State University; Meg Pollard, American River College; John Purisky, Salem State College; Donald J. Raux, Siena College; Ray Reisig, Pace University, Pleasantville; Judith Resnick, Borough of Manhattan Community College; Mary Ann Reynolds, Western Washington University; Ruthie G. Reynolds, Howard University; Carla Rich, Pensacola Junior College; Rod Ridenour, Montana State University—Bozeman; Ray Rigoli, Ramapo College of New Jersey; Larry Rittenberg, University of Wisconsin; Jeff Ritter, St. Norbert College; Cecile M. Roberti, Community College of Rhode Island; Brandi Roberts, Southeastern Louisiana University; Patricia A. Robinson, Johnson and Wales University; Nancy Rochman, University of Arizona; Lawrence Roman, Cuyahoga Community College; Marc A. Rubin, Miami University; John A. Rude, Bloomsburg University; Robert Russ, Northern Kentucky University.

Alfredo Salas, El Paso Community College; Christine Schalow, California State University—San Bernardino; Michael Schoderbek, Rutgers University; Richard Schroeder, University of North Carolina—Charlotte; Bill N. Schwartz, Stevens Institute of Technology; Jerry Searfoss, University of Utah; Cindy Seipel, New Mexico State University; Anne E. Selk, University of Wisconsin—Green Bay; William Seltz, University of Massachusetts; Suzanne Sevalstad, University of Nevada; Mary Alice Seville, Oregon State University; Donald Smillie, Southwest Missouri State University; Aileen Smith, Stephen F. Austin State University; Gerald Smith, University of Northern Iowa; Pam Smith, Northern Illinois University; Talitha Smith, Auburn University; William E. Smith, Xavier University; Will Snyder, San Diego State University; Naomi Soderstrom, University of Colorado—Boulder; Chris Solomon, Trident Technical College; Teresa A. Speck, St. Mary’s University of Minnesota; Charles Stanley, Baylor University; Vic Stanton, University of California, Berkeley; Ron Stone, California State University—Northridge; Gary Stout, California State University—Northridge; Gracelyn Stuart, Palm Beach Community College; Paul Swanson, Illinois Central College; Ellen L. Sweatt, Georgia Perimeter College.

William Talbot, Montgomery College; Diane Tanner, University of North Florida; Pamadda Tantral, Fairleigh Dickinson University; Steve Teeter, Utah Valley State College; Michael Tydlaska, Mountain View College; Michael F. van Breda, Texas Christian University; Joan Van Hise, Fairfi eld University; Richard Van Ness, Schenectady County Community College; Christopher Wallace, California State University—Sacramento; Barbara Warschawski, Schenectady County Community College; Andrea B. Weickgenannt, Northern Kentucky University; David P. Weiner, University of San Francisco; Frederick Weis, Claremont McKenna College; T. Sterling Wetzel, Oklahoma State University; Wendy Wilson, Southern Methodist University; Allan Young, DeVry University; Linda G. Wade, Tarleton State University; Stuart K. Webster, University of Wyoming; Kathryn Yarbrough, University of North Carolina—Charlotte; V. Joyce Yearley, New Mexico State University; Judith Zander, Grossmont College

Ancillary Authors, Contributors, Proofers, and Accuracy Checkers

We sincerely thank the following individuals for their hard work in preparing the content that accompanies this textbook: Ellen Bartley St. Joseph’s College LuAnn Bean Florida Institute of Technology Jack Borke University of Wisconsin—Platteville Melanie Bunting Edgewood College Sandra Cohen Columbia College—Chicago James M. Emig Villanova University Larry R. Falcetto Emporia State University Heidi Hansel Kirkwood Community College

Coby Harmon University of California, Santa Barbara DeAnna Kirchen Golden West College Laura McNally Black Hills State University Jill Mitchell Northern Virginia Community College Barb Muller Arizona State University George Psarsas Aurora University Laura Prosser Black Hills State University Alice Sineath Forsyth Technical Community College Teresa Speck Saint Mary’s University of Minnesota Mark Ulrich St. John’s University Sheila Viel University of Wisconsin—Milwaukee Dick D. Wasson Southwestern College

Andrea Weickgenannt Xavier University Melanie Yon

Advisory Board

Robert Braun Southeastern Louisiana University Rita Grant Grand Valley State University Marcye Hampton University of Central Florida Michelle Moshier State University of New York—Albany Courtney Naismith Collin College Michael Newman University of Houston Pamela Rouse Butler University Chris Solomon Trident Technical College



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How do you start a business? How do you determine whether your business is making or losing

money? How should you fi nance expansion—should you borrow, should you issue stock, should

you use your own funds? How do you convince banks to lend you money or investors to buy your

stock? Success in business requires making countless decisions, and decisions require fi nancial


The purpose of this chapter is to show you what role accounting plays in providing fi nancial


Introduction to Financial Statements 1

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary and exercises with solutions.

Visit for additional tutorials and practice opportunities.

The Chapter Preview describes the purpose of the chapter and highlights major topics.

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The Chapter Outline presents the chapter’s topics and subtopics, as well as practice opportunities.



• Forms of business organization

• Users and uses of fi nancial information

• Ethics in fi nancial reporting

▼1 Identify the forms of business organization and the uses of accounting information.


1 Business Organization Forms

▼3 Describe the four fi nancial statements and how they are prepared.

• Income statement • Retained earnings statement • Balance sheet • Statement of cash fl ows • Interrelationships of statements • Other annual report elements


3 3a Financial Statements 3b Components of Annual


▼2 Explain the three principal types of business activity.

• Financing activities • Investing activities • Operating activities


2 Business Activities



Many students who take this course do not plan to be accountants. If you are in that group, you might be thinking, “If I’m not going to be an accountant, why do I need to know accounting?” Well, consider this quote from Harold Geneen, the former chairman of IT&T: “To be good at your business, you have to know the numbers—cold.” In business, accounting and fi nancial statements are the means for communicating the numbers. If you don’t know how to read fi nancial statements, you can’t really know your business.

Knowing the numbers is sometimes even a matter of corporate survival. Consider the story of Columbia Sportswear Company, headquartered in Portland, Oregon. Gert Boyle’s family fl ed Nazi Germany when she was 13 years old and then purchased a small hat company in Oregon, Columbia Hat Company. In 1971, Gert’s husband, who was then running the company, died suddenly of a heart attack. The company was in the midst of an aggressive expansion, which had taken its sales above $1 million for the fi rst time but which had also left the company fi nancially stressed. Gert took over the small, struggling company with help from her son Tim, who was then a senior at the University of Oregon. Somehow, they kept the company afl oat.

Today, Columbia has more than 4,000 employees and annual sales in excess of $1 billion. Its brands include Columbia, Mountain Hardwear, Sorel, and Montrail.

Gert still heads up the Board of Directors, and Tim is the company’s President and CEO.

Columbia doesn’t just focus on fi nancial success. The company is very committed to corporate, social, and environmental responsibility. For example, several of its factories have participated in a project to increase

health awareness of female factory workers in developing countries. Columbia was also a founding member of the Sustainable Apparel Coalition, which is a group that strives to reduce the environmental and social impact of the apparel industry. In addition, it monitors all of the independent factories that produce its products to ensure that they comply with the company’s Standards of Manufacturing Practices. These standards address issues including forced labor, child labor, harassment, wages and benefi ts, health and safety, and the environment.

Employers such as Columbia Sportswear generally assume that managers in all areas of the company are “fi nancially literate.” To help prepare you for that, in this textbook you will learn how to read and prepare fi nancial statements, and how to use basic tools to evaluate fi nancial results.

Knowing the Numbers

The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business.

© My Good Images/Shutterstock




4 1 Introduction to Financial Statements

LEARNING OBJECTIVE 1 Identify the forms of business organization and the uses of accounting information.▼

-Simple to establish -Owner controlled -Tax advantages

Sole Proprietorship

-Simple to establish -Shared control -Broader skills and resources -Tax advantages


-Easier to transfer ownership -Easier to raise funds -No personal liability


Suppose you graduate with a business degree and decide you want to start your own business. But what kind of business? You enjoy working with people, espe- cially teaching them new skills. You also spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might be successful in opening an outdoor guide service where you grew up, in the Sierra Nevada mountains.


Your next decision is to determine the organizational form of your business. You have three choices—sole proprietorship, partnership, or corporation.

SOLE PROPRIETORSHIP You might choose the sole proprietorship form for your outdoor guide service. A business owned by one person is a sole proprietorship. It is simple to set up and gives you control over the business. Small owner- operated businesses such as barber shops, law offi ces, and auto repair shops are often sole proprietorships, as are farms and small retail stores.

PARTNERSHIP Another possibility is for you to join forces with other individuals to form a partnership. A business owned by two or more persons associated as partners is a partnership. Partnerships often are formed because one individual does not have enough economic resources to initiate or expand the business. Sometimes partners bring unique skills or resources to the partnership. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certifi ed public accountants), often organize as partnerships.

CORPORATION As a third alternative, you might organize as a corporation. A busi- ness organized as a separate legal entity owned by stockholders is a corporation. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money. There- fore, it is easier for corporations to raise funds. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole pro- prietorships or partnerships and eventually incorporate. Other factors to consider in deciding which organizational form to choose are taxes and legal liability. If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stock- holders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter. Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states. These hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations. Probably the most common among these hybrids types are limited liability companies (LLCs) and subchapter S corporations. These forms are discussed extensively in business law classes. The combined number of proprietorships and partnerships in the United States is more than fi ve times the number of corporations. However, the revenue

ALTERNATIVE TERMINOLOGY Stockholders are sometimes called shareholders.

Alternative Terminology notes present synonymous terms that you may come across in practice.



Business Organization and Accounting Information Uses 5

produced by corporations is eight times greater. Most of the largest businesses in the United States—for example, Coca-Cola, ExxonMobil, General Motors, Citigroup, and Microsoft—are corporations. Because the majority of U.S. business is done by corporations, the emphasis in this textbook is on the corporate form of organization.


The purpose of fi nancial information is to provide inputs for decision-making. Accounting is the information system that identifi es, records, and communicates the economic events of an organization to interested users. Users of accounting information can be divided broadly into two groups: internal users and external users.

Internal Users Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, fi nance directors, and company offi cers. In running a business, managers must answer many important questions, as shown in Illustration 1-1.

To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as fi nancial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized fi nancial information in the form of fi nancial statements.

Accounting Across the Organization boxes show applications of accounting information in various business functions.

Owning a Piece of the Bar

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