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Principles of Accounting ELEVENTH EDITION Belverd E. Needles, Jr., Ph.D., C.P.A., C.M.A. DePaul University Marian Powers, Ph.D. Northwestern University Susan V. Crosson, M.S. Accounting, C.P.A Santa Fe College Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Principles of Accounting, Eleventh Edition © 2011, 2008 South-Western, Cengage Learning Belverd Needles, Marian Powers, Susan Crosson ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be reproduced, transmitted, stored, or used Vice President of Editorial, Business: in any form or by any means graphic, electronic, or mechanical, Jack W. Calhoun including but not limited to photocopying, recording, scanning, Editor in Chief: Rob Dewey digitizing, taping, web distribution, information networks, or Executive Editor: Sharon Oblinger information storage and retrieval systems, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, Supervising Developmental Editor: without the prior written permission of the publisher. Katie Yanos Sr. Marketing Manager: Kristen Hurd Marketing Coordinator: Heather Mooney For product information and technology assistance, contact Sr. Marketing Communications Manager: us at Cengage Learning Customer & Sales Support, Libby Shipp 1-800-354-9706 Content Project Manager: Darrell Frye For permission to use material from this text or product, submit Media Editor: Bryan England all requests online at www.cengage.com/permissions Further permissions questions can be emailed to Editorial Assistant: Julie Warwick [email protected] Frontlist Buyer, Manufacturing: Doug Wilke Production Service: S4Carlisle Publishing Services ExamView® is a registered trademark of eInstruction Corp. Windows is a registered trademark of the Microsoft Corporation Sr. Art Director: Stacy Jenkins Shirley used herein under license. Macintosh and Power Macintosh are Cover and Internal Designer: registered trademarks of Apple Computer, Inc. used herein under Grannan Graphic Design license. Cover Image: © Getty Images/Image Bank Permissions Account Manager: John Hill © 2011 Cengage Learning. All Rights Reserved. Cengage Learning WebTutor™ is a trademark of Cengage Learning. Library of Congress Control Number: 2009941180 Student Edition ISBN 10: 1-4390-3774-4 Student Edition ISBN 13: 978-1-4390-3774-4 Instructors Edition ISBN 10: 0-538-75528-8 Instructors Edition ISBN 13: 978-0-538-75528-3 Loose-leaf Edition ISBN 10: 0-538-75519-9 Loose-leaf Edition ISBN 13: 978-0-538-75519-1 South-Western Cengage Learning 5191 Natorp Boulevard Mason, OH 45040 USA Cengage Learning products are represented in Canada by Nelson Education, Ltd. For your course and learning solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.CengageBrain.com Printed in the United States of America 1 2 3 4 5 6 7 13 12 11 10 09 BRIEF CONTENTS 1 Uses of Accounting Information and the Financial Statements 2 2 Analyzing Business Transactions 48 3 Measuring Business Income 98 4 Completing the Accounting Cycle 142 5 Financial Reporting and Analysis 180 SUPPLEMENT TO CHAPTER 5 How to Read an Annual Report 226 6 The Operating Cycle and Merchandising Operations 266 SUPPLEMENT TO CHAPTER 6 Special-Purpose Journals 302 7 Internal Control 318 8 Inventories 350 9 Cash and Receivables 390 10 Current Liabilities and Fair Value Accounting 430 11 Long-Term Assets 472 12 Contributed Capital 518 13 Long-Term Liabilities 562 14 The Corporate Income Statement and the Statement of Stockholders’ Equity 614 15 The Statement of Cash Flows 656 16 Financial Performance Measurement 706 17 Partnerships 754 18 The Changing Business Environment: A Manager’s Perspective 794 19 Cost Concepts and Cost Allocation 836 iii iv Brief Contents 20 Costing Systems: Job Order Costing 882 21 Costing Systems: Process Costing 920 22 Value-Based Systems: ABM and Lean 958 23 Cost Behavior Analysis 988 24 The Budgeting Process 1040 25 Performance Management and Evaluation 1092

26 Standard Costing and Variance Analysis 1136 27 Short-Run Decision Analysis 1184 28 Capital Investment Analysis 1224 APPENDIX A Accounting for investments 1262 APPENDIX B Present Value Tables 1276 CONTENTS Preface xvii About the Authors xxxvii CHAPTER 1 Uses of Accounting Information and the Financial Statements 2 DECISION POINT (cid:2) A USER’S FOCUS KEEP-FIT CENTER 3 Financial Position and the Accounting Equation 17 Accounting as an Information System 4 Business Goals, Activities, and Performance Assets 18 Measures 4 Liabilities 18 Financial and Management Accounting 7 Owner’s Equity 18 Processing Accounting Information 7 Financial Statements 19 Ethical Financial Reporting 8 Income Statement 19 Decision Makers: The Users of Accounting Statement of Owner’s Equity 20 Information 10 The Balance Sheet 20 Management 10 Statement of Cash Flows 21 Users with a Direct Financial Interest 11 Relationships Among the Financial Statements 21 Users with an Indirect Financial Interest 12 Generally Accepted Accounting Principles 24 Governmental and Not-for-Profit Organizations 12 GAAP and the Independent CPA’s Report 25 Accounting Measurement 13 Organizations That Issue Accounting Standards 26 Business Transactions 14 Other Organizations That Influence GAAP 26 Money Measure 14 Professional Conduct 27 Separate Entity 15 Corporate Governance 27 The Forms of Business Organization 15 (cid:2) KEEP-FIT CENTER: REVIEW PROBLEM 28 Characteristics of Corporations, Sole Proprietorships, STOP & REVIEW 31 and Partnerships 15 CHAPTER ASSIGNMENTS 33 CHAPTER 2 Analyzing Business Transactions 48 DECISION POINT (cid:2) A USER’S FOCUS PAWS AND HOOFS Business Transaction Analysis 58 CLINIC 49 Owner’s Investment to Form the Business 58 Measurement Issues 50 Economic Event That Is Not a Business Recognition 50 Transaction 59 Valuation 51 Prepayment of Expenses in Cash 59 Classification 53 Purchase of an Asset on Credit 59 Ethics and Measurement Issues 53 Purchase of an Asset Partly in Cash and Partly on Credit 60 Double-Entry System 54 Payment of a Liability 60 Accounts 54 Revenue in Cash 61 The T Account 54 Revenue on Credit 61 The T Account Illustrated 55 Revenue Collected in Advance 61 Rules of Double-Entry Accounting 55 Collection on Account 62 Normal Balance 56 Expense Paid in Cash 62 Owner’s Equity Accounts 56 v vi Contents Expense to Be Paid Later 63 Recording and Posting Transactions 70 Withdrawals 63 Chart of Accounts 70 Summary of Transactions 65 General Journal 70 The Trial Balance 65 General Ledger 72 Preparation and Use of a Trial Balance 65 Some Notes on Presentation 73 Finding Trial Balance Errors 67 (cid:2) PAWS AND HOOFS CLINIC: REVIEW PROBLEM 75 Cash Flows and the Timing STOP & REVIEW 79 of Transactions 68 CHAPTER ASSIGNMENTS 81 CHAPTER 3 Measuring Business Income 98 DECISION POINT (cid:2) A USER’S FOCUS RELIABLE Type 2 Adjustment: Recognizing Unrecorded, ANSWERING SERVICE 99 Incurred Expenses (Accrued Expenses) 111 Profitability Measurement: Issues and Type 3 Adjustment: Allocating Recorded, Unearned Ethics 100 Revenues (Deferred Revenues) 113 Net Income 100 Type 4 Adjustment: Recognizing Unrecorded, Earned Revenues (Accrued Revenues) 114 Income Measurement Assumptions 101 A Note About Journal Entries 115 Ethics and the Matching Rule 102 Using the Adjusted Trial Balance to Prepare Accrual Accounting 104 Financial Statements 116 Recognizing Revenues 104 Cash Flows from Accrual-Based Recognizing Expenses 105 Information 119 Adjusting the Accounts 105 (cid:2) RELIABLE ANSWERING SERVICE: REVIEW Adjustments and Ethics 106 PROBLEM 121 The Adjustment Process 107 STOP & REVIEW 125 Type 1 Adjustment: Allocating Recorded Costs CHAPTER ASSIGNMENTS 127 (Deferred Expenses) 107 CHAPTER 4 Completing the Accounting Cycle 142 DECISION POINT (cid:2) A USER’S FOCUS WESTWOOD The Accounts After Posting 148 MOVERS 143 The Post-Closing Trial Balance 150 From Transactions to Financial Reversing Entries: An Optional First Statements 144 Step 152 The Accounting Cycle 144 The Work Sheet: An Accountant’s Tool 154 Closing Entries 144 Preparing the Work Sheet 154 Preparing Closing Entries 147

Using the Work Sheet 157 Step 1: Closing the Credit Balances 147 (cid:2) WESTWOOD MOVERS: REVIEW PROBLEM 158 Step 2: Closing the Debit Balances 147 STOP & REVIEW 160 Step 3: Closing the Income Summary Account CHAPTER ASSIGNMENTS 162 Balance 147 Step 4: Closing the Withdrawals Account Balance 147 vii Contents CHAPTER 5 Financial Reporting and Analysis 180 DECISION POINT (cid:2) A USER’S FOCUS FUN-FOR-FEET Classified Balance Sheet 190 COMPANY 181 Assets 190 Foundations of Financial Reporting 182 Liabilities 192 Objective of Financial Reporting 182 Owner’s Equity 193 Qualitative Characteristics of Accounting Dell’s Balance Sheets 194 Information 182 Forms of the Income Statement 196 Accounting Conventions 184 Multistep Income Statement 196 Ethical Financial Reporting 184 Dell’s Income Statements 199 Accounting Conventions for Preparing Single-Step Income Statement 200 Financial Statements 185 Using Classified Financial Statements 201 Consistency 185 Evaluation of Liquidity 201 Full Disclosure (Transparency) 186 Evaluation of Profitability 202 Materiality 187 (cid:2) FUN-FOR-FEET COMPANY: REVIEW PROBLEM 208 Conservatism 187 STOP & REVIEW 210 Cost-Benefit 188 CHAPTER ASSIGNMENTS 212 SUPPLEMENT TO CHAPTER 5 How to Read an Annual Report 226 The Components of an Annual Report 226 Financial Statements 228 Letter to the Stockholders 227 Notes to the Financial Statements 233 Financial Highlights 227 Reports of Management’s Responsibilities 234 Description of the Company 227 Reports of Certified Public Accountants 234 Management’s Discussion and Analysis 227 CHAPTER 6 The Operating Cycle and Merchandising Operations 266 DECISION POINT (cid:2) A USER’S FOCUS FONG Perpetual Inventory System 275 COMPANY 267 Purchases of Merchandise 275 Managing Merchandising Businesses 268 Sales of Merchandise 277 Operating Cycle 268 Periodic Inventory System 281 Choice of Inventory System 270 Purchases of Merchandise 282 Foreign Business Transactions 270 Sales of Merchandise 284 Terms of Sale 272 (cid:2) FONG COMPANY: REVIEW PROBLEM 286 Sales and Purchases Discounts 272 STOP & REVIEW 289 Transportation Costs 273 CHAPTER ASSIGNMENTS 290 Terms of Debit and Credit Card Sales 274 SUPPLEMENT TO CHAPTER 6 Special-Purpose Journals 302 Sales Journal 302 Cash Receipts Journal 308 Purchases Journal 306 Cash Payments Journal 311 viii Contents CHAPTER 7 Internal Control 318 DECISION POINT (cid:2) A USER’S FOCUS FISHER’S Internal Control over Merchandising GRILL 319 Transactions 325 Management Issues Related to Internal Internal Control and Management Goals 325 Control 320 Control of Cash 326 The Need for Internal Controls 320 Control of Cash Receipts 326 Management’s Responsibility for Internal Control of Purchases and Cash Disbursements 327 Control 321 Petty Cash Funds 332 Independent Accountant’s Audit of Internal Establishing the Petty Cash Fund 332 Control 322 Making Disbursements from the Petty Cash Internal Control: Components, Activities, Fund 333 and Limitations 322 Reimbursing the Petty Cash Fund 333 Components of Internal Control 322 (cid:2) FISHER’S GRILL: REVIEW PROBLEM 335 Control Activities 323 STOP & REVIEW 337 Limitations of Internal Control 324 CHAPTER ASSIGNMENTS 338 CHAPTER 8 Inventories 350 DECISION POINT (cid:2) A USER’S FOCUS SNUGS First-In, First-Out (FIFO) Method 362 COMPANY 351 Last-In, First-Out (LIFO) Method 363 Managing Inventories 352 Summary of Inventory Costing Methods 364 Inventory Decisions 352 Impact of Inventory Decisions 365 Evaluating the Level of Inventory 353 Effects on the Financial Statements 365 Effects of Inventory Misstatements on Income Effects on Income Taxes 365 Measurement 355 Effects on Cash Flows 367 Inventory Cost and Valuation 358 Inventory Cost Under the Perpetual Goods Flows and Cost Flows 358 Inventory System 367 Lower-of-Cost-or-Market (LCM) Rule 359 Valuing Inventory by Estimation 370 Disclosure of Inventory Methods 360 Retail Method 370 Inventory Cost Under the Periodic Gross Profit Method 371 Inventory System 361 (cid:2) SNUGS COMPANY: REVIEW PROBLEM 373 Specific Identification Method 361 STOP & REVIEW 376 Average-Cost Method 362

CHAPTER ASSIGNMENTS 378 CHAPTER 9 Cash and Receivables 390 DECISION POINT (cid:2) A USER’S FOCUS PENTE COMPUTER Financing Receivables 396 COMPANY 391 Ethics and Estimates in Accounting for Management Issues Related to Cash Receivables 398 and Receivables 392 Cash Equivalents and Cash Control 399 Cash Management 392 Cash Equivalents 399 Accounts Receivable and Credit Policies 393 Fair Value of Cash and Cash Equivalents 399 Evaluating the Level of Accounts Receivable 394 Cash Control Methods 400 ix Contents Bank Reconciliations 401 Duration of a Note 413 Uncollectible Accounts 403 Interest and Interest Rate 413 The Allowance Method 404 Maturity Value 414 Disclosure of Uncollectible Accounts 404 Accrued Interest 414 Estimating Uncollectible Accounts Expense 405 Dishonored Note 414 Writing Off Uncollectible Accounts 409 (cid:2) PENTE COMPUTER COMPANY: REVIEW PROBLEM 415 Notes Receivable 411 STOP & REVIEW 417 Maturity Date 412 CHAPTER ASSIGNMENTS 419 CHAPTER 10 Current Liabilities and Fair Value Accounting 430 DECISION POINT (cid:2) A USER’S FOCUS MEGGIE’S FITNESS Valuation Approaches to Fair Value CENTER 431 Accounting 448 Management Issues Related to Current Interest and the Time Value of Money 448 Liabilities 432 Calculating Present Value 449 Managing Liquidity and Cash Flows 432 Applications Using Present Value 453 Evaluating Accounts Payable 432 Valuing an Asset 453 Reporting Liabilities 434 Deferred Payment 454 Common Types of Current Liabilities 436 Other Applications 455 Definitely Determinable Liabilities 436 (cid:2) MEGGIE’S FITNESS CENTER: REVIEW PROBLEM 456 Estimated Liabilities 443 STOP & REVIEW 458 Contingent Liabilities and CHAPTER ASSIGNMENTS 460 Commitments 447 CHAPTER 11 Long-Term Assets 472 DECISION POINT (cid:2) A USER’S FOCUS CAMPUS Disposal of Depreciable Assets 490 CLEANERS 473 Discarded Plant Assets 491 Management Issues Related to Long-Term Plant Assets Sold for Cash 491 Assets 474 Exchanges of Plant Assets 493 Acquiring Long-Term Assets 476 Natural Resources 494 Financing Long-Term Assets 477 Depletion 494 Applying the Matching Rule 478 Depreciation of Related Plant Assets 495 Acquisition Cost of Property, Plant, and Development and Exploration Costs in the Oil and Equipment 479 Gas Industry 495 General Approach to Acquisition Costs 480 Intangible Assets 497 Specific Applications 480 Research and Development Costs 500 Depreciation 483 Computer Software Costs 500 Factors in Computing Depreciation 484 Goodwill 500 Methods of Computing Depreciation 484 (cid:2) CAMPUS CLEANERS: REVIEW PROBLEM 502 Special Issues in Depreciation 488 STOP & REVIEW 505 CHAPTER ASSIGNMENTS 507 x Contents CHAPTER 12 Contributed Capital 518 DECISION POINT (cid:2) A USER’S FOCUS GAMMON, INC. 519 Preference as to Assets 532 Management Issues Related to Contributed Convertible Preferred Stock 532 Capital 520 Callable Preferred Stock 533 The Corporate Form of Business 520 Issuance of Common Stock 534 Advantages and Disadvantages of Par Value Stock 535 Incorporation 521 No-Par Stock 536 Equity Financing 522 Issuance of Stock for Noncash Assets 537 Dividend Policies 524 Accounting for Treasury Stock 539 Using Return on Equity to Measure Purchase of Treasury Stock 539 Performance 526 Sale of Treasury Stock 540 Stock Options as Compensation 527 Retirement of Treasury Stock 542 Cash Flow Information 527 (cid:2) GAMMON, INC.: REVIEW PROBLEM 544 Components of Stockholders’ Equity 528 STOP & REVIEW 547 Preferred Stock 531 CHAPTER ASSIGNMENTS 549 Preference as to Dividends 531 CHAPTER 13 Long-Term Liabilities 562 DECISION POINT (cid:2) A USER’S FOCUS WILSON Case 1: Market Rate Above Face Rate 579 MANUFACTURING COMPANY 563 Case 2: Market Rate Below Face Rate 580 Management Issues Related to Issuing Long- Amortization of Bond Discounts Term Debt 564 and Premiums 581 Deciding to Issue Long-Term Debt 564 Amortizing a Bond Discount 581 Evaluating Long-Term Debt 565 Amortizing a Bond Premium 586 Types of Long-Term Debt 566 Retirement of Bonds 590 Cash Flow Information 572 Calling Bonds 590 The Nature of Bonds 573 Converting Bonds 591 Bond Issue: Prices and Interest Rates 573 Other Bonds Payable Issues 592

Characteristics of Bonds 574 Sale of Bonds Between Interest Dates 592 Accounting for the Issuance of Bonds 575 Year-End Accrual of Bond Interest Expense 593 Bonds Issued at Face Value 575 (cid:2) WILSON MANUFACTURING COMPANY: Bonds Issued at a Discount 576 REVIEW PROBLEM 596 Bonds Issued at a Premium 577 STOP & REVIEW 599 Bond Issue Costs 578 CHAPTER ASSIGNMENTS 602 Using Present Value to Value a Bond 579 T he Corporate Income Statement and the Statement CHAPTER 14 of Stockholders’ Equity 614 DECISION POINT (cid:2) A USER’S FOCUS KOWALSKI, Gains and Losses 619 INC. 615 Write-Downs and Restructurings 619 Performance Measurement: Quality of Nonoperating Items 620 Earnings Issues 616 Income Taxes 621 The Effect of Accounting Estimates and Deferred Income Taxes 622 Methods 617 xi Contents Net of Taxes 623 Retained Earnings 629 Earnings per Share 625 Stock Dividends and Stock Splits 630 Basic Earnings per Share 626 Stock Dividends 630 Diluted Earnings per Share 626 Stock Splits 633 Comprehensive Income and the Statement Book Value 635 of Stockholders’ Equity 627 (cid:2) KOWALSKI, INC.: REVIEW PROBLEM 637 Comprehensive Income 627 STOP & REVIEW 640 The Statement of Stockholders’ Equity 629 CHAPTER ASSIGNMENTS 642 CHAPTER 15 The Statement of Cash Flows 656 DECISION POINT (cid:2) A USER’S FOCUS LOPATA Operating Activities 668 CORPORATION 657 Depreciation 670 Overview of the Statement Gains and Losses 671 of Cash Flows 658 Changes in Current Assets 671 Purposes of the Statement of Cash Flows 658 Changes in Current Liabilities 672 Uses of the Statement of Cash Flows 658 Schedule of Cash Flows from Operating Classification of Cash Flows 658 Activities 673 Required Disclosure of Noncash Investing Investing Activities 674 and Financing Transactions 660 Investments 675 Format of the Statement of Cash Flows 660 Plant Assets 675 Ethical Considerations and the Statement Financing Activities 678 of Cash Flows 662 Bonds Payable 678 Analyzing Cash Flows 663 Common Stock 678 Can a Company Have Too Much Cash? 663 Retained Earnings 679 Cash-Generating Efficiency 663 Treasury Stock 681 Asking the Right Questions About the Statement of Cash Flows 665 (cid:2) LOPATA CORPORATION: REVIEW PROBLEM 682 Free Cash Flow 665 STOP & REVIEW 686 CHAPTER ASSIGNMENTS 688 CHAPTER 16 Financial Performance Measurement 706 DECISION POINT (cid:2) A USER’S FOCUS WASHINGTON Trend Analysis 718 INVESTMENTS 707 Vertical Analysis 718 Foundations of Financial Performance Ratio Analysis 721 Measurement 708 Comprehensive Illustration of Ratio Financial Performance Measurement: Management’s Analysis 722 Objectives 708 Evaluating Liquidity 723 Financial Performance Measurement: Evaluating Profitability 723 Creditors’ and Investors’ Objectives 708 Evaluating Long-Term Solvency 726 Standards of Comparison 709 Evaluating the Adequacy of Cash Flows 727 Sources of Information 711 Evaluating Market Strength 729 Executive Compensation 712 (cid:2) WASHINGTON INVESTMENTS: REVIEW PROBLEM 731 Tools and Techniques of Financial Analysis 715 STOP & REVIEW 735 Horizontal Analysis 715 CHAPTER ASSIGNMENTS 737 xii Contents CHAPTER 17 Partnerships 754 DECISION POINT (cid:2) A USER’S FOCUS HOLDER Dissolution of a Partnership 767 AND WILLIAMS PARTNERSHIP 755 Admission of a New Partner 767 Partnership Characteristics 756 Withdrawal of a Partner 770 Characteristics of Partnerships 756 Death of a Partner 772 Advantages and Disadvantages of Partnerships 757 Liquidation of a Partnership 772 Limited Partnerships and Joint Ventures 757 Gain on Sale of Assets 773 Accounting for Partners’ Equity 759 Loss on Sale of Assets 775 Distribution of Partnership Income (cid:2) HOLDER AND WILLIAMS PARTNERSHIP: and Losses 761 REVIEW PROBLEM 778 Stated Ratios 761 STOP & REVIEW 781 Capital Balance Ratios 762 CHAPTER ASSIGNMENTS 783 Salaries, Interest, and Stated Ratios 763 CHAPTER 18 The Changing Business Environment: A Manager’s Perspective 794 DECISION POINT (cid:2) A MANAGER’S FOCUS GOOD Achieving Continuous Improvement 809 FOODS STORE 795 Performance Measures: A Key to Achieving The Role of Management Accounting 796 Organizational Objectives 811

Management Accounting and Financial Accounting: Using Performance Measures in the Management A Comparison 796 Process 811 Management Accounting and the Management The Balanced Scorecard 812 Process 797 Benchmarking 814 Value Chain Analysis 803 Standards of Ethical Conduct 814 Primary Processes and Support Services 803 (cid:2) GOOD FOODS STORE: REVIEW PROBLEM 816 Advantages of Value Chain Analysis 805 STOP & REVIEW 819 Managers and Value Chain Analysis 805 CHAPTER ASSIGNMENTS 821 Continuous Improvement 807 Cookie Company (Continuing Case) 835 Management Tools for Continuous Improvement 807 CHAPTER 19 Cost Concepts and Cost Allocation 836 DECISION POINT (cid:2) A MANAGER’S FOCUS THE CHOICE Statement of Cost of Goods Manufactured 844 CANDY COMPANY 837 Cost of Goods Sold and a Manufacturer’s Income Cost Information 838 Statement 845 Managers’ Use of Cost Information 838 Inventory Accounts in Manufacturing Cost Information and Organizations 838 Organizations 846 Cost Classifications and Their Uses 838 Document Flows and Cost Flows Through the Inventory Accounts 846 Cost Traceability 839 The Manufacturing Cost Flow 847 Cost Behavior 840 Elements of Product Costs 850 Value-Adding Versus Nonvalue-Adding Costs 840 Cost Classifications for Financial Reporting 841 Prime Costs and Conversion Costs 851 Computing Product Unit Cost 852 Financial Statements and the Reporting of Costs 842 Product Cost Measurement Methods 852 Income Statement and Accounting for Computing Service Unit Cost 854 Inventories 842 xiii Contents Cost Allocation 855 (cid:2) THE CHOICE CANDY COMPANY: Allocating the Costs of Overhead 855 REVIEW PROBLEM 861 STOP & REVIEW 863 Allocating Overhead: The Traditional Approach 857 CHAPTER ASSIGNMENTS 866 Allocating Overhead: The ABC Approach 859 Cookie Company (Continuing Case) 880 Costing Systems: Job Order Costing 882 CHAPTER 20 DECISION POINT (cid:2) A MANAGER’S FOCUS AUGUSTA Completed Units 891 CUSTOM GOLF CARTS, INC. 883 Sold Units 891 Product Unit Cost Information and the Reconciliation of Overhead Costs 892 Management Process 884 A Job Order Cost Card and the Computation Planning 884 of Unit Cost 893 Performing 884 A Manufacturer’s Job Order Cost Card and the Evaluating 884 Computation of Unit Cost 893 Communicating 884 Job Order Costing in a Service Organization 894 Product Costing Systems 885 (cid:2) AUGUSTA CUSTOM GOLF CARTS, INC.: Job Order Costing in a Manufacturing REVIEW PROBLEM 897 Company 887 STOP & REVIEW 899 Materials 888 CHAPTER ASSIGNMENTS 901 Labor 890 Cookie Company (Continuing Case) 919 Overhead 890 Costing Systems: Process Costing 920 CHAPTER 21 DECISION POINT (cid:2) A MANAGER’S FOCUS MILK PRODUCTS Accounting for Costs 931 COMPANY 921 Assigning Costs 931 The Process Costing System 922 Process Costing for Two or More Production Patterns of Product Flows and Cost Flow Departments 933 Methods 923 Preparing a Process Cost Report Using the Cost Flows Through the Work in Process Inventory Average Costing Method 935 Accounts 924 Accounting for Units 935 Computing Equivalent Production 925 Accounting for Costs 937 Equivalent Production for Direct Materials 926 Assigning Costs 937 Equivalent Production for Conversion Costs 927 (cid:2) MILK PRODUCTS COMPANY: REVIEW PROBLEM 940 Summary of Equivalent Production 927 STOP & REVIEW 943 Preparing a Process Cost Report Using the CHAPTER ASSIGNMENTS 945 FIFO Costing Method 928 Cookie Company (Continuing Case) 957 Accounting for Units 928 xiv Contents Value-Based Systems: ABM and Lean 958 CHAPTER 22 DECISION POINT (cid:2) A MANAGER’S FOCUS BEAN BAG The New Operating Environment and Lean CONVERTIBLES, INC. 959 Operations 968 Value-Based Systems and Management 960 Just-in-Time (JIT) 968 Value Chains and Supply Chains 961 Continuous Improvement of the Work Process Value Analysis 962 Environment 970 Value-Adding and Non-Value-Adding Accounting for Product Costs in a JIT Operating Activities 963 Environment 970 Value-Based Systems 963 Backflush Costing 972 Activity-Based Management 963 Comparison of ABM and Lean 976 Managing Lean Operations 964 (cid:2) BEAN BAG CONVERTIBLES, INC.: REVIEW PROBLEM 977

Activity-Based Costing 964 STOP & REVIEW 980 The Cost Hierarchy and the Bill of CHAPTER ASSIGNMENTS 982 Activities 965 Cookie Company (Continuing Case) 997 Cost Behavior Analysis 998 CHAPTER 23 DECISION POINT (cid:2) A MANAGER’S FOCUS MY MEDIA Cost-Volume-Profit Analysis 1010 PLACE 999 Breakeven Analysis 1012 Cost Behavior and Management 1000 Using an Equation to Determine the Breakeven The Behavior of Costs 1001 Point 1013 Mixed Costs and the Contribution Margin The Breakeven Point for Multiple Products 1014 Income Statement 1006 Using C-V-P Analysis to Plan Future Sales, The Engineering Method 1006 Costs, and Profits 1017 The Scatter Diagram Method 1006 Applying C-V-P to Target Profits 1017 The High-Low Method 1007 (cid:2) MY MEDIA PLACE: REVIEW PROBLEM 1020 Statistical Methods 1009 STOP & REVIEW 1023 Contribution Margin Income Statements 1009 CHAPTER ASSIGNMENTS 1025 Cookie Company (Continuing Case) 1038 The Budgeting Process 1040 CHAPTER 24 DECISION POINT (cid:2) A MANAGER’S FOCUS FRAMECRAFT The Overhead Budget 1053 COMPANY 1041 The Selling and Administrative Expense The Budgeting Process 1042 Budget 1054 Advantages of Budgeting 1042 The Cost of Goods Manufactured Budget 1055 Budgeting and Goals 1043 Financial Budgets 1057 Budgeting Basics 1043 The Budgeted Income Statement 1057 The Master Budget 1045 The Capital Expenditures Budget 1058 Preparation of a Master Budget 1045 The Cash Budget 1058 Budget Procedures 1048 The Budgeted Balance Sheet 1061 Operating Budgets 1049 (cid:2) FRAMECRAFT COMPANY: REVIEW PROBLEM 1063 The Sales Budget 1049 STOP & REVIEW 1066 The Production Budget 1050 CHAPTER ASSIGNMENTS 1068 The Direct Materials Purchases Budget 1051 Cookie Company (Continuing Case) 1091 The Direct Labor Budget 1053 xv Contents Performance Management and Evaluation 1092 CHAPTER 25 DECISION POINT (cid:2) A MANAGER’S FOCUS WINTER Performance Evaluation of Investment WONDERLAND RESORT 1093 Centers 1105 Performance Measurement 1094 Return on Investment 1105 What to Measure, How to Measure 1094 Residual Income 1107 Other Measurement Issues 1094 Economic Value Added 1108 Organizational Goals and the Balanced The Importance of Multiple Performance Scorecard 1095 Measures 1110 The Balanced Scorecard and Management 1095 Performance Incentives and Goals 1111 Responsibility Accounting 1097 Linking Goals, Performance Objectives, Measures, Types of Responsibility Centers 1098 and Performance Targets 1111 Organizational Structure and Performance Performance-Based Pay 1112 Management 1100 The Coordination of Goals 1112 Performance Evaluation of Cost Centers and (cid:2) WINTER WONDERLAND RESORT: Profit Centers 1102 REVIEW PROBLEM 1115 Evaluating Cost Center Performance Using Flexible STOP & REVIEW 1118 Budgeting 1102 CHAPTER ASSIGNMENTS 1120 Evaluating Profit Center Performance Using Cookie Company (Continuing Case) 1135 Variable Costing 1103 Standard Costing and Variance Analysis 1136 CHAPTER 26 DECISION POINT (cid:2) A MANAGER’S FOCUS ICU, INC. 1137 Computing and Analyzing Direct Labor Standard Costing 1138 Variances 1150 Standard Costs and Managers 1138 Computing Direct Labor Variances 1150 Computing Standard Costs 1139 Analyzing and Correcting Direct Labor Variances 1152 Standard Direct Materials Cost 1139 Computing and Analyzing Overhead Standard Direct Labor Cost 1139 Variances 1154 Standard Overhead Cost 1140 Using a Flexible Budget to Analyze Overhead Total Standard Unit Cost 1141 Variances 1154 Variance Analysis 1142 Computing Overhead Variances 1154 The Role of Flexible Budgets in Variance Analyzing and Correcting Overhead Variances 1159 Analysis 1142 Using Cost Variances to Evaluate Managers’ Using Variance Analysis to Control Costs 1145 Performance 1161 Computing and Analyzing Direct Materials (cid:2) ICU, INC.: REVIEW PROBLEM 1163 Variances 1147 STOP & REVIEW 1168 Computing Direct Materials Variances 1147 CHAPTER ASSIGNMENTS 1170 Analyzing and Correcting Direct Materials Cookie Company (Continuing Case) 1183 Variances 1149 Short-Run Decision Analysis 1184 CHAPTER 27 DECISION POINT (cid:2) A MANAGER’S FOCUS HOME STATE Incremental Analysis for Short-Run Decisions 1186

BANK 1185 Incremental Analysis for Outsourcing Short-Run Decision Analysis and the Decisions 1189 Management Process 1186 xvi Contents Incremental Analysis for Special Order Incremental Analysis for Sell or Process- Decisions 1191 Further Decisions 1199 Incremental Analysis for Segment (cid:2) HOME STATE BANK: REVIEW PROBLEM 1202 Profitability Decisions 1194 STOP & REVIEW 1205 Incremental Analysis for Sales Mix CHAPTER ASSIGNMENTS 1207 Decisions 1196 Cookie Company (Continuing Case) 1223 Capital Investment Analysis 1224 CHAPTER 28 DECISION POINT (cid:2) A MANAGER’S FOCUS The Time Value of Money 1234 NEIGHBORHOOD COMMUNICATIONS 1225 Interest 1234 The Capital Investment Process 1226 Present Value 1235 Capital Investment Analysis 1226 Present Value of a Single Sum Due in the Capital Investment Analysis in the Management Future 1236 Process 1227 Present Value of an Ordinary Annuity 1236 The Minimum Rate of Return on Investment 1229 The Net Present Value Method 1238 Cost of Capital 1229 Advantages of the Net Present Value Method 1238 Other Measures for Determining Minimum Rate of The Net Present Value Method Illustrated 1238 Return 1230 Other Methods of Capital Investment Ranking Capital Investment Proposals 1230 Analysis 1241 Measures Used in Capital Investment The Payback Period Method 1241 Analysis 1231 The Accounting Rate-of-Return Method 1242 Expected Benefits from a Capital Investment 1231 (cid:2) NEIGHBORHOOD COMMUNICATIONS: Equal Versus Unequal Cash Flows 1232 REVIEW PROBLEM 1244 Carrying Value of Assets 1232 STOP & REVIEW 1246 Depreciation Expense and Income Taxes 1232 CHAPTER ASSIGNMENTS 1248 Disposal or Residual Values 1233 Cookie Company (Continuing Case) 1260 APPENDIX A Accounting for Investments 1262 Management Issues Related to Investments 1262 Trading Securities 1264 Available-for-Sale Securities 1267 Long-Term Investments in Equity Securities 1267 Investments in Debt Securities 1271 Long-Term Investments in Bonds 1272 STOP & REVIEW 1273 APPENDIX B Present Value Tables 1276 Endnotes 1280 Company Index 1284 Subject Index 1285 PREFACE Accounting This revision of Principles of Accounting is based on an understanding of the in Motion! nature, culture, and motivations of today’s undergraduate students and on exten- sive feedback from many instructors who use our book. These substantial changes meet the needs of these students, who not only face a business world increasingly complicated by ethical issues, globalization, and technology but who also have more demands on their time. To assist them to meet these challenges, the authors carefully show them how the effects of business transactions, which are the result of business decisions, are recorded in a way that will be reflected on the finan- cial statements. Instructors will find that building on the text’s historically strong pedagogy, the authors have strengthened transaction analysis and its link to the accounting cycle. Updated Content, Strengthened Transaction Analysis Organization Maintaining a solid foundation in double-entry accounting, we increased the and Pedagogy number of in-text journal entries and have used T accounts linked to these journal-entry illustrations throughout the financial accounting chapters. In Chapter 2, “Analyzing Business Transactions,” for example, we clarified the rela- tionship of transaction analysis to the accounting cycle. In Chapter 6, “The Oper- ating Cycle and Merchandising Accounting,” we include transaction illustrations for all transactions mentioned in the chapter. At the same time, we reduced exces- sive detail, shortened headings, simplified explanations, and increased readability in an effort to reduce the length of each chapter. Application of Double Entry: Assets (cid:2) Liabilities (cid:3) Owner’s Equity CASH WAGES EXPENSE Dr. Cr. Dr. Cr. July 1 40,000 July 3 3,200 July 26 4,800 10 2,800 6 13,320 19 1,400 9 2,600 22 5,000 26 4,800 Entry in Journal Form: Dr. Cr. July 26 Wages Expense 4,800 Cash 4,800 Content and Organization: Partnerships, Special-Purpose Journals, and Investments Based on user input, Chapter 17 introduces a new topic of partnerships to the

text. To make room for this, the investments chapter is now located in Appendix A with ample assignment material to provide greater flexibility of coverage. xvii xviii Preface Also based on user desires, we have inserted a supplement on special-purpose journals with assignment material after Chapter 6. Strong Pedagogical System Principles of Accounting originated the pedagogical system of Integrated Learn- ing Objectives. The system supports both learning and teaching by providing flexibility in support of the instructor’s teaching of first-year accounting. The chapter review and all assignments identify the applicable learning objective(s) for easy reference. Each learning objective refers to a specific content area, usually either con- ceptual content or procedural techniques, in short and easily understandable seg- ments. Each segment is followed by a “Stop and Apply” section that illustrates and solves a short exercise related to the learning objective. STOP & APPLY Match the letter of each item below with the numbers of the related items: a. An inventory cost ____ 3. Application of the LCM rule b. An assumption used in the valuation of ____ 4. Goods flow inventory ____ 5. Transportation charge for mer- c. Full disclosure convention chandise shipped FOB shipping d. Conservatism convention point e. Consistency convention ____ 6. Cost flow f. Not an inventory cost or assumed flow ____ 7. Choosing a method and sticking with it ____ 1. Cost of consigned goods ____ 8. Transportation charge for mer- ____ 2. A note to the financial statements chandise shipped FOB destination explaining inventory policies SOLUTION 1. f; 2. c; 3. d; 4. b; 5. a; 6. f; 7. e; 8. f To make the text more visually appealing and readable, it is divided into student-friendly sections with brief bulleted lists, new art, photographs, and end- of-section review material. Cash Flows To avoid financial distress, a company must be able to pay its bills on time. Because and the Timing the timing of cash flows is critical to maintaining adequate liquidity to pay bills, managers and other users of financial information must understand the difference of Transactions between transactions that generate immediate cash and those that do not. Con- sider the transactions of Miller Design Studio shown in Figure 2-3. Most of them LO5 Show how the timing involve either an inflow or outflow of cash. of transactions affects cash As you can see in Figure 2-3, Miller’s Cash account has more transactions flows and liquidity. than any of its other accounts. Look at the transactions of July 10, 15, and 22: (cid:2) July 10: Miller received a cash payment of $2,800. (cid:2) July 15: The firm billed a customer $9,600 for a service it had already per- formed. (cid:2) July 22: The firm received a partial payment of $5,000 from the customer, but it had not received the remaining $4,600 by the end of the month. Because Miller incurred expenses in providing this service, it must pay careful attention to its cash flows and liquidity. One way Miller can manage its expenditures is to rely on its creditors to give it time to pay. Compare the transactions of July 3, 5, and 9 in Figure 2-3. xix Preface Further, to reduce distractions, the margins of the text include only Study Study Note Notes, which alert students to common misunderstandings of concepts and tech- niques; key ratio and cash flow icons, which highlight discussions of profitability After Step 1 has been completed, and liquidity; and accounting equations. Icons and equations appear in the finan- the Income Summary account cial chapters (Chapters 1–17). reflects the account balance of the Design Revenue account before it was closed. Enhanced Real- IFRS, Fair Value, and Other Updates World Examples International Financial Reporting Standards and fair value have been integrated Demonstrate throughout the book where accounting standards have changed and also in the Business Focus features where applicable. All current events, statistics, and tables Accounting have been updated with the latest data. in Motion FOCUS ON BUSINESS PRACTICE

IFRS: The Arrival of International Financial Reporting Standards in the United States Over the next few years, international financial and Exchange Commission (SEC) recently voted to reporting standards (IFRS) will become much more allow foreign registrants in the United States. This important in the United States and globally. The is a major development because in the past, the International Accounting Standards Board (IASB) SEC required foreign registrants to explain how the has been working with the Financial Accounting standards used in their statements differed from Standards Board (FASB) and similar boards in other U.S. standards. This change affects approximately 10 nations to achieve identical or nearly identical stan- percent of all public U.S. companies. In addition, the dards worldwide. IFRS are now required in many SEC may in the near future allow U.S. companies to parts of the world, including Europe. The Securities- use IFRS.11 Use of Small, Diverse Companies Each chapter begins with a Decision Point, a real-world scenario about a small company that challenges students to see the connection between accounting information and management decisions. DECISION POINT (cid:2) A USER’S FOCUS (cid:2) How can Pente Computer PENTE COMPUTER COMPANY Company manage its cash needs? (cid:2) How can the company Pente Computer Company sells computer products for cash reduce the level of or on credit. The company’s peak sales occur in August and uncollectible accounts and September, when students are shopping for computers increase the likelihood that and computer-related supplies, and during the pre-holiday accounts receivable will be season in November and D ecember. It is now January, and paid on time? Andre Pente, the company’s owner, has been reviewing the (cid:2) How can the company company’s performance over the past two years. He has evaluate the effectiveness determined that in those years, approximately 1.5 p ercent of its credit policies and of net sales have been uncollectible, and he is concerned the level of its accounts receivable? that this year, the company may not have enough cash to cover operations before sales begin to increase again in late summer. In this chapter, we discuss concepts and tech- niques that would help Pente manage his cash and accounts receivable so that the company maintains its liquidity. xx Preface These company examples come full circle at the end of the chapter by linking directly to the Review Problem. Smaller, diverse company examples illustrate accounting concepts and encourage students to apply what they have learned. (cid:2) PENTE COMPUTER COMPANY: REVIEW PROBLEM In this chapter’s Decision Point, we posed the following questions: • How can Pente Computer Company manage its cash needs? • How can the company reduce the level of uncollectible accounts and increase the likelihood that accounts receivable will be paid on time? • How can the company evaluate the effectiveness of its credit policies and the level of its accounts receivable? During the months when sales are at their peak, Pente Computer Company may have excess cash available that it can invest in a way that earns a return but still permits ready access to cash. At other times, it may have to arrange for short-term borrowing. To ensure that it can borrow funds when it needs to, the company must maintain good relations with its bank. Use of Well-Known Public Companies This textbook also offers examples from highly recognizable public companies, such as CVS Caremark, Southwest Airlines, Dell Computer, and Netflix, to relate basic accounting concepts and techniques to the real world. Chapter 5, “Finan- cial Reporting and Analysis,” helps students interpret financial information. The latest available data is used in exhibits to incorporate the most recent FASB pronouncements. The authors illustrate current practices in financial reporting by referring to data from Accounting Trends and Techniques (AICPA) and integrate international topics wherever appropriate. Consolidated means that data from all CVS Caremark Corporation CVS’s fiscal year ends on the Saturday

companies owned by CVS are combined. Consolidated Statements of Operations closest to December 31. Fiscal Year Ended Dec. 31, 2008 Dec. 29, 2007 Dec. 30, 2006 (In millions, except per share amounts) (52 weeks) (52 weeks) (53 weeks) Net revenues $87,471.9 $76,329.5 $43,821.4 Cost of revenues 69,181.5 60,221.8 32,079.2 Gross profit 18,290.4 16,107.7 11,742.2 Total operating expenses 12,244.2 11,314.4 9,300.6 Operating profit1 6,046.2 4,793.3 2,441.6 Interest expense, net2 509.5 434.6 215.8 Earnings before income tax provision 5,536.7 4,358.7 2,225.8 Loss from discontinued operations, (132) — — net of income tax benefit of $82.4 Income tax provision 2,192.6 1,721.7 856.9v Net earnings3 3,212.1 2,637.0 1,368.9 Preference dividends, net of income tax benefit4 14.1 14.2 13.9 Net earnings available to common shareholders $ 3,198.0 $ 2,622.8 $ 1,355.0 BASIC EARNINGS PER COMMON SHARE:5 Net earnings $ 2.23 $ 1.97 $ 1.65 Weighted average common shares outstanding 1,433.5 1,328.2 820.6 DILUTED EARNINGS PER COMMON SHARE: Net earnings $ 2.18 $ 1.92 $ 1.60 Weighted average common shares outstanding 1,469.1 1,371.8 853.2 xxi Preface Revised and Expanded Assignments Assignments have been carefully scrutinized for direct relevancy to the learning objectives in the chapters. Names and numbers for all Short Exercises, Exercises, and Problems have been changed except those used on videos. We have reversed the alternate and main problems from the previous edition. Most importantly, alternative problems have been expanded so that there are ample problems for any course. All of the cases have been updated as appropriate and the number of cases in each chapter has been reduced in response to user preferences. The variety of cases in each chapter depends on their relevance to the chapter topics, but throughout the text there are cases involving conceptual understanding, ethical dilemmas, interpreting financial reports, group activities, business communication, and the Internet. Annual report cases based on CVS Caremark and Southwest Airlines can be found at the end of the chapter. Specific Chapter Changes The following chapter-specific changes have been made in this edition of Principles of Accounting: Chapter 1: Uses of Accounting Information and the Financial Statements • Discussion of performance measures revised using CVS and General Motors as examples of how these measures relate to profitability and liquidity • Discussion of the statement of cash flows revised to relate the statement to business activities and goals • Updated and enhanced coverage of the roles of the Financial Account- ing Standards Board (FASB) and the International Accounting Standards Board (IASB) • New Focus on Business Practice box on SEC’s decision to let foreign com- panies registered in the United States use international financial reporting standards (IFRS) • New study note on the role of the Public Company Accounting Oversight Board (PCAOB) Chapter 2: Analyzing Business Transactions • Learning Objective (LO) 3 revised to clarify and emphasize the role of T accounts, journal form, and their relationship to the general ledger • New example of recognition violation • Section on valuation revised to address fair value and IFRS • New Focus on Business Practice box on fair value accounting in an interna- tional marketplace • Cash flow discussion edited for clearer delineation of the sequence of transactions Chapter 3: Measuring Business Income • New example of earnings management focusing on Dell Computer • New Focus on Business Practice box describing the FASB’s rules for revenue recognition and the one broad principle (IFRS) that the IASB uses Chapter 4: Completing the Accounting Cycle • In-text examples focusing on Miller Design Studio simplified by using fewer accounts, thus clarifying the process of preparing closing entries and the worksheet xxii Preface Chapter 5: Financial Reporting and Analysis • Section on the objective of financial reporting revised to reflect FASB’s empha- sis on the needs of capital providers and other users of financial reports

• Coverage of qualitative characteristics simplified and shortened • New Focus on Business Practice box on convergence of U.S. GAAP and IFRS and their effect on accounting standards • New Focus on Business Practice box on how convergence of U.S. GAAP and IFRS can make financial analysis more difficult • New Focus on Business Practice box on the use of ratios (performance mea- sures) in executive compensation Chapter 6: The Operating Cycle and Merchandising Transactions • Discussion of the operating cycle revised for greater clarity • T accounts and journal entries used to illustrate accounting for merchandis- ing transactions under both the perpetual and periodic inventory systems • Updated Focus on Business Practice box on the increased use of credit and debit cards • Clearer differentiation between the cost of goods available for sale and the cost of goods sold in LO4 • New supplement on Special-Purpose Journals Chapter 7: Internal Control • New Focus on Business Practice box on the effectiveness of the Sarbanes- Oxley Act in preventing fraud • New Focus on Business Practice box on methods of preventing shoplifting • Material reformatted to clarify discussion of documents used in an internal control plan for purchases and cash disbursements Chapter 8: Inventories • Discussion of disclosure of inventory methods shortened for greater clarity • New Focus on Business Practice box on the lower-of-cost-or-market rule • New Focus on Business Practice box on the use of LIFO inside and outside the United States • New Focus on Business Practice box on how IFRS and U.S. standards define fair value Chapter 9: Cash and Receivables • Concept of fair value introduced at various points throughout the chapter • Revised Focus on Business Practice box on estimating cash collections • New coverage of subprime loans Chapter 10: Current Liabilities and Fair Value Accounting • Chapter revised to include coverage of fair value accounting • Discussion and assignments related to future value deleted to emphasize pres- ent value and fair value, which are more directly related to this course • New study note on the disclosure of the fair value of short-term debt Chapter 11: Long-Term Assets • Coverage of tax laws revised to address the Economic Stimulus Act of 2008 • Coverage of intangible assets revised to reflect current standards • Revised Focus on Business Practice box on customer lists xxiii Preface Chapter 12: Contributed Capital • Revised Focus on Business Practice box on politics and accounting for stock options • Section on cash flow information added to LO1 • Updated Focus on Business Practice box on share buybacks Chapter 13: Long-Term Liabilities • Bonds interest rates changed so that they are more realistic and less compli- cated than in previous edition • Updated discussion of accounting for defined pension plans • New Focus on Business Practice box on post-retirement liabilities • Section on cash flow information added to LO1 Chapter 14: The Corporate Income Statement and the Statement of Stock- holders’ Equity • Nonoperating items, which were covered in LO3 in previous edition, now discussed in LO1 • New Focus on Business Practice box on looking beyond the bottom line • Revised Focus on Business Practice box on pro-forma earnings Chapter 15: The Statement of Cash Flows • Clarification of required disclosure of noncash investing and financing activi- ties in LO1 • Sections on the risks of having too much cash and on interpreting the state- ment of cash flows added to LO2 • New Focus on Business Practice box on the IASB’s support of the direct method Chapter 16: Financial Performance Measurement • Updated Focus on Business Practice box on pro-forma earnings • Revised Focus on Business Practice box on performance measurement Chapter 17: Partnerships • New chapter added in response to users’ requests Chapter 18: The Changing Business Environment: A Manager’s Perspective • Updated definition of management accounting • Lean production introduced as a key term • Sections on total quality management and activity based management revised

• Updated Focus on Business Practice box on how to blow the whistle on fraud Chapter 19: Cost Concepts and Cost Allocation • Discussions of costs in LO2 in previous edition incorporated in LO1 • Section on document and cost flows through the inventory accounts in new LO3 revised • Introduction to methods of product cost measurement added and section on computing service unit cost shortened in new LO4 • LO7 and LO8 streamlined and incorporated in new LO5 Chapter 20: Costing Systems: Job Order Costing • Chapter 20 in previous edition separated into two chapters, with new C hapter 20 focusing on job order costing and new Chapter 21 focusing on process costing • Operations costing system introduced as a key concept xxiv Preface • Discussions of manufacturer’s job order cost card, computation of unit cost, and job order costing in a service organization included in new LO4 • New Focus on Business Practice box on the use of project costing Chapter 21: Costing Systems: Process Costing • New chapter (part of Chapter 20 in previous edition) Chapter 22: Value-Based Systems: ABM and Lean • LO1 and LO2 in last edition combined and revised • Section on process value analysis included in LO1 • New listing of ABC’s disadvantages in LO2 • New focus on lean operations in LO3 Chapter 23: Cost Behavior Analysis • LO1 and LO2 in last edition combined and revised • Discussions of variable, fixed, and mixed costs and discussions of step costs and linear relationships included in LO1 • Discussion of contribution margin income statement included in LO2 • LO5 revised to clarify concepts Chapter 24: The Budgeting Process • Section on advantages of budgeting and three key terms—static budget, con- tinuous budget, and zero-based budgeting—added to revised LO1 Chapter 25: Performance Management and Evaluation • LO1 and LO2 in last edition combined and revised Chapter 26: Standard Costing and Variance Analysis • LO1 and LO2 in last edition combined and revised Chapter 27: Short-Run Decision Analysis • Chapter revised to focus on short-run decisions and incremental analysis; cap- ital investment analysis and time value of money now covered in Chapter 28 Chapter 28: Capital Investment Analysis • New chapter Online Solutions South-Western, a division of Cengage Learning, offers a vast array of online solu- for Every Learning tions to suit your course and your students’ learning styles. Choose the product that best meets your classroom needs and course goals. Please check with your Style sales representative for more details and ordering information. CengageNOW™ CengageNOW for Needles/Powers Principles of Accounting, 11e is a powerful and fully integrated online teaching and learning system that provides you with flexibility and control. This complete digital solution offers a comprehensive set of digital tools to power your course. CengageNOW offers the following: (cid:2) Homework, including algorithmic variations (cid:2) Integrated e-book (cid:2) Personalized study plans, which include a variety of multimedia assets (from exercise demonstrations to videos to iPod content) for students as they m aster the chapter materials xxv Preface (cid:2) Assessment options, including the full test bank and algorithmic variations (cid:2) Reporting capability based on AACSB, AICPA, and IMA competencies and standards (cid:2) Course Management tools, including grade book (cid:2) WebCT and Blackboard Integration Visit www.cengage.com/tlc for more information. ® WebTutor™ on Blackboard and WebCT™ WebTutor™ is available packaged with Needles/Powers Principles of Accounting, 11e or for individual student purchase. Jump-start your course and customize rich, text-specific content with your Course Management System. (cid:2) Jump-start: Simply load a WebTutor cartridge into your Course Manage- ment System. (cid:2) Customize content: Easily blend, add, edit, reorganize, or delete content. Content includes media assets, quizzing, test bank, web links, discussion top- ics, interactive games and exercises, and more. Visit www.cengage.com/webtutor for more information.

Teaching Tools (cid:2) Instructor’s Resource CD-ROM: Included on this CD set are the key sup- for Instructors plements designed to aid instructors, including the Solutions Manual, Exam- View Test Bank, Word Test Bank, and Lecture PowerPoint slides. (cid:2) Solutions Manual: The Solutions Manual contains answers to all exercises, problems, and activities that appear in the text. As always, the solutions are author-written and verified multiple times for numerical accuracy and consis- tency with the core text. (cid:2) ExamView® Pro Testing Software: This intuitive software allows you to easily customize exams, practice tests, and tutorials and deliver them over a network, on the Internet, or in printed form. In addition, ExamView comes with searching capabilities that make sorting the wealth of questions from the printed test bank easy. The software and files are found on the IRCD. (cid:2) Lecture PowerPoint® Slides: Instructors will have access to PowerPoint slides online and on the IRCD. These slides are conveniently designed around learning objectives for partial chapter teaching and include art for dynamic presentations. There are also lecture outline slides for each chapter for those instructors who prefer them. (cid:2) Instructor’s Companion Website: The instructor website contains a vari- ety of resources for instructors, including the Instructor’s Resource Manual (which has chapter planning matrices, chapter resource materials and outlines, chapter reviews, difficulty and time charts, etc.), and PowerPoint slides. www. cengage.com/accounting/needles (cid:2) Klooster & Allen’s General Ledger Software: Prepared by Dale Klooster and Warren Allen, this best-selling, educational, general ledger package introduces students to the world of computerized accounting through a more intuitive, user-friendly system than the commercial software they will use in the future. In addition, students have access to general ledger files xxvi Preface with information based on problems from the textbook and practice sets. This context allows them to see the difference between manual and com- puterized accounting systems firsthand. Also, the program is enhanced with a problem checker that enables students to determine if their entries are correct. Klooster & Allen emulates commercial general ledger pack- ages more closely than other educational packages. Problems that can be used with Klooster/Allen are highlighted by an icon. The Inspector Files found on the IRCD allow instructors to grade students’ work. A free Net- work Version is available to schools whose students purchase Klooster/ Allen’s General Ledger Software. Learning CengageNOW™ Resources for CengageNOW for Needles/Powers Principles of Accounting, 11e is a powerful Students and fully integrated online teaching and learning system that provides you with flexibility and control. This complete digital solution offers a comprehensive set of digital tools to power your course. CengageNOW offers the following: (cid:2) Homework, including algorithmic variations (cid:2) Integrated e-book (cid:2) Personalized study plans, which include a variety of multimedia assets (from exercise demonstrations to videos to iPod content) for students as they master the chapter materials (cid:2) Assessment options, including the full test bank and algorithmic variations (cid:2) Reporting capability based on AACSB, AICPA, and IMA competencies and standards (cid:2) Course Management tools, including grade book (cid:2) WebCT and Blackboard Integration Visit www.cengage.com/tlc for more information. WebTutor™ on Blackboard® and WebCT™ (cid:2) WebTutor™ is available packaged with Needles/Powers Principles of Account- ing, 11e or for individual student purchase. Jump-start your course and cus- tomize rich, text-specific content with your Course Management System. (cid:2) Jump-start: Simply load a WebTutor cartridge into your Course Manage- ment System. (cid:2) Customize content: Easily blend, add, edit, reorganize, or delete content. Content includes media assets, quizzing, test bank, web links, discussion top-

ics, interactive games and exercises, and more. Visit www..cengage.com/webtutor for more information. Klooster & Allen’s General Ledger Software: This best-selling, educational, general ledger software package introduces you to the world of computerized accounting through a more intuitive, user-friendly system than the commercial software you’ll use in the future. Also, the program is enhanced with a problem checker that provides feedback on selected activities and emulates commercial general ledger packages more closely than other educational packages. Problems that can be used with Klooster/Allen are highlighted by an icon. xxvii Preface Working Papers (Printed): A set of preformatted pages allow students to more easily work end-of-chapter problems and journal entries. Student CD-ROM for Peachtree®: You will have access to Peachtree so you can familiarize yourself with computerized accounting systems used in the real world. You will gain experience from working with actual software, which will make you more desirable as a potential employee. Electronic Working Papers in Excel® Passkey Access (for sale online): Students can now work end-of-chapter assignments electronically in Excel with easy-to follow, preformatted worksheets. This option is available via an online download with a passkey. Companion Website: The student website contains a variety of educational resources for students, including online quizzing, the Glossary, Flashcards, and Learning Objectives. www.cengage.com/accounting/needles Acknowledgements A successful textbook is a collaborative effort. We are grateful to the many pro- fessors, other professional colleagues, and students who have taught and studied from our book, and we thank all of them for their constructive comments. In the space available, we cannot possibly mention everyone who has been helpful, but we do want to recognize those who made special contributions to our efforts in preparing the eleventh edition of Principles of Accounting. We wish to express deep appreciation to colleagues at DePaul University, who have been extremely supportive and encouraging. Very important to the quality of this book are our proofreaders, Margaret Kearney and Cathy Larson, to whom we give special thanks. We also appreci- ate the support of our Supervising Development Editor, Katie Yanos; Execu- tive Editor, Sharon Oblinger; Senior Marketing Manager, Kristen Hurd; and Content Project Manager, Darrell Frye. Others who have had a major impact on this book through their reviews, suggestions, and participation in surveys, interviews, and focus groups are listed below. We cannot begin to say how grateful we are for the feedback from the many instructors who have generously shared their responses and teaching experi- ences with us. Daneen Adams, Santa Fe College Sidney Askew, Borough of Manhattan Community College Nancy Atwater, College of St. Scholastica Algis Backaitis, Wayne County Community College Abdul Baten, Northern Virginia Community College Robert Beebe, Morrisville State College Teri Bernstein, Santa Monica College Martin Bertisch, York College Tes Bireda, Hillsborough Community College James Bryant, Catonsville Community College Earl Butler, Broward Community College Lloyd Carroll, Borough of Manhattan Community College Stanley Carroll, New York City College of Technology Roy Carson, Anne Arundel Community College Janet Caruso, Nassau Community College Sandra Cereola, Winthrop University James J. Chimenti, Jamestown Community College xxviii Preface Carolyn Christesen, SUNY Westchester Community College Stan Chu, Borough of Manhattan Community College Jay Cohen, Oakton Community College Sandra Cohen, Columbia College Scott Collins, The Pennsylvania State University Joan Cook, Milwaukee Area Tech College—Downtown Barry Cooper, Borough of Manhattan Community College Michael Cornick, Winthrop University Robert Davis, Canisius College Ron Deaton, Grays Harbor College Jim Delisa, Highline Community College Tim Dempsey, DeVry College of Technology Vern Disney, University of South Carolina Sumter

Eileen Eichler, Farmingdale State College Mary Ewanechko, Monroe Community College Cliff Frederickson, Grays Harbor College John Gabelman, Columbus State Community College Lucille Genduso, Kaplan University Nashwa George, Berkeley Rom Gilbert, Santa Fe College Janet Grange, Chicago State University Tom Grant, Kutztown Tim Griffin, Hillsborough Community College—Ybor City Campus Sara Harris, Arapahoe Community College Lori Hatchell, Aims Community College Roger Hehman, Raymond Walters College/University of Cincinnati Sueann Hely, West Kentucky Community & Technical College Many Hernandez, Borough of Manhattan Community College Michele Hill, Schoolcraft College Cindy Hinz, Jamestown Community College Jackie Holloway, National Park Community College Phillip Imel, Southwest Virginia Community College Jeff Jackson, San Jacinto College Irene Joanette-Gallio, Western Nevada Community College Vicki Jobst, Benedictine University Doug Johnson, Southwest Community College Jeff Kahn, Woodbury University John Karayan, Woodbury University Miriam Keller-Perkins, University of California-Berkeley Randy Kidd, Longview Community College David Knight, Borough of Manhattan Community College Emil Koren, Saint Leo University Bill Lasher, Jamestown Business College Jennifer LeSure, Ivy Tech State College Archish Maharaja, Point Park University Harvey Man, Borough of Manhattan Community College Robert Maxwell, College Of The Canyons Stuart McCrary, Northwestern University Noel McKeon, Florida Community College—Jacksonville Terri Meta, Seminole Community College Roger Moore, Arkansas State University—Beebe Carol Murphy, Quinsigamond Community College Carl Muzio, Saint John’s University Mary Beth Nelson, North Shore Community College xxix Preface Andreas Nicolaou, Bowling Green State University Patricia Diane Nipper, Southside Virginia Community College Tim Nygaard, Madisonville Community College Susan L. Pallas, Southeast Community College Clarence Perkins, Bronx Community College Janet Pitera, Broome Community College Eric Platt, Saint John’s University Shirley Powell, Arkansas State University—Beebe LaVonda Ramey, Schoolcraft College Michelle Randall, Schoolcraft College Eric Rothenburg, Kingsborough Community College Rosemarie Ruiz, York College—CUNY Michael Schaefer, Blinn College Sarah Shepard, West Hills College Coalinga Linda Sherman, Walla Walla Community College Deborah Stephenson, Winston-Salem State University Ira Stolzenberg, SUNY—Old Westbury David Swarts, Clinton Community College Linda Tarrago, Hillsborough Community College—Main Campus Thomas Thompson, Savannah Technical College Peter Vander Weyst, Edmonds Community College Lynnwood Dale Walker, Arkansas State University—Beebe Doris Warmflash, Westchester Community College Wanda Watson, San Jacinto College—Central Andy Williams, Edmonds Community College—Lynnwood Josh Wolfson, Borough of Manhattan Community College Paul Woodward, Santa Fe College Allen Wright, Hillsborough Community College—Main Campus Jian Zhou, SUNY at Binghamton This page intentionally left blank ABOUT THE AUTHORS Belverd E. Needles, Jr., Ph.D., C.P.A., C.M.A. DePaul University Belverd Needles is an internationally recognized expert in accounting education. He has published in leading journals and is the author or editor of more than 20 books and monographs. His current research relates to international finan- cial reporting, performance measurement, and corporate governance of high- performance companies in the United States, Europe, India, and Australia. His textbooks are used throughout the world and have received many awards, includ- ing the 2008 McGuffey Award from the Text and Academic Authors Associa- tion. Dr. Needles was named Educator of the Year by the American Institute of CPAs, Accountant of the Year for Education by the national honorary soci- ety Beta Alpha Psi, and Outstanding International Accounting Educator by the American Accounting Association. Among the numerous other awards he has received are the Excellence in Teaching Award from DePaul University and the Illinois CPA Society’s Outstanding Educator Award and Life-Time Achievement

Award. Active in many academic and professional organizations, he has served as the U.S. representative on several international accounting committees, includ- ing the Education Committee of the International Federation of Accountants (IFAC). He is currently vice president of education of the American Accounting Association. Marian Powers, Ph.D. Northwestern University Internationally recognized as a dynamic teacher in executive education, Marian Powers specializes in teaching managers how to read and understand financial reports, including the impact that international financial reporting standards have on their companies. More than 1,000 executives per year from countries throughout the world, including France, the Czech Republic, Australia, India, China, and Brazil, attend her classes. She has taught at the Kellogg’s Allen Cen- ter for Executive Education at Northwestern University since 1987 and at the Center for Corporate Financial Leadership since 2002. Dr. Powers’s research on international financial reporting, performance measurement, and corporate governance has been published in leading journals, among them The Accounting Review; The International Journal of Accounting; Issues in Accounting Education; The Journal of Accountancy; The Journal of Business, Finance and Accounting; and Financial Management. She has also coauthored three interactive multime- dia software products: Fingraph Financial Analyst™ (financial analysis software); Financial Analysis and Decision Making, a goal-based learning simulation focused on interpreting financial reports; and Introduction to Financial Accounting, a goal-based simulation that uses the Financial Consequences Model to introduce financial accounting and financial statements to those unfamiliar with account- ing. Dr. Powers is a member of the American Accounting Association, European Accounting Association, International Association of Accounting Education and Research, and Illinois CPA Society. She currently serves on the board of directors of the Illinois CPA Society and the board of the CPA Endowment Fund of Illi- nois. She has served as vice president of Programs and secretary of the Educational Foundation. xxxi xxxii About the Authors Susan V. Crosson, Santa Fe College Susan V. Crosson is the accounting program coordinator and a professor of accounting at Santa Fe College, Gainesville, FL. Susan has also enjoyed teach- ing at the University of Florida, Washington University in St. Louis, Univer- sity of Oklahoma, Johnson County Community College in Kansas, and Kansas City Kansas Community College. She is known for her innovative application of pedagogical strategies online and in the classroom. She is a recipient of the Outstanding Educator Award from the American Accounting Association’s Two Year College Section, an Institute of Management Accountants’ Fac- ulty Development Grant to blend technology into the classroom, the Florida Association of Community Colleges Professor of the Year Award for Instruc- tional Excellence, and the University of Oklahoma’s Halliburton Education Award for Excellence. Susan is active in many academic and professional organizations. She served in the American Institute of CPA Pre- certification Education Executive Committee and is on the Florida Institute of CPAs Relations with Accounting Educators committee and the Florida Association of Accounting Educators Steering Committee. She has served as the Ameri- can Accounting Association’s Vice President for Sections and Regions and as a council member-at-large, chairperson of the Membership Committee, and was chairperson of the Two-Year Accounting Section. Previously she served as chairperson of the Florida Institute of CPAs Accounting Careers and Edu- cation Committee and was chair of the Florida Institute of CPAs Relations with Accounting Educators Committee. Susan was on the American Institute of CPAs’ Core Competencies Best Practices Task Force also. Susan co-authors accounting textbooks for Cengage Learning: Principles of Accounting and Financial and Managerial Accounting, and Managerial Accounting with Bel

Needles and Marian Powers. Susan holds a BBA in Economics and Account- ing from Southern Methodist University and a MS in Accounting from Texas Tech University. Principles of Accounting ELEVENTH EDITION C H A P T E R Uses of Accounting 1 Information and the Financial Statements Today, more people than ever before recognize the impor- Making a Statement tance of accounting information and the profound effect that unethical and misleading financial reports can have on a business, INCOME STATEMENT its owners, its employees, its lenders, and the financial markets. In Revenues this chapter, we discuss the importance of ethical financial report- – Expenses ing, the uses and users of accounting information, and the financial = Net Income statements that accountants prepare. We end the chapter with a discussion of generally accepted accounting principles. STATEMENT OF OWNER’S EQUITY Beginning Balance LEARNING OBJECTIVES + Net Income – Withdrawals LO1 Define accounting and describe its role in making informed = Ending Balance decisions, identify business goals and activities, and explain the importance of ethics in accounting. (pp. 4–10) BALANCE SHEET Assets Liabilities LO2 Identify the users of accounting information. (pp. 10–13) LO3 Explain the importance of business transactions, money Owner’s Equity measure, and separate entity. (pp. 13–15) A = L + OE LO4 Identify the three basic forms of business organization. (pp. 15–16) STATEMENT OF CASH FLOWS Operating activities LO5 Define financial position, and state the accounting + Investing activities + Financing activities equation. (pp. 17–19) = Change in Cash + Beginning Balance LO6 Identify the four basic financial statements. (pp. 19–23) = Ending Cash Balance LO7 Explain how generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) relate to Financial statements financial statements and the independent CPA’s report, and measure how well a identify the organizations that influence GAAP. (pp. 24–27) business is run. 2 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Is Keep-Fit Center meeting its goal of profitability? KEEP-FIT CENTER (cid:2) As owner of Keep-Fit Center, what financial knowledge does On January 1, 2010, Lilian Jackson, an experienced fitness coach, Lilian Jackson need to measure started a business called Keep-Fit Center, which offers classes and progress toward the company’s goals? private instruction in aerobics, yoga, and Pilates. By December 31, 2010, the center had generated fees of $375,500, and its clients were (cid:2) In deciding whether to make giving it high marks for excellent service. Lilian is therefore now con- a loan to Keep-Fit Center, what financial knowledge sidering expanding the business. To do so, she would need a bank would a bank need to evaluate loan, and to qualify for one, both she and the bank would have to use the company’s financial various financial measures to determine the business’s profitability performance? and liquidity (i.e., its ability to repay the loan). Whether a business is small like Keep-Fit Center or large like CVS, the same financial measures are used to evaluate it. In this chapter, as you learn more about accounting and the business environment, you will become familiar with these financial measures and be able to answer questions such as those on the right. 33 4 CHAPTER 1 Uses of Accounting Information and the Financial Statements Accounting as Accounting is an information system that measures, processes, and communicates an Information financial information about an economic entity.1 An economic entity is a unit that exists independently, such as a business, a hospital, or a governmental body. Although System the central focus of this book is on business entities, we include other economic units at appropriate points in the text and end-of-chapter assignments. LO1 Define accounting and Accountants focus on the needs of decision makers who use financial informa- describe its role in making tion, whether those decision makers are inside or outside a business or other economic

informed decisions, identify entity. Accountants provide a vital service by supplying the information decision mak- business goals and activities, and ers need to make “reasoned choices among alternative uses of scarce resources in the explain the importance of ethics conduct of business and economic activities.”2 As shown in Figure 1-1, accounting is in accounting. a link between business activities and decision makers. 1. Accounting measures business activities by recording data about them for future use. 2. The data are stored until needed and then processed to become useful information. 3. The information is communicated through reports to decision makers. In other words, data about business activities are the input to the accounting system, and useful information for decision makers is the output. Business Goals, Activities, and Performance Measures A business is an economic unit that aims to sell goods and services to customers at prices that will provide an adequate return to its owners. The list that follows contains the names of some well-known businesses and the principal goods or services that they sell. BUSINESS ACTIVITIES DECISION MAKERS Actions Data Information ACCOUNTING MEASUREMENT PROCESSING COMMUNICATION SALES INVOICE $5,200 A F AUNN AICNANI TROPER L L FIGURE 1-1 Accounting as an Information System Purchase Order Accounting as an Information System 5 FIGURE 1-2 BUSINESS GOALS BUSINESS ACTIVITIES Business Goals and Activities FIRST BANK PROFITABILITY FINANCING OPERATING TITLE DEED LIQUIDITY INVESTING Wal-Mart Corp. Comprehensive discount store Reebok International Ltd. Athletic footwear and clothing Best Buy Co. Consumer electronics, personal computers Wendy’s International Inc. Food service Starbucks Corp. Coffee Southwest Airlines Co. Passenger airline Despite their differences, these businesses have similar goals and engage in similar activities, as shown in Figure 1-2. The two major goals of all businesses are profitability and liquidity. Study Note (cid:2) Profitability is the ability to earn enough income to attract and hold invest- Users of accounting information ment capital. focus on a company’s (cid:2) Liquidity is the ability to have enough cash to pay debts when they are due. profitability and liquidity. Thus, more than one measure of For example, Toyota may meet the goal of profitability by selling many cars performance is of interest to at a price that earns a profit, but if its customers do not pay for their cars quickly them. For example, lenders are enough to enable Toyota to pay its suppliers and employees, the company may concerned primarily with cash fail to meet the goal of liquidity. If a company is to survive and be successful, it flow, and owners are concerned must meet both goals. with earnings and withdrawals. All businesses, including Lilian Jackson’s Keep-Fit Center, pursue their goals by engaging in operating, investing, and financing activities. (cid:2) Operating activities include selling goods and services to customers, employ- ing managers and workers, buying and producing goods and services, and paying taxes. (cid:2) Investing activities involve spending the capital a company receives in pro- ductive ways that will help it achieve its objectives. These activities include buying land, buildings, equipment, and other resources that are needed to operate the business and selling them when they are no longer needed. 6 CHAPTER 1 Uses of Accounting Information and the Financial Statements FOCUS ON BUSINESS PRACTICE What Does CVS Have to Say About Itself? CVS, a major drug store chain, describes the company’s progress in meeting its major business objectives as follows: FINANCING: OPERATING: Obtains Funds from Sells Products and Liquidity: “Along with our strong free cash flow generation, . . . — Stockholders Services Through we faced virtually none of the liquidity issues that sent — Investors More Than — Banks and 3,500 Drugstores shockwaves across so much of the business landscape in Other Creditors and Pharmacies 2008. CVS Caremark has a solid balance sheet and an invest-

ment grade credit rating, and we maintain a commercial INVESTING: paper program currently backed by $4 billion in committed Invests Funds in bank facilities.” — Furniture, Fixtures and Equipment — Improvements Profitability: “CVS Caremark generated record revenue and earn- to Buildings ings, achieved industry-leading same-store sales growth, — Computer Equipment and continued to gain share across our businesses.”3 CVS’s main business activities are shown at the right. (cid:2) Financing activities involve obtaining adequate funds, or capital, to begin operations and to continue operating. These activities include obtaining capi- tal from creditors, such as banks and suppliers, and from owners. They also include repaying creditors and paying a return to the owners. An important function of accounting is to provide performance measures, which indicate whether managers are achieving their business goals and whether the business activities are well managed. The evaluation and interpretation of financial statements and related performance measures is called financial analy- sis. For financial analysis to be useful, performance measures must be well aligned with the two major goals of business—profitability and liquidity. Profitability is commonly measured in terms of earnings or income, and cash flows are a common measure of liquidity. In 2008, the drug and pharmacy chain CVS projected earnings of $3.5 billion and cash flows from operating activities of $4.5 billion in 2009. These figures indicate that CVS was achieving both profit- ability and liquidity in difficult financial times.4 Not all companies were so fortu- nate in 2008. For instance, General Motors reported that it would have to curtail spending on new auto and truck models because its earnings (or profitability) and cash flows were negative; in fact, they were the largest in the history of the U.S. auto industry. Clearly, General Motors was not meeting either its profitability or liquidity goals to such an extent that management had to go to the government for a bailout in the billions of dollars. In spite of the bailout, the company was forced to declare bankruptcy in 2009. Although it is important to know the amounts of earnings and cash flows in any given period and whether they are rising or falling, ratios of accounting measures are also useful tools of financial analysis. For example, to assess Keep- Fit Center’s profitability, it would be helpful to consider the ratio of its earnings to total assets, and for liquidity, the ratio of its cash flows to total assets. In addi- tion, ratios of accounting measures allow for comparisons from one period to another and from one company to another. Accounting as an Information System 7 FOCUS ON BUSINESS PRACTICE Cash Bonuses Depend on Accounting Numbers! Nearly all businesses use the amounts reported in their selecting measures that are not easily manipulated is impor- financial statements as a basis for rewarding management. tant. Equally important is maintaining a balance of measures Because managers act to achieve these accounting measures, that reflect the goals of profitability and liquidity.5 Financial and Management Accounting Accounting’s role of assisting decision makers by measuring, processing, and com- municating financial information is usually divided into the categories of manage- ment accounting and financial accounting. Although the functions of management accounting and financial accounting overlap, the two can be distinguished by the principal users of the information they provide. Management accounting provides internal decision makers, who are charged with achieving the goals of profitability and liquidity, with information about operating, investing, and financing activities. Managers and employees who conduct the activities of the business need information that tells them how they have done in the past and what they can expect in the future. For example, The Gap, a retail clothing business, needs an operating report on each outlet that tells how much was sold at that outlet and what costs were

incurred, and it needs a budget for each outlet that projects the sales and costs for the next year. Financial accounting generates reports and communicates them to exter- nal decision makers so they can evaluate how well the business has achieved its goals. These reports are called financial statements. CVS, whose stock is traded on the New York Stock Exchange, sends its financial statements to its owners (called stockholders), its banks and other creditors, and government regulators. Financial statements report directly on the goals of profitability and liquid- ity and are used extensively both inside and outside a business to evaluate the business’s success. It is important for every person involved with a business to understand financial statements. They are a central feature of accounting and a primary focus of this book. Processing Accounting Information It is important to distinguish accounting from the ways in which accounting information is processed by bookkeeping, computers, and management informa- tion systems. Accounting includes the design of an information system that meets users’ needs, and its major goals are the analysis, interpretation, and use of information. Bookkeeping, on the other hand, is mechanical and repetitive; it is the process of recording financial transactions and keeping financial records. It is a small—but important—part of accounting. Today, computers collect, organize, and communicate vast amounts of information with great speed. They can perform both routine bookkeeping chores and complex calculations. Accountants were among the earliest and most enthusiastic users of computers, and today they use computers in all aspects of their work. 8 CHAPTER 1 Uses of Accounting Information and the Financial Statements Computers make it possible to create a management information system to Study Note organize a business’s many information needs. A management information sys- tem (MIS) consists of the interconnected subsystems that provide the information Computerized accounting needed to run a business. The accounting information system is the most important information is only as reliable and useful as the data that go subsystem because it plays the key role of managing the flow of economic data to all into the system. The accountant parts of a business and to interested parties outside the business. must have a thorough under- standing of the concepts Ethical Financial Reporting that underlie accounting to ensure the data’s reliability and Ethics is a code of conduct that applies to everyday life. It addresses the question usefulness. of whether actions are right or wrong. Actions—whether ethical or unethical, right or wrong—are the product of individual decisions. Thus, when an organi- zation acts unethically by using false advertising, cheating customers, polluting the environment, or treating employees unfairly, it is not the organization that is responsible—it is the members of management and other employees who have made a conscious decision to act in this manner. Ethics is especially important in preparing financial reports because users of these reports must depend on the good faith of the people involved in their preparation. Users have no other assurance that the reports are accurate and fully disclose all relevant facts. The intentional preparation of misleading financial statements is called fraud- ulent financial reporting.6 It can result from the distortion of records (e.g., the manipulation of inventory records), falsified transactions (e.g., fictitious sales), or the misapplication of various accounting principles. There are a number of motives for fraudulent reporting—for instance, to cover up financial weakness to obtain a higher price when a company is sold; to meet the expectations of inves- tors, owners, and financial analysts; or to obtain a loan. The incentive can also be personal gain, such as additional compensation, promotion, or avoidance of penalties for poor performance. Whatever the motive for fraudulent financial reporting, it can have dire con-

sequences, as the accounting scandals that erupted at Enron Corporation and WorldCom attest. Unethical financial reporting and accounting practices at those two major corporations caused thousands of people to lose their jobs, their invest- ment incomes, and their pensions. They also resulted in prison sentences and fines for the corporate executives who were involved. FOCUS ON BUSINESS PRACTICE How Did Accounting Develop? Accounting is a very old discipline. Forms of it have been famous Italian mathematician, scholar, and philosopher essential to commerce for more than 5,000 years. Account- Fra Luca Pacioli. In 1494, Pacioli published his most impor- ing, in a version close to what we know today, gained tant work, Summa de Arithmetica, Geometrica, Proportioni et widespread use in the 1400s, especially in Italy, where it Proportionalita, which contained a detailed description of was instrumental in the development of shipping, trade, accounting as practiced in that age. This book became the construction, and other forms of commerce. This system most widely read book on mathematics in Italy and firmly of double-entry bookkeeping was documented by the established Pacioli as the “Father of Accounting.” Accounting as an Information System 9 Unethical accounting practices at Enron led to the collapse of the company and the loss of thousands of jobs and pensions. This photograph shows the former Enron building in Houston, Texas. Courtesy of Paul S. Wolf, 2009/Used under license from Shutterstock.com. In 2002, Congress passed the Sarbanes-Oxley Act to regulate financial reporting and the accounting profession, among other things. This legislation ordered the Securities and Exchange Commission (SEC) to draw up rules requir- ing the chief executives and chief financial officers of all publicly traded U.S. companies to swear that, based on their knowledge, the quarterly statements and annual reports that their companies file with the SEC are accurate and complete. Violation can result in criminal penalties. A company’s management expresses its duty to ensure that financial reports are not false or misleading in the manage- ment report that appears in the company’s annual report. For example, Target Corporation’s management report includes the following statement: Management is responsible for the consistency, integrity and presentation of the information in the Annual Report.7 However, it is accountants, not management, who physically prepare and audit financial reports. To meet the high ethical standards of the accounting pro- fession, they must apply accounting concepts in such a way as to present a fair view of a company’s operations and financial position and to avoid misleading readers of their reports. Like the conduct of a company, the ethical conduct of a profession is a collection of individual actions. As a member of a profession, each accountant has a responsibility—not only to the profession but also to employers, clients, and society as a whole—to ensure that any report he or she prepares or audits provides accurate, reliable information. The high regard that the public has historically had for the accounting profes- sion is evidence that an overwhelming number of accountants have upheld the ethics of the profession. Even as the Enron and WorldCom scandals were making headlines, a Gallup Poll showed an increase of 28 percent in the accounting pro- fession’s reputation between 2002 and 2005, placing it among the most highly rated professions.8 Accountants and top managers are, of course, not the only people responsible for ethical financial reporting. Managers and employees at all levels must be con- scious of their responsibility for providing accurate financial information to the people who rely on it. 10 CHAPTER 1 Uses of Accounting Information and the Financial Statements STOP & APPLY Match the terms below with the definitions (some answers may be used more than once): _____ 1. Management accounting a. An unethical practice _____ 2. Liquidity b. A business goal _____ 3. Financial accounting c. Engaged in by all businesses

_____ 4. Investing activities d. Major function of accounting _____ 5. Operating activities _____ 6. Financing activities _____ 7. Profitability _____ 8. Fraudulent financial reporting SOLUTION 1. d; 2. b; 3. d; 4. c; 5. c; 6. c; 7. b; 8. a Decision Makers: As shown in Figure 1-3, the people who use accounting information to make The Users of decisions fall into three categories: Accounting 1. Those who manage a business Information 2. Those outside a business enterprise who have a direct financial interest in the business LO2 Identify the users of 3. Those who have an indirect financial interest in a business accounting information. These categories apply to governmental and not-for-profit organizations as well as to profit-oriented ventures. Management MManagement refers to the people who are responsible for operating a business and Study Note mmeeting its goals of profitability and liquidity. In a small business, management may cconsist solely of the owners. In a large business, managers must decide what to do, Managers are internal users of accounting information. hhow to do it, and whether the results match their original plans. Successful managers cconsistently make the right decisions based on timely and valid information. FIGURE 1-3 DECISION MAKERS The Users of Accounting Information MANAGEMENT THOSE WITH DIRECT THOSE WITH INDIRECT FINANCIAL INTEREST FINANCIAL INTEREST Finance Investment Investors Tax Authorities Operations and Creditors Regulatory Agencies Production Labor Unions Marketing Customers Human Resources Economic Planners Information Systems Accounting Decision Makers: The Users of Accounting Information 11 To make good decisions, Lilian Jackson and other owners and managers need answers to such questions as: (cid:2) What were the company’s earnings during the past quarter? (cid:2) Is the rate of return to the owners adequate? (cid:2) Does the company have enough cash? (cid:2) Which products or services are most profitable? Because so many key decisions are based on accounting data, management is one of the most important users of accounting information. In its decision-making process, management performs functions that are essential to the operation of a business. The same basic functions must be per- formed in all businesses, and each requires accounting information on which to base decisions. The basic management functions are: Financing the business: obtaining funds so that a company can begin and con- tinue operating Investing resources: investing assets in productive ways that support a company’s goals Producing goods and services: managing the production of goods and services Marketing goods and services: overseeing how goods or services are advertised, sold, and distributed Managing employees: overseeing the hiring, evaluation, and compensation of employees Providing information to decision makers: gathering data about all aspects of a company’s operations, organizing the data into usable information, and provid- ing reports to managers and appropriate outside parties. Accounting plays a key role in this function. Users with a Direct Financial Interest Another group of decision makers who need accounting information are those with a direct financial interest in a business. They depend on accounting to measure and report information about how a business has performed. Most businesses periodi- cally publish a set of general-purpose financial statements that report their success in meeting the goals of profitability and liquidity. These statements show what has happened in the past, and they are important indicators of what will happen in the future. Many people outside the company carefully study these financial reports. The two most important groups are investors (including owners) and creditors. FOCUS ON BUSINESS PRACTICE What Do CFOs Do? According to a survey, the chief financial officer (CFO) is the involving international operations, and many of them are “new business partner of the chief executive officer” (CEO). becoming CEOs of their companies. Those who do become CFOs are increasingly required to take on responsibilities CEOs are finding that “a financial background is invaluable when

for strategic planning, mergers and acquisitions, and tasks they’re saddled with the responsibility of making big calls.”9 12 CHAPTER 1 Uses of Accounting Information and the Financial Statements Investors Those such as Lilian Jackson, owner of the Keep-Fit Center, and Study Note CCVS’s stockholders who may invest in a business and acquire a part ownership in The primary external users of iit are interested in its past success and its potential earnings. A thorough study of accounting information are aa company’s financial statements helps potential investors judge the prospects for investors and creditors. aa profitable investment. After investing, they must continually review their com- mmitment, again by examining the company’s financial statements. Creditors Most companies borrow money for both long- and short-term oper- ating needs. Creditors, those who lend money or deliver goods and services before being paid, are interested mainly in whether a company will have the cash to pay interest charges and to repay the debt at the appropriate time. They study a com- pany’s liquidity and cash flow as well as its profitability. Banks, finance companies, mortgage companies, securities firms, insurance firms, suppliers, and other lenders must analyze a company’s financial position before they make a loan. Users with an Indirect Financial Interest In recent years, society as a whole, through governmental and public groups, has become one of the largest and most important users of accounting informa- tion. Users who need accounting information to make decisions on public issues include tax authorities, regulatory agencies, and various other groups. Tax Authorities Government at every level is financed through the collection of taxes. Companies and individuals pay many kinds of taxes, including federal, state, and city income taxes; Social Security and other payroll taxes; excise taxes; and sales taxes. Each tax requires special tax returns and often a complex set of records as well. Proper reporting is generally a matter of law and can be very complicated. The Inter- nal Revenue Code, for instance, contains thousands of rules governing the prepara- tion of the accounting information used in computing federal income taxes. Regulatory Agencies Most companies must report periodically to one or more regulatory agencies at the federal, state, and local levels. For example, all publicly traded corporations must report periodically to the Securities and Exchange Commission (SEC). This body, set up by Congress to protect the public, regu- lates the issuing, buying, and selling of stocks in the United States. Companies listed on a stock exchange also must meet the special reporting requirements of their exchange. Other Groups Labor unions study the financial statements of corporations as part of preparing for contract negotiations; a company’s income and costs often play an important role in these negotiations. Those who advise investors and creditors—financial analysts, brokers, underwriters, lawyers, economists, and the financial press—also have an indirect interest in the financial performance and prospects of a business. Consumer groups, customers, and the general public have become more concerned about the financing and earnings of corporations as well as the effects that corporations have on inflation, the environment, social issues, and the quality of life. And economic planners, among them the President’s Council of Economic Advisers and the Federal Reserve Board, use aggregated accounting information to set and evaluate economic policies and programs. Governmental and Not-for-Profit Organizations More than 30 percent of the U.S. economy is generated by governmental and not-for-profit organizations (hospitals, universities, professional organizations, Accounting Measurement 13 and charities). The managers of these diverse entities perform the same functions as managers of businesses, and they therefore have the same need for accounting information and a knowledge of how to use it. Their functions include raising

funds from investors (including owners), creditors, taxpayers, and donors and deploying scarce resources. They must also plan how to pay for operations and to repay creditors on a timely basis. In addition, they have an obligation to report their financial performance to legislators, boards, and donors, as well as to deal with tax authorities, regulators, and labor unions. Although most of the examples in this text focus on business enterprises, the same basic principles apply to gov- ernmental and not-for-profit organizations. STOP & APPLY Match the terms below with the type of user of accounting information (some answers may be used more than once): _____ 1. Tax authorities a. Internal user _____ 2. Investors b. Direct external user _____ 3. Management c. Indirect user _____ 4. Creditors _____ 5. Regulatory agencies _____ 6. Labor unions and consumer groups SOLUTION 1. c; 2. b; 3. a; 4. b; 5. c; 6. c Accounting In this section, we begin the study of the measurement aspects of accounting— Measurement that is, what accounting actually measures. To make an accounting measurement, the accountant must answer four basic questions: LO3 Explain the importance 1. What is measured? of business transactions, money 2. When should the measurement be made? measure, and separate entity. 3. What value should be placed on what is measured? 4. How should what is measured be classified? Accountants in industry, professional associations, public accounting, govern- ment, and academic circles debate the answers to these questions constantly, and the answers change as new knowledge and practice require. But the basis of today’s accounting practice rests on a number of widely accepted concepts and conventions, which are described in this book. We begin by focusing on the first question: What is measured? We discuss the other three questions (recognition, valuation, and classification) in the next chapter. Every system must define what it measures, and accounting is no exception. Basically, financial accounting uses money to gauge the impact of business trans- actions on separate business entities. 14 CHAPTER 1 Uses of Accounting Information and the Financial Statements Business Transactions Business transactions are economic events that affect a business’s financial posi- tion. Businesses can have hundreds or even thousands of transactions every day. These transactions are the raw material of accounting reports. A transaction can be an exchange of value (a purchase, sale, payment, col- lection, or loan) between two or more parties. A transaction also can be an eco- nomic event that has the same effect as an exchange transaction but that does not involve an exchange. Some examples of “nonexchange” transactions are losses from fire, flood, explosion, and theft; physical wear and tear on machinery and equipment; and the day-by-day accumulation of interest. To be recorded, a transaction must relate directly to a business entity. Suppose a customer buys toothpaste from CVS but has to buy shampoo from a competing store because CVS is out of shampoo. The transaction in which the toothpaste was sold is entered in CVS’s records. However, the purchase of the shampoo from the competitor is not entered in CVS’s records because even though it indi- rectly affects CVS economically, it does not involve a direct exchange of value between CVS and the customer. Money Measure All business transactions are recorded in terms of money. This concept is called money measure. Of course, nonfinancial information may also be recorded, but it is through the recording of monetary amounts that a business’s transactions and activities are measured. Money is the only factor common to all business transactions, and thus it is the only unit of measure capable of producing financial data that can be compared. The monetary unit a business uses depends on the country in which the busi- Study Note ness resides. For example, in the United States, the basic unit of money is the dollar. In Japan, it is the yen; in Europe, the euro; and in the United Kingdom,

The common unit of measurement used in the the pound. In international transactions, exchange rates must be used to translate United States for financial from one currency to another. An exchange rate is the value of one currency in reporting purposes is the dollar. terms of another. For example, a British person purchasing goods from a U.S. company like CVS and paying in U.S. dollars must exchange British pounds for U.S. dollars before making payment. In effect, currencies are goods that can be bought and sold. Table 1-1 illustrates the exchange rates for several currencies in dollars. It shows the exchange rate for British pounds as $1.49 per pound on a particular date. Like the prices of many goods, currency prices change daily according to supply and demand. For example, a year earlier, the exchange rate for British pounds was $1.98. Although our discussion in this book focuses on dollars, some examples and assignments involve foreign currencies. TABLE 1-1 Price Price Examples of Foreign Exchange Rates Country in $U.S. Country in $U.S. Australia (dollar) 0.72 Hong Kong (dollar) 0.13 Brazil (real) 0.46 Japan (yen) 0.011 Britain (pound) 1.49 Mexico (peso) 0.07 Canada (dollar) 0.85 Russia (ruble) 0.03 Europe (euro) 1.35 Singapore (dollar) 0.68 Source: The Wall Street Journal, January 7, 2009. The Forms of Business Organization 15 Separate Entity For accounting purposes, a business is a separate entity, distinct not only from Study Note its creditors and customers but also from its owners. It should have its own set of For accounting purposes, a financial records, and its records and reports should refer only to its own affairs. business is always separate For example, Just Because Flowers Company should have a bank account and distinct from its owners, separate from the account of Holly Sapp, the owner. Holly Sapp may own a creditors, and customers. home, a car, and other property, and she may have personal debts, but these are not the resources or debts of Just Because Flowers. Holly Sapp may own another business, say a stationery shop. If she does, she should have a completely separate set of records for each business. STOP & APPLY Match the terms below with the type of user of accounting information: _____ 1. R equires an exchange of value a. Business transaction between two or more parties b. Money measure _____ 2. R equires a separate set of records for c. Separate entity a business _____ 3. A n amount associated with a business transaction SOLUTION 1. a; 2. c; 3. b The Forms The three basic forms of business organization are the sole proprietorship, the part- of Business nership, and the corporation. Accountants recognize each form as an economic unit separate from its owners. Legally, however, only the corporation is separate from Organization its owners. The characteristics of corporations make them very efficient in amassing capital, which enables them to grow extremely large. As Figure 1-4 shows, even LO4 Identify the three basic though corporations are fewer in number than sole proprietorships and partnerships, forms of business organization. they contribute much more to the U.S. economy in monetary terms. For example, in 2007, Exxon Mobil generated more revenues than all but 30 of the world’s coun- tries. Here, we point out the most important features of each form of business. Characteristics of Corporations, Sole Proprietorships, and Partnerships AA sole proprietorship is a business owned by one person.* The owner takes Study Note aall the profits or losses of the business and is liable for all its obligations. As A key disadvantage of a F Figure 1-4 shows, sole proprietorships represent the largest number of businesses partnership is the unlimited iin the United States, but typically they are the smallest in size. liability of its owners. Unlimited A partnership is like a sole proprietorship in most ways, but it has two or liability can be avoided by mmore owners. The partners share the profits and losses of the business accord- organizing the business as a iing to a prearranged formula. Generally, any partner can obligate the business

corporation or, in some states, by forming what is known as *Accounting for a sole proprietorship is simpler than accounting for a partnership or corpora- a limited liability partnership tion. For that reason, we focus on the sole proprietorship in the early part of this book. At (LLP). critical points, however, we call attention to the essential differences between accounting for a sole proprietorship and accounting for a partnership or corporation. 16 CHAPTER 1 Uses of Accounting Information and the Financial Statements FIGURE 1-4 Number and Receipts of U.S. Proprietorships, Partnerships, and Corporations NUMBER OF BUSINESSES Proprietorships 19,710 Partnerships 2,375 Corporations 5,401 0 2 4 6 8 10 12 14 16 18 20 22 Millions RECEIPTS OF BUSINESSES Proprietorships $ 1,050 Partnerships 2,923 Corporations 20,690 $0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000 Billions Source: U.S. Treasury Department, Internal Revenue Service, Statistics of Income Bulletin, Winter 2006. to another party, and the personal resources of each partner can be called on to pay the obligations. A partnership must be dissolved if the ownership changes, as when a partner leaves or dies. If the business is to continue as a partnership after this occurs, a new partnership must be formed. Both the sole proprietorship and the partnership are convenient ways of separating the owners’ commercial activities from their personal activities. Legally, however, there is no economic separation between the owners and the businesses. A corporation, on the other hand, is a business unit chartered by the state and legally separate from its owners (the stockholders). The stockhold- ers, whose ownership is represented by shares of stock, do not directly control the corporation’s operations. Instead, they elect a board of directors to run the corporation for their benefit. In exchange for their limited involvement in the corporation’s operations, stockholders enjoy limited liability; that is, their risk of loss is limited to the amount they paid for their shares. Thus, stockholders are often willing to invest in risky, but potentially profitable, activities. Also, because stockholders can sell their shares without dissolving the corporation, the life of a corporation is unlimited and not subject to the whims or health of a proprietor or a partner. FOCUS ON BUSINESS PRACTICE Are Most Corporations Big or Small Businesses? Most people think of corporations as large national or only about 15,000 have stock that is publicly bought and global companies whose shares of stock are held by thou- sold. The vast majority of corporations are small businesses sands of people and institutions. Indeed, corporations can privately held by a few stockholders. Illinois alone has more be huge and have many stockholders. However, of the than 250,000 corporations. Thus, the study of corporations approximately 4 million corporations in the United States, is just as relevant to small businesses as it is to large ones. Financial Position and the Accounting Equation 17 STOP & APPLY Match the descriptions on the left with the forms of business enterprise on the right: _____ 1. Pays dividends _____ 5. M ost numerous but usually small in size _____ 2. Owned by only one person _____ 6. Biggest segment of the economy _____ 3. Multiple co-owners a. Sole proprietorship _____ 4. M anagement appointed by board of b. Partnership directors c. Corporation SOLUTION 1. c; 2. a; 3. b; 4. c; 5. a; 6. c Financial Financial position refers to a company’s economic resources, such as cash, inven- Position and tory, and buildings, and the claims against those resources at a particular time. Another term for claims is equities. the Accounting Every company has two types of equities: creditors’ equities, such as bank Equation loans, and owner’s equity. The sum of these equities equals a company’s resources: LO5 Define financial position, and state the accounting Economic Resources (cid:2) Creditors’ Equities (cid:3) Owner’s Equity equation. In accounting terminology, economic resources are called assets and creditors’

equities are called liabilities. So the equation can be written like this: Assets (cid:2) Liabilities (cid:3) Owner’s Equity This equation is known as the accounting equation. The two sides of the equa- tion must always be equal, or “in balance,” as shown in Figure 1-5. To evalu- ate the financial effects of business activities, it is important to understand their effects on this equation. FIGURE 1-5 The Accounting Equation Owner’s Assets Liabilities Equity A = L + OE 18 CHAPTER 1 Uses of Accounting Information and the Financial Statements Assets Assets are the economic resources of a company that are expected to benefit the company’s future operations. Certain kinds of assets—for example, cash and money that customers owe to the company (called accounts receivable)—are monetary items. Other assets—inventories (goods held for sale), land, buildings, and equipment—are nonmonetary, physical items. Still other assets—the rights granted by patents, trademarks, and copyrights—are nonphysical. Liabilities Liabilities are a business’s present obligations to pay cash, transfer assets, or provide services to other entities in the future. Among these obligations are amounts owed to suppliers for goods or services bought on credit (called accounts payable), borrowed money (e.g., money owed on bank loans), sala- ries and wages owed to employees, taxes owed to the government, and ser- vices to be performed. As debts, liabilities are claims recognized by law. That is, the law gives creditors the right to force the sale of a company’s assets if the company fails to pay its debts. Creditors have rights over owners and must be paid in full before the owners receive anything, even if payment of the debt uses up all the assets of the business. Owner’s Equity Owner’s equity represents the claims by the owner of a business to the assets of the business. Theoretically, owner’s equity is what would be left if all liabili- ties were paid, and it is sometimes said to equal net assets. By rearranging the accounting equation, we can define owner’s equity this way: Owner’s Equity (cid:2) Assets (cid:4) Liabilities Owner’s equity is affected by the owner’s investments in and withdrawals from the business and by the business’s revenues and expenses. Owner’s invest- ments are assets that the owner puts into the business (e.g., by transferring cash from a personal bank account to the business’s bank account). In this case, the assets (cash) of the business increase, and the owner’s equity in those assets also increases. Owner’s withdrawals are assets that the owner takes out of the business (e.g., by transferring cash from the business’s bank account to a personal bank account). In this case, the assets of the business decrease, as does the owner’s equity in the business. Simply stated, revenues and expenses are the increases and decreases in owner’s equity that result from operating a business. For example, the amount a customer pays (or agrees to pay in the future) to CVS for a product or service is a revenue for CVS. CVS’s assets (cash or accounts receivable) increase, as does its stockholders’ (owner’s) equity in those assets. On the other hand, the amount CVS must pay out (or agree to pay out) so that it can provide a product or service is an expense. In this case, the assets (cash) decrease or the liabilities (accounts payable) increase, and the owner’s equity decreases. Generally, a company is successful if its revenues exceed its expenses. When revenues exceed expenses, the difference is called net income. When expenses exceed revenues, the difference is called net loss. It is important not to confuse expenses and withdrawals, both of which reduce owner’s equity. In summary, owner’s equity is the accumulated net income (revenues (cid:4) expenses) less with- drawals over the life of the business. Financial Statements 19 STOP & APPLY Johnson Company had assets of $140,000 and liabilities of $60,000 at the beginning of the year, and assets of $200,000 and liabilities of $70,000 at the end of the year. During the year, $20,000

was invested in the business, and withdrawals of $24,000 were made. What amount of net income did the company earn during the year? Beginning of the year Assets (cid:2) Liabilities (cid:3) Owner’s Equity $140,000 (cid:2) $60,000 (cid:3) $ 80,000 During year Investment (cid:3) 20,000 Withdrawals (cid:4) 24,000 ? Net income End of year $200,000 (cid:2) $70,000 (cid:3) $130,000 SOLUTION Net income (cid:2) $54,000 Start by finding the owner’s equity at the beginning of the year. (Check: $140,000 (cid:4) $60,000 (cid:2) $80,000) Then find the owner’s equity at the end of the year. (Check: $200,000 (cid:4) $70,000 (cid:2) $130,000) Then determine net income by calculating how the transactions during the year led to the owner’s equity amount at the end of the year. (Check: $80,000 (cid:3) $20,000 (cid:4) $24,000 (cid:3) $54,000 (cid:2) $130,000) Financial Financial statements are the primary means of communicating important account- Statements ing information about a business to those who have an interest in the business. These statements are models of the business enterprise in that they show the business in financial terms. As is true of all models, however, financial statements LO6 Identify the four basic are not perfect pictures of the real thing. Rather, they are the accountant’s best financial statements. effort to represent what is real. Four major financial statements are used to com- municate accounting information about a business: the income statement, the statement of owner’s equity, the balance sheet, and the statement of cash flows. Study Note Businesses use four basic Income Statement financial statements to communicate financial The income statement summarizes the revenues earned and expenses incurred by information to decision makers. a business over an accounting period (see Exhibit 1-1). Many people consider it the most important financial report because it shows whether a business achieved its profitability goal—that is, whether it earned an acceptable income. Exhibit 1-1 shows that Weiss Consultancy had revenues of $14,000 from consulting. From this amount, total expenses of $5,600 were deducted (equipment rental expense of $2,800, wages expense of $1,600, and utilities expense of $1,200) to arrive at net income of $8,400. To show the period to which the statement applies, it is dated “For the Month Ended December 31, 2011.” 20 CHAPTER 1 Uses of Accounting Information and the Financial Statements EXHIBIT 1-1 Income Statement for Weiss Consultancy Weiss Consultancy Income Statement For the Month Ended December 31, 2011 Revenues Consulting fees earned $14,000 Expenses Equipment rental expense $2,800 Wages expense 1,600 Utilities expense 1,200 Total expenses 5,600 Net income $ 8,400 Statement of Owner’s Equity The statement of owner’s equity shows the changes in owner’s equity over an accounting period. In Exhibit 1-2, beginning owner’s equity is zero because Weiss Consultancy began operations in this accounting period. During the month, the owner, James Weiss, invested $200,000 in the business, and the company earned an income (as shown on the income statement) of $8,400. Deducted from this amount are $2,400 of withdrawals that the owner made during the month, leav- ing an ending balance of $206,000 of capital in the business. The Balance Sheet The purpose of a balance sheet is to show the financial position of a business on Study Note a certain date, usually the end of the month or year (see Exhibit 1-3). For this rea- son, it often is called the statement of financial position and is dated as of a specific The date on the balance sheet is date. The balance sheet presents a view of the business as the holder of resources, a single date, whereas the dates or assets, that are equal to the claims against those assets. The claims consist of the on the other three statements cover a period of time, such as a company’s liabilities and the owner’s equity in the company. Exhibit 1-3 shows month, quarter, or year. that Weiss Consultancy has several categories of assets, which total $208,400. These assets equal the total liabilities of $2,400 (accounts payable) plus the ending

balance of owner’s equity of $206,000. Notice that the amount of the owner’s Capital account on the balance sheet comes from the ending balance on the state- ment of owner’s equity. EXHIBIT 1-2 Weiss Consultancy Statement of Owner’s Equity for Weiss Consultancy Statement of Owner’s Equity For the Month Ended December 31, 2011 J. Weiss, Capital, December 1, 2011 $ 0 Investment by J. Weiss 200,000 Net income for the month 8,400 Subtotal $208,400 Less withdrawals 2,400 J. Weiss, Capital, December 31, 2011 $206,000 Financial Statements 21 EXHIBIT 1-3 Balance Sheet for Weiss Consultancy Weiss Consultancy Balance Sheet December 31, 2011 Assets Liabilities Cash $ 62,400 Accounts payable $ 2,400 Accounts receivable 4,000 Total liabilities $ 2,400 Supplies 2,000 Owner’s Equity Land 40,000 Buildings 100,000 J. Weiss, Capital 206,000 Total assets $208,400 Total liabilities and owner’s equity $208,400 Statement of Cash Flows Whereas the income statement focuses on a company’s profitability, the state- Study Note ment of cash flows focuses on its liquidity (see Exhibit 1-4). Cash flows are the inflows and outflows of cash into and out of a business. Net cash flows are the The statement of cash flows explains the change in cash in difference between the inflows and outflows. terms of operating, investing, As you can see in Exhibit 1-4, the statement of cash flows is organized accord- and financing activities over an ing to the three major business activities described earlier in the chapter. accounting period. It provides (cid:2) Cash flows from operating activities: The first section of Exhibit 1-4 shows valuable information that cannot the cash produced by business operations. Weiss’s operating activities pro- be determined in an examination duced net cash flows of $4,800 (liquidity) compared to net income of $8,400 of the other financial statements. (profitability). The company used cash to increase accounts receivable and supplies. However, by borrowing funds, it increased accounts payable. This is not a good trend, which Weiss should try to reverse in future months. (cid:2) Cash flows from investing activities: Weiss used cash to expand by pur- Study Note chasing land and a building. (cid:2) Cash flows from financing activities: Weiss obtained most of its cash from Notice the sequence in which the owner, who then made a small cash withdrawal. these statements are prepared: Income statement, statement of Overall, Weiss had a net increase in cash of $62,400, due in large part to the owner’s equity, balance sheet, investment by the owner. In future months, Weiss must generate more cash and finally, the statement of through operations. cash flows. The statement of cash flows is related directly to the other three financial statements. Notice that net income comes from the income statement and that withdrawals come from the statement of owner’s equity. The other items in the state- ment r epresent changes in the balance sheet accounts: accounts receivable, supplies, accounts payable, land, and buildings. Here we focus on the importance and overall structure of the statement. Its construction and use are discussed in a later chapter. Relationships Among the Financial Statements Exhibit 1-5 illustrates the relationships among the four financial statements by showing how they would appear for Weiss Consultancy. The period covered is the month of December 2011. Notice the similarity of the headings at the top 22 CHAPTER 1 Uses of Accounting Information and the Financial Statements of each statement. Each identifies the company and the kind of statement. The income statement, the statement of owner’s equity, and the statement of cash flows indicate the period to which they apply; the balance sheet gives the specific date to which it applies. Much of this book deals with developing, using, and interpreting more complete versions of these statements. EXHIBIT 1-4 Statement of Cash Flows for Weiss Consultancy Weiss Consultancy Statement of Cash Flows For the Month Ended December 31, 2011 Cash flows from operating activities Net income $ 8,400

Adjustments to reconcile net income to net cash flows from operating activities (Increase) in accounts receivable ($ 4,000) (Increase) in supplies (2,000) Increase in accounts payable 2,400) (3,600) Net cash flows from operating activities $ 4,800 Cash flows from investing activities Purchase of land ($ 40,000) Purchase of building (100,000) Net cash flows from investing activities (140,000) Cash flows from financing activities Investments by owner $ 200,000 Withdrawals (2,400) Net cash flows from financing activities 197,600 Net increase (decrease) in cash $ 62,400 Cash at beginning of month 0 Cash at end of month $ 62,400 Note: Parentheses indicate a negative amount. Financial Statements 23 EXHIBIT 1-5 Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows for Weiss Consultancy Weiss Consultancy Weiss Consultancy Statement of Cash Flows Income Statement For the Month Ended December 31, 2011 For the Month Ended December 31, 2011 Cash flows from operating activities Revenues Net income $ 8,400 Consulting fees $14,000 Adjustments to reconcile Expenses net income to net cash Equipment rental expense $2,800 flows from operating Wages expense 1,600 activities Utilities expense 1,200 (Increase) in accounts ($ 4,000) Total expenses 5,600 receivable Net income $ 8,400 (Increase) in supplies (2,000) Weiss Consultancy Increase in accounts Statement of Owner’s Equity payable 2,400) (3,600) For the Month Ended December 31, 2011 Net cash flows from operating activities $ 4,800 J. Weiss, Capital, December 1, 2011 $ 0 Investment by J. Weiss 200,000 Cash flows from investing activities Net income for the month 8,400 Purchase of land ($ 40,000) Subtotal $208,400 Purchase of building (100,000) Less withdrawals 2,400 Net cash flows from J. Weiss, Capital, December 31, 2011 $206,000 investing activities (140,000) Cash flows from financing activities Investments Weiss Consultancy by owner $200,000 Balance Sheet Withdrawals (2,400) December 31, 2011 Net cash flows from Assets Liabilities financing activities 197,600 Net increase (decrease) Cash $ 62,400 Accounts payable $ 2,400 in cash $ 62,400 Accounts 4,000 Total liabilities $ 2,400 Cash at beginning of receivable month 0 Supplies 2,000 Owner’s Equity Cash at end of month $ 62,400 Land 40,000 Buildings 100,000 J. Weiss, Capital 206,000 Total liabilities and T otal assets $208,400 owner’s equity $208,400 24 CHAPTER 1 Uses of Accounting Information and the Financial Statements STOP & APPLY Complete the following financial statements by determining the amounts that correspond to the letters. (Assume no new investments by owners.) Income Statement Revenues $2,775 Expenses (a) Net income $ (b) Statement of Owner’s Equity Beginning balance $7,250 Net income (c) Less withdrawals 500 Ending balance $7,500 Balance Sheet Total assets $ (d) Liabilities $4,000 Owner’s equity L. Buckman, capital (e) Total liabilities and owner’s equity $ (f) SOLUTION Net income links the income statement and the statement of owner’s equity. The ending balance of owner’s equity links the statement of owner’s equity and the balance sheet. Thus, start with (c), which must equal $750 (check: $7,250 (cid:3) $750 (cid:4) $500 (cid:2) $7,500). Then, (b) equals (c), or $750. Thus, (a) must equal $2,025 (check: $2,775 – $2,025 (cid:2) $750). Because (e) equals $7,500 (ending balance from the statement of owner’s equity), (f) must equal $11,500 (check: $4,000 (cid:3) $7,500 (cid:2) $11,500). Now, (d) equals (f), or $11,500. Generally To ensure that financial statements are understandable to their users, a set Accepted of practices, called generally accepted accounting principles (GAAP), has been developed to provide guidelines for financial accounting. “Generally Accounting accepted accounting principles encompass the conventions, rules, and proce- Principles dures necessary to define accepted accounting practice at a particular time.”10 In other words, GAAP arise from wide agreement on the theory and prac- LO7 Explain how generally tice of accounting at a particular time. These “principles” are not like the

accepted accounting principles unchangeable laws of nature in chemistry or physics. They evolve to meet the (GAAP) and international finan- needs of decision makers, and they change as circumstances change or as bet- cial reporting standards (IFRS) ter methods are developed. relate to financial statements In this book, we present accounting practice, or GAAP, as it is today, and the independent CPA’s and we try to explain the reasons or theory on which the practice is based. report, and identify the organiza- Both theory and practice are important to the study of accounting. H owever, tions that influence GAAP. accounting is a discipline that is always growing, changing, and improv- ing. Just as years of research are necessary before a new surgical method or lifesaving drug can be introduced, it may take years for new accounting discoveries to be implemented. As a result, you may encounter practices that seem contradictory. In some cases, we point out new directions in accounting. Your instructor also may mention certain weaknesses in current theory or practice. Generally Accepted Accounting Principles 25 TABLE 1-2 Firm Home Office Some Major Clients Large International Certified Public Accounting Firms Deloitte & Touche New York General Motors, Procter & Gamble Ernst & Young New York Coca-Cola, McDonald’s KPMG New York General Electric, Xerox PricewaterhouseCoopers New York Exxon Mobil, IBM, Ford GAAP and the Independent CPA’s Report Because financial statements are prepared by management and could be falsi- fied for personal gain, all companies that sell shares of their stock to the public and many companies that apply for sizable loans have their financial statements audited by an independent certified public accountant (CPA). Independent means that the CPA is not an employee of the company being audited and has no financial or other compromising ties with it. CPAs are licensed by all states for the same reason that lawyers and doctors are—to protect the public by ensuring the quality of professional service. The firms listed in Table 1-2 employ about 25 percent of all CPAs. An audit is an examination of a company’s financial statements and the accounting systems, controls, and records that produced them. The purpose Study Note of the audit is to ascertain that the financial statements have been prepared in accordance with generally accepted accounting principles. If the independent The audit lends credibility to CPA is satisfied that this standard has been met, his or her report contains the a set of financial statements. following language: The auditor does not attest to the absolute accuracy of the In our opinion, the financial statements . . . present fairly, in all material published information or to respects . . . in conformity with generally accepted accounting principles . . . the value of the company as an investment. All he or she This wording emphasizes that accounting and auditing are not exact sciences. renders is an opinion, based on Because the framework of GAAP provides room for interpretation and the appropriate testing, about the application of GAAP necessitates the making of estimates, the auditor can render fairness of the presentation of only an opinion about whether the financial statements present fairly or conform the financial information. in all material respects to GAAP. The auditor’s report does not preclude minor or immaterial errors in the financial statements. However, a favorable report from FOCUS ON BUSINESS PRACTICE IFRS: The Arrival of International Financial Reporting Standards in the United States Over the next few years, international financial and Exchange Commission (SEC) recently voted to reporting standards (IFRS) will become much more allow foreign registrants in the United States. This important in the United States and globally. The is a major development because in the past, the International Accounting Standards Board (IASB) SEC required foreign registrants to explain how the has been working with the Financial Accounting standards used in their statements differed from

Standards Board (FASB) and similar boards in other U.S. standards. This change affects approximately 10 nations to achieve identical or nearly identical stan- percent of all public U.S. companies. In addition, the dards worldwide. IFRS are now required in many SEC may in the near future allow U.S. companies to parts of the world, including Europe. The Securities- use IFRS.11 26 CHAPTER 1 Uses of Accounting Information and the Financial Statements the auditor does imply that, on the whole, investors (owners) and creditors can rely on the financial statements. Historically, auditors have enjoyed a strong repu- tation for competence and independence. The independent audit has been an important factor in the worldwide growth of financial markets. Organizations That Issue Accounting Standards Two organizations issue accounting standards that are used in the United States: Study Note the FASB and the IASB. The Financial Accounting Standards Board (FASB) The FASB is the primary source is the most important body for developing rules on accounting practice. This of GAAP, but the IASB is independent body has been designated by the Securities and Exchange Commis- increasing in importance. sion (SEC) to issue Statements of Financial Accounting Standards. With the growth of financial markets throughout the world, global coop- eration in the development of accounting principles has become a priority. The International Accounting Standards Board (IASB) has approved more than 40 international financial reporting standards (IFRS). Foreign companies may use these standards in the United States rather than having to convert their statements to U.S. GAAP as called for by the FASB standards. Other Organizations That Influence GAAP Many organizations directly or indirectly influence GAAP and so influence much of what is in this book. The Public Company Accounting Oversight Board (PCAOB), a governmen- Study Note tal body created by the Sarbanes-Oxley Act, regulates the accounting profession The PCAOB regulates audits of and has wide powers to determine the standards that auditors must follow and to public companies registered discipline them if they do not. with the Securities and The American Institute of Certified Public Accountants (AICPA), the pro- Exchange Commission. fessional association of certified public accountants, influences accounting prac- tice through the activities of its senior technical committees.* The Securities and Exchange Commission (SEC) is an agency of the federal Study Note government that has the legal power to set and enforce accounting practices for companies whose securities are offered for sale to the general public. As such, it The AICPA is the primary has enormous influence on accounting practice. professional organization of certified public accountants. The Governmental Accounting Standards Board (GASB), which is under the same governing body as the FASB, issues accounting standards for state and local governments. U.S. tax laws that govern the assessment and collection of revenue for operat- ing the federal government also influence accounting practice. Because a major source of the government’s revenue is the income tax, the tax laws specify the rules for determining taxable income. The Internal Revenue Service (IRS) interprets and enforces these rules. In some cases, the rules conflict with good a ccounting *In May 2005, the AICPA passed a resolution to start working with the FASB to develop GAAP for privately held, for-profit companies, which would result in recognition, measure- ment, and disclosure differences, where appropriate, from current GAAP for public compa- nies. If and when this resolution is acted upon, two sets of GAAP will exist: one for private companies and one for public companies. Generally Accepted Accounting Principles 27 practice, but they are nonetheless an important influence on practice. Cases in which the tax laws affect accounting practice are noted throughout this book. Professional Conduct The code of professional ethics of the American Institute of Certified Public

Accountants (and adopted, with variations, by each state) governs the conduct of CPAs. Fundamental to this code is responsibility to clients, creditors, investors (owners), and anyone else who relies on the work of a CPA. The code requires CPAs to act with integrity, objectivity, and independence. (cid:2) Integrity means the accountant is honest and candid and subordinates per- sonal gain to service and the public trust. (cid:2) Objectivity means the accountant is impartial and intellectually honest. (cid:2) Independence means the accountant avoids all relationships that impair or even appear to impair his or her objectivity. The accountant must also exercise due care in all activities, carrying out pro- fessional responsibilities with competence and diligence. For example, an accoun- tant must not accept a job for which he or she is not qualified, even at the risk of losing a client to another firm, and careless work is unacceptable. These broad principles are supported by more specific rules that public accountants must fol- low; for instance, with certain exceptions, client information must be kept strictly confidential. Accountants who violate the rules can be disciplined or even sus- pended from practice. The Institute of Management Accountants (IMA) also has a code of profes- Study Note sional conduct. It emphasizes that management accountants have a responsibility The IMA is the primary to be competent in their jobs, to keep information confidential except when autho- professional association of rized or legally required to disclose it, to maintain integrity and avoid conflicts of management accountants. interest, and to communicate information objectively and without bias.12 Corporate Governance The financial scandals at Enron, WorldCom, and other companies highlighted the importance of corporate governance, which is the oversight of a corporation’s management and ethics by its board of directors. Corporate governance is grow- ing and is clearly in the best interests of a business. A survey of 124 corporations in 22 countries found that 78 percent of boards of directors had established ethi- cal standards, a fourfold increase over a 10-year period. In addition, research has shown that, over time, companies with codes of ethics tend to have higher stock prices than those that have not adopted such codes.13 To strengthen corporate governance, a provision of the Sarbanes-Oxley Act requires boards of directors to establish an audit committee made up of indepen- dent directors who have financial expertise. This provision is aimed at ensuring that boards of directors are objective in evaluating management’s performance. The audit committee is also responsible for engaging the corporation’s indepen- dent auditors and reviewing their work. Another of the committee’s functions is to ensure that adequate systems exist to safeguard the corporation’s resources and that accounting records are reliable. In short, the audit committee is the front line of defense against fraudulent financial reporting. 28 CHAPTER 1 Uses of Accounting Information and the Financial Statements STOP & APPLY Match the common acronym with its description: _____ 1. GAAP a. Sets U.S. accounting standards _____ 2. IFRS b. Audits financial statements _____ 3. CPA c. Established by the Sarbanes-Oxley Act _____ 4. FASB d. Sets international accounting standards _____ 5. IASB e. Established by the FASB _____ 6. PCAOB f. Established by the IASB _____ 7. AICPA g. Influences accounting standards through _____ 8. SEC member CPAs h. Receives audited financial statements of public companies SOLUTION 1. c; 2. f; 3. b; 4. a; 5. d; 6. c; 7. g; 8. h (cid:2) KEEP-FIT CENTER: REVIEW PROBLEM The Decision Point at the beginning of this chapter focused on Keep-Fit Center, an apparently successful new company. Although the firm generated commissions from sales of property, the owner, Lilian Jackson, had these questions: • Is Keep-Fit Center meeting its goal of profitability? • As owner of Keep-Fit Center, what financial knowledge does Lilian Jackson need

to measure progress toward the company’s goals? • In deciding whether to make a loan to Keep-Fit Center, what financial knowledge would a bank need to evaluate the company’s financial performance? As you’ve learned in this chapter, managers and others with an interest in a business measure its profitability in financial terms such as net sales, net income, total assets, and owner’s equity and liquidity in terms such as cash flows. Owners and managers report on the progress they have made toward their financial goals in their company’s financial statements. Preparation and Interpretation of Financial Statements LO6 Keep-Fit Center: Review Problem 29 The following financial statement accounts and amounts are from the records of Keep-Fit Center for the year ended December 31, 2010, the company’s first year of operations: Accounts payable $ 19,000 Accounts receivable 104,000 Cash 111,000 Equipment 47,000 Fees revenue 375,000 Investment by L. Jackson 100,000 Marketing expense 18,000 Salaries 172,000 Salaries payable 78,000 Studio and equipment rent expense 91,000 Supplies 2,000 Supplies expense 6,000 Utilities expense 11,000 Withdrawals 10,000 Required 1. Prepare an income statement, statement of owner’s equity, and balance sheet for Keep-Fit Center. For examples, refer to Exhibit 1-5. 2. User insight: From the income statement and balance sheet, does it appear that Keep-Fit Center is profitable? Why or why not? Answers to 1. Preparation of financial statements Review Problem 30 CHAPTER 1 Uses of Accounting Information and the Financial Statements 2. Keep-Fit Center is profitable. The income statement shows that it earned $77,000 after expenses were deducted from fees revenue. Further, it may be observed that this $77,000 of net income is very good when compared to total assets of $264,000 and owner’s equity on the balance sheet. Stop & Review 31 STOP & REVIEW LO1 Defi ne accounting and Accounting is an information system that measures, processes, and communicates describe its role in financial information about an economic entity. It provides the information nec- making informed deci- essary to make reasoned choices among alternative uses of scarce resources in the sions, identify business conduct of business and economic activities. A business is an economic entity that engages in operating, investing, and financing activities to achieve the goals of goals and activities, and profitability and liquidity. explain the importance Management accounting focuses on the preparation of information primarily of ethics in accounting. for internal use by management. Financial accounting is concerned with the devel- opment and use of reports that are communicated to those outside the business as well as to management. Ethical financial reporting is important to the well-being of a company; fraudulent financial reports can have serious consequences for many people. LO2 Identify the users of Accounting plays a significant role in society by providing information to man- accounting information. agers of all institutions and to individuals with a direct financial interest in those institutions, including present or potential investors (owners) and creditors. Accounting information is also important to those with an indirect financial interest in the business—for example, tax authorities, regulatory agencies, and economic planners. LO3 Explain the importance To make an accounting measurement, the accountant must determine what is of business transactions, measured, when the measurement should be made, what value should be placed on money measure, and what is measured, and how to classify what is measured. The objects of accounting separate entity. measurement are business transactions. Financial accounting uses money measure to gauge the impact of these transactions on a separate business entity. LO4 Identify the three basic The three basic forms of business organization are the sole proprietorship, the part- forms of business nership, and the corporation. Accountants recognize each form as an economic organization. unit separate from its owners, although legally only the corporation is separate from

its owners. A sole proprietorship is a business owned by one person. A partnership is like a sole proprietorship in most ways, but it has two or more owners. A corpora- tion, on the other hand, is a business unit chartered by the state and legally separate from its owners (the stockholders). LO5 Defi ne fi nancial position, Financial position refers to a company’s economic resources and the claims against and state the accounting those resources at a particular time. The accounting equation shows financial equation. position as Assets (cid:2) Liabilities (cid:3) Owner’s Equity. Business transactions affect financial position by decreasing or increasing assets, liabilities, and owner’s equity in such a way that the accounting equation is always in balance. LO6 Identify the four basic The four basic financial statements are the income statement, the statement of fi nancial statements. owner’s equity, the balance sheet, and the statement of cash flows. They are the primary means by which accountants communicate the financial condition and activities of a business to those who have an interest in the business. 32 CHAPTER 1 Uses of Accounting Information and the Financial Statements LO7 Explain how generally Acceptable accounting practice consists of the conventions, rules, and procedures accepted accounting that make up generally accepted accounting principles at a particular time. GAAP principles (GAAP) and are essential to the preparation and interpretation of financial statements and the international fi nancial independent CPA’s report. Foreign companies registered in the United States may use international financial reporting standards (IFRS). reporting standards Among the organizations that influence the formulation of GAAP are (IFRS) relate to fi nancial the Public Company Accounting Oversight Board, the Financial Accounting statements and the inde- Standards Board, the American Institute of Certified Public Accountants, the pendent CPA’s report, Securities and Exchange Commission, and the Internal Revenue Service. and identify the orga- All accountants are required to follow a code of professional ethics, the founda- nizations that infl uence tion of which is responsibility to the public. Accountants must act with integrity, GAAP. objectivity, and independence, and they must exercise due care in all their activities. The board of directors is responsible for determining corporate policies and appointing corporate officers. It is also responsible for corporate governance, the oversight of a corporation’s management and ethics. The audit committee, which is appointed by the board and made up of independent directors, is an important factor in corporate governance. REVIEW of Concepts and Terminology The following concepts and terms Financial analysis 6 (LO1) Management 10 (LO2) were introduced in this chapter: Financial position 17 (LO5) Management accounting 7 (LO1) Accounting 4 (LO1) Financial statements 7 (LO1) Management information system Accounting equation 17 (LO5) Financing activities 6 (LO1) (MIS) 8 (LO1) American Institute of Certified Fraudulent financial reporting Money measure 14 (LO3) Public Accountants (AICPA) 8 (LO1) Net assets 18 (LO5) 26 (LO7) Generally accepted accounting Net income 18 (LO5) Assets 18 (LO5) principles (GAAP) 24 (LO7) Net loss 18 (LO5) Audit 25 (LO7) Governmental Accounting Objectivity 27 (LO1) Audit committee 27 (LO7) Standards Board (GASB) Operating activities 5 (LO1) Balance sheet 20 (LO6) 26 (LO7) Owner’s equity 18 (LO5) Bookkeeping 7 (LO1) Income statement 19 (LO6) Partnership 15 (LO4) Business 4 (LO1) Independence 27 (LO7) Performance measures 6 (LO1) Business transactions 14 (LO3) Institute of Management Accountants (IMA) 27 (LO7) Profitability 5 (LO1) Cash flows 21 (LO6) Public Company Accounting Integrity 27 (LO7) Certified public accountant (CPA) Oversight Board (PCAOB) 25 (LO7) Internal Revenue Service (IRS) 26 (LO7) 26 (LO7) Corporate governance 27 (LO7) Revenues 18 (LO5) International Accounting Standards Corporation 16 (LO4) Board (IASB) 26 (LO7) Sarbanes-Oxley Act 9 (LO1)

Due care 27 (LO7) Securities and Exchange Commis- International financial reporting Ethics 8 (LO1) standards (IFRS) sion (SEC) 12, 26 (LO2 and LO7) Exchange rate 14 (LO3) 26 (LO7) Separate entity 15 (LO3) Expenses 18 (LO5) Investing activities 5 (LO1) Sole proprietorship 15 (LO4) Financial accounting 7 (LO1) Liabilities 18 (LO5) Statement of cash flows 21 (LO6) Financial Accounting Standards Liquidity 5 (LO1) Statement of owner’s equity Board (FASB) 26 (LO7) 20 (LO6) Chapter Assignments 33 CHAPTER ASSIGNMENTS BUILDING Your Basic Knowledge and Skills Short Exercises Short exercises are simple applications of chapter material for one or more learn- ing objectives. If you need help locating the related text discussions, refer to the LO numbers in the margin. LO1 Accounting and Business Enterprises SE 1. Match the terms on the left with the definitions on the right: _____ 1. Accounting a. The process of producing account- _____ 2. Profitability ing information for the internal use of a company’s management. _____ 3. Liquidity b. Having enough cash available to _____ 4. Financing activities pay debts when they are due. _____ 5. Investing activities c. Activities management engages in to _____ 6. Operating activities obtain adequate funds for beginning and continuing to operate a business. _____ 7. Financial accounting d. The process of generating and _____ 8. Management accounting communicating accounting infor- _____ 9. Ethics mation in the form of financial _____ 10. F raudulent financial statements to decision makers reporting outside the organization. e. Activities management engages in to spend capital in ways that are productive and will help a business achieve its objectives. f. The ability to earn enough income to attract and hold investment capital. g. An information system that mea- sures, processes, and communi- cates financial information about an identifiable economic entity. h. The intentional preparation of mis- leading financial statements. i. Activities management engages in to operate the business. j. A code of conduct that addresses whether actions are right or wrong. LO3 LO4 Accounting Concepts SE 2. Indicate whether each of the following words or phrases relates most closely to (a) a business transaction, (b) a separate entity, or (c) a money measure: 1. Partnership 4. Sole proprietorship 2. U.S. dollar 5. Sale of an asset 3. Payment of an expense 34 CHAPTER 1 Uses of Accounting Information and the Financial Statements LO4 Forms of Business Organization SE 3. Match the descriptions on the left with the forms of business organization on the right: _____ 1. Most numerous a. Sole proprietorship b. Partnership _____ 2. Commands most revenues c. Corporation _____ 3. Has two or more co-owners _____ 4. Has stockholders _____ 5. Is owned by only one person _____ 6. Has a board of directors LO5 The Accounting Equation SE 4. Determine the amount missing from each accounting equation below. Assets (cid:2) Liabilities (cid:3) Owner’s Equity 1. ? $50,000 $ 70,000 2. $156,000 $84,000 ? 3. $292,000 ? $192,000 LO5 The Accounting Equation SE 5. Use the accounting equation to answer each question below. 1. The assets of Aaron Company are $240,000, and the liabilities are $90,000. What is the amount of the owner’s equity? 2. The liabilities of Oak Company equal one-fifth of the total assets. The own- er’s equity is $40,000. What is the amount of the liabilities? LO5 The Accounting Equation SE 6. U se the accounting equation to answer each question below. 1. At the beginning of the year, Fazio Company’s assets were $45,000, and its own- er’s equity was $25,000. During the year, assets increased by $30,000 and liabili- ties increased by $5,000. What was the owner’s equity at the end of the year? 2. At the beginning of the year, Gal Company had liabilities of $50,000 and owner’s equity of $96,000. If assets increased by $40,000 and liabilities decreased by $30,000, what was the owner’s equity at the end of the year? LO5 The Accounting Equation and Net Income SE 7. Carlton Company had assets of $280,000 and liabilities of $120,000 at the

beginning of the year, and assets of $400,000 and liabilities of $140,000 at the end of the year. During the year, the owner invested an additional $40,000 in the business, and the company made withdrawals of $48,000. What amount of net income did the company earn during the year? LO6 Preparation and Completion of a Balance Sheet SE 8. Use the following accounts and balances to prepare a balance sheet with the accounts in proper order for Global Company at June 30, 2010, using Exhibit 1-3 as a model: Accounts Receivable $ 1,600 Wages Payable 700 Owner’s Capital 28,700 Building 22,000 Cash ? Chapter Assignments 35 LO6 Preparation of Financial Statements SE 9. Tarech Company engaged in activities during the first year of its operations that resulted in the following: service revenue, $4,800; expenses, $2,450; and withdrawals, $410. In addition, the year-end balances of selected accounts were as follows: Cash, $1,890; Other Assets, $1,000; Accounts Payable, $450; and Owner’s Capital, $500. In proper format, prepare the income statement, state- ment of retained earnings, and balance sheet for Tarech Company (assume the year ends on December 31, 2010). (Hint: You must solve for the beginning and ending balances of Owner’s Equity for 2010.) Exercises Exercises are more complex applications of chapter concepts than short exercises. LO1 LO2 Discussion Questions LO3 LO4 E 1. Develop a brief answer to each of the following questions: 1. What makes accounting a valuable discipline? 2. Why do managers in governmental and not-for-profit organizations need to understand financial information as much as managers in profit-seeking businesses do? 3. Are all economic events business transactions? 4. Sole proprietorships, partnerships, and corporations differ legally; how and why does accounting treat them alike? LO1 LO5 Discussion Questions LO6 LO7 E 2. Develop a brief answer to each of the following questions: 1. How are expenses and withdrawals similar, and how are they different? 2. In what ways are CVS and Southwest Airlines comparable? Not comparable? 3. How do generally accepted accounting principles (GAAP) differ from the laws of science? 4. What are some unethical ways in which a business may do its accounting or prepare its financial statements? LO1 LO2 The Nature of Accounting LO3 LO7 E 3. Match the terms on the left with the descriptions on the right: _____ 1. Bookkeeping a. The recording of all business trans- actions in terms of money _____ 2. Creditors b. A process by which information _____ 3. Money measure is exchanged between individuals _____ 4. F inancial Accounting through a common system of Standards Board (FASB) symbols, signs, or behavior _____ 5. Business transactions c. The process of identifying and assign- _____ 6. Financial statements ing values to business transactions d. Legislation ordering CEOs and _____ 7. Communication CFOs to swear that any reports _____ 8. S ecurities and Exchange they file with the SEC are accurate Commission (SEC) and complete _____ 9. Investors e. Shows how well a company is _____ 10. Sarbanes-Oxley Act meeting the goals of profitability and liquidity _____ 11. Management f. Collectively, the people who have _____ 12. M anagement information overall responsibility for operating system a business and meeting its goals 36 CHAPTER 1 Uses of Accounting Information and the Financial Statements g. People who commit money to earn a financial return h. The interconnected subsystems that provide the information needed to run a business i. The most important body for developing and issuing rules on accounting practice, called Statements of Financial Accounting Standards j. An agency set up by Congress to protect the public by regulating the issuing, buying, and selling of stocks k. Economic events that affect a busi- ness’s financial position l. People to whom money is due LO2 LO4 Users of Accounting Information and Forms of Business Organization E 4. Gottlieb Pharmacy has recently been formed to develop a new type of drug treatment for cancer. Previously a partnership, Gottlieb has now become a cor-

poration. Describe the various groups that will have an interest in the financial statements of Gottlieb. What is the difference between a partnership and a corpo- ration? What advantages does the corporate form have over the partnership form of business organization? LO3 Business Transactions E 5. Velu owns and operates a minimart. Which of Velu’s actions described below are business transactions? Explain why any other actions are not considered trans- actions. 1. Velu reduces the price of a gallon of milk in order to match the price offered by a competitor. 2. Velu pays a high school student cash for cleaning up the driveway behind the market. 3. Velu fills his son’s car with gasoline in payment for his son’s restocking the vending machines and the snack food shelves. 4. Velu pays interest to himself on a loan he made to the business three years ago. LO3 LO4 Accounting Concepts E 6. Financial accounting uses money measures to gauge the impact of business transactions on a separate business entity. Indicate whether each of the following words or phrases relates most closely to (a) a business transaction, (b) a separate entity, or (c) a money measure: 1. Corporation 5. Sole proprietorship 9. Japanese yen 2. Euro 6. U.S. dollar 10. Purchase of supplies 3. Sales of products 7. Partnership 4. Receipt of cash 8. Owner’s investments LO3 Money Measure E 7. You have been asked to compare the sales and assets of four companies that make computer chips to determine which company is the largest in each category. You have gathered the following data, but they cannot be used for direct com- parison because each company’s sales and assets are in its own currency: Chapter Assignments 37 Company (Currency) Sales Assets U.S. Chip (U.S. dollar) 2,750,000 1,300,000 Nanhai (Hong Kong dollar) 5,000,000 2,800,000 Tova (Japanese yen) 350,000,000 290,000,000 Holstein (Euro) 3,500,000 3,900,000 Assuming that the exchange rates in Table 1-1 are current and appropriate, con- vert all the figures to U.S. dollars and determine which company is the largest in sales and which is the largest in assets. LO5 The Accounting Equation E 8. Use the accounting equation to answer each question that follows. Show any calculations you make. 1. The assets of Rasche Company are $380,000, and the owner’s equity is $155,000. What is the amount of the liabilities? 2. The liabilities and owner’s equity of Lee Company are $65,000 and $79,500, respectively. What is the amount of the assets? 3. The liabilities of Hurka Company equal one-third of the total assets, and owner’s equity is $180,000. What is the amount of the liabilities? 4. At the beginning of the year, Jahis Company’s assets were $310,000, and its owner’s equity was $150,000. During the year, assets increased $45,000 and liabilities decreased $22,500. What is the owner’s equity at the end of the year? LO5 LO6 Identification of Accounts E 9. 1. Indicate whether each of the following accounts is an asset (A), a liability (L), or a part of owner’s equity (OE): a. Cash d. Owner’s Capital g. Supplies b. Salaries Payable e. Land c. Accounts Receivable f. Accounts Payable 2. Indicate whether each account below would be shown on the income state- ment (IS), the statement of owner’s equity (OE), or the balance sheet (BS). a. Repair Revenue d. Cash g. Withdrawals b. Automobile e. Rent Expense c. Fuel Expense f. Accounts Payable LO6 Preparation of a Balance Sheet E 10. Listed in random order are some of the account balances for the Uptime Services Company as of December 31, 2011. Accounts Payable $ 25,000 Accounts Receivable $31,250 Building 56,250 Cash 12,500 Owner’s Capital 106,250 Equipment 25,000 Supplies 6,250 Place the balances in proper order and prepare a balance sheet similar to the one in Exhibit 1-3. LO6 Preparation and Integration of Financial Statements E 11. Proviso Company had the following accounts and balances during 2010: S ervice Revenue, $26,400; Rent Expense, $2,400; Wages Expense, $16,680; Advertising Expense, $2,700; Utilities Expense, $1,800; and With- drawals, $1,400. In addition, the year-end balances of selected accounts were

38 CHAPTER 1 Uses of Accounting Information and the Financial Statements as follows: Cash, $3,100; Accounts Receivable, $1,500; Supplies, $200; Land, $2,000; Accounts Payable, $900; Investment by Owner, $2,480; and begin- ning capital balance of $2,000. In proper format, prepare the income statement, statement of owner’s equity, and balance sheet for Proviso Company (assume the year ends on December 31, 2010). (Hint: You must solve for the beginning and ending balances of owner’s equity for 2010.) LO5 Owner’s Equity and the Accounting Equation E 12. The total assets and liabilities at the beginning and end of the year for Schu- pan Company are listed below. Assets Liabilities Beginning of the year $180,000 $ 68,750 End of the year 275,000 150,500 Determine Schupan Company’s net income or loss for the year under each of the following alternatives: 1. The owner made no investments in or withdrawals from the business during the year. 2. The owner made no investments in the business but withdrew $27,500 during the year. 3. The owner invested $16,250 in the business but made no withdrawals during the year. 4. The owner invested $12,500 in the business and withdrew of $29,000 during the year. LO6 Statement of Cash Flows E 13. Martin Service Company began the year 2010 with cash of $55,900. In addition to earning a net income of $38,000 and making cash withdrawals of $19,500, Martin Service borrowed $78,000 from the bank and purchased equip- ment with $125,000 of cash. Also, Accounts Receivable increased by $7,800, and Accounts Payable increased by $11,700. Determine the amount of cash on hand at December 31, 2010, by preparing a statement of cash flows similar to the one in Exhibit 1–4. LO4 LO5 Statement of Owner’s Equity LO6 E 14. Below is information from the statement of owner’s equity of Mrs. Kitty’s Cookies for a recent year. Withdrawals 0 Net income ? Owner’s Equity, January 31, 2010 $159,490 Owner’s Equity, January 31, 2009 $105,000 Prepare the statement of owner’s equity for Mrs. Kitty’s Cookies in good form. You will need to solve for the amount of net income. What is owner’s equity? Why might the owner decide not to make any withdrawals from the company? LO7 Accounting Abbreviations E 15. Identify the accounting meaning of each of the following abbreviations: AICPA, SEC, PCAOB, GAAP, FASB, IRS, GASB, IASB, IMA, and CPA. Chapter Assignments 39 Problems LO6 Preparation and Interpretation of Financial Statements P 1. B elow is a list of financial statement items. ____ Utilities expense ____ Equipment ____ Withdrawals ____ Building ____ Revenues ____ Fees earned ____ Owner’s capital ____ Accounts receivable ____ Cash ____ Net income ____ Accounts payable ____ Supplies ____ Land ____ Rent expense ____ Wages expense Required 1. Indicate whether each item is found on the income statement (IS), statement of owner’s equity (OE), and/or balance sheet (BS). User insight (cid:2) 2. Which statement is most closely associated with the goal of profitability? LO6 Integration of Financial Statements P 2. The following three independent sets of financial statements have several amounts missing: Income Statement Set A Set B Set C Revenues $5,320 $ 8,600 $ m Expenses a g 2,010 Net income $ 510 $ h $ n Statement of Owner’s Equity Beginning balance $1,780 $15,400 $ 200 Net income b i 450 Less withdrawals c 1,000 o Ending balance $ d $16,000 $ p Balance Sheet Total assets $ e $ j $1,900 Liabilities $ f $ 2,000 $1,300 Owner’s equity Owner’s capital 2,100 k q Total liabilities and owner’s equity $2,700 $ l $ r Required 1. Complete each set of financial statements by determining the amounts that correspond to the letters. User insight (cid:2) 2. Why is it necessary to prepare the income statement prior to the balance sheet? Curious if you got the right answer? Look at the Check Figures section that pre- cedes Chapter 1. LO1 LO6 Preparation and Interpretation of Financial Statements P 3. Below are the financial accounts of Special Assets. The company has just completed its 10th year of operations ended December 31, 2011. Accounts Payable $ 3,600

Accounts Receivable 4,500 Cash 71,700 Commission Sales Revenue 400,000 Commissions Expense 225,000 Commissions Payable 22,700 40 CHAPTER 1 Uses of Accounting Information and the Financial Statements Equipment $59,900 Marketing Expense 20,100 Office Rent Expense 36,000 Owner’s Capital, December 31, 2010 64,300 Supplies 700 Supplies Expense 2,600 Telephone and Computer Expenses 5,100 Wages Expense 32,000 Withdrawals 33,000 Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Special Assets. There were no investments by the owner during the year. User insight (cid:2) 2. The owner is considering expansion. What other statement would be useful to the owner in assessing whether the company’s operations are generating suffi- cient funds to support the expenses? Why would it be useful? LO4 LO6 Preparation and Interpretation of Financial Statements P 4. The following are the accounts of Unique Ad, an agency that develops mar- keting materials for print, radio, and television. The agency’s first year of opera- tions just ended on January 31, 2010. Accounts Payable $ 19,400 Accounts Receivable 24,900 Advertising Service Revenue 165,200 Cash 1,800 Equipment Rental Expense 37,200 Marketing Expense 6,800 Office Rent Expense 13,500 Owner’s Capital 5,000* Salaries Expense 86,000 Salaries Payable 1,300 Supplies 1,600 Supplies Expense 19,100 Withdrawals 0 *Represents the initial investment by the owner. Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Unique Ad. User insight (cid:2) 2. Review the financial statements and comment on the financial challenges Unique Ad faces. LO1 LO6 Use and Interpretation of Financial Statements LO7 P 5. The financial statements for the Oros Riding Club follow. Chapter Assignments 41 Oros Riding Club Income Statement For the Month Ended November 30, 2011 Revenues Riding lesson revenue $4,650 Locker rental revenue 1,450 Total revenues $6,100 Expenses Salaries expense $1,125 Feed expense 750 Utilities expense 450 Total expenses 2,325 Net income $3,775 Oros Riding Club Statement of Owner’s Equity For the Month Ended November 30, 2011 Owner’s capital, October 31, 2011 $35,475 Investment by owner 6,000 Net income for the month 3,775 Subtotal $45,250 Less withdrawals 2,400 Owner’s capital, November 30, 2011 $42,850 Oros Riding Club Balance Sheet November 30, 2011 Assets Liabilities Cash $ 6,700 Accounts payable $11,250 Accounts receivable 900 Owner’s Equity Supplies 750 Owner’s capital 42,850 Land 15,750 Building 22,500 Horses 7,500 Total liabilities and Total assets $54,100 owner’s equity $54,100 42 CHAPTER 1 Uses of Accounting Information and the Financial Statements Oros Riding Club Statement of Cash Flows For the Month Ended November 30, 2011 Cash flows from operating activities Net income $3,775 Adjustments to reconcile net income to net cash flows from operating activities Increase in accounts receivable $ (400) Increase in supplies (550) Increase in accounts payable 400 (550) Net cash flows from operating activities $3,225 Cash flows from investing activities Purchase of horses $2,000 Sale of horses (1,000) Net cash flows from financing activities 1,000 Cash flows from financing activities Investment by Owner $6,000 Cash withdrawals (2,400) Net cash flows from financing activities 3,600 Net increase in cash $7,825 Cash at beginning of month 475 Cash at end of month $8,300 Required User insight (cid:2) 1. Explain how the four statements for Oros Riding Club relate to each other. User insight (cid:2) 2. Which statements are most closely associated with the goals of liquidity and profitability? Why? User insight (cid:2) 3. If you were the owner of this business, how would you evaluate the com- pany’s performance? Give specific examples. User insight (cid:2) 4. If you were a banker considering Oros Riding Club for a loan, why might you want the company to be audited by an independent CPA? What would the audit tell you? Looking for more practice? Alternate problems have the same format and learn- ing objectives as problems that appear earlier. Alternate Problems

LO6 Integration of Financial Statements P 6. Below are three independent sets of financial statements with several amounts missing. Chapter Assignments 43 Income Statement Set A Set B Set C Revenues $ 1,200 $ g $ 240 Expenses a 5,000 m Net income $ b $ h $ 148 Statement of Owner’s Equity Beginning balance $ 2,900 $24,400 $ 340 Net income c 1,600 n Less withdrawals 200 i o Ending balance $ 3,090 $ j $ p Balance Sheet Total assets $ d $30,000 $ q Liabilities $1,600 $ 5,000 $ r Owner’s equity Owner’s capital e k 380 Total liabilities and owner’s equity $ f $ l $ 580 Required 1. Complete each set of financial statements by determining the amounts that correspond to the letters. User insight (cid:2) 2. In what order is it necessary to prepare the financial statements and why? LO1 LO6 Preparation and Interpretation of Financial Statements P 7. Below are the financial accounts of Metro Labs. The company has just com- pleted its third year of operations ended November 30, 2011. Accounts Payable $ 7,400 Accounts Receivable 51,900 Cash 115,750 Design Service Revenue 300,000 Marketing Expense 19,700 Office Rent Expense 50,000 Owner’s Capital, November 30, 2010 70,400 Salaries Expense 96,000 Salaries Payable 2,700 Supplies 800 Supplies Expense 6,350 Withdrawals 40,000 Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Metro Labs. There were no investments by the owner during the year. User insight (cid:2) 2. Evaluate the company’s ability to meet its bills when they come due. LO4 LO6 Preparation and Interpretation of Financial Statements P 8. Below are the accounts of Giordano’s Pizza. The company has just com- pleted its first year of operations ended September 30, 2010. Accounts Payable $10,500 Accounts Receivable 13,200 Cash 2,600 Delivery Truck Rent Expense 7,200 44 CHAPTER 1 Uses of Accounting Information and the Financial Statements Equipment $ 6,300 Equipment Rental Expense 2,900 Marketing Expense 1,500 Owner’s Capital 2,000* Pizza Revenue 82,000 Salaries Expense 56,000 Salaries Payable 700 Supplies 400 Supplies Expense 4,100 Withdrawals 1,000 *Represents the initial investment by the owner Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Giordano’s Pizza. User insight (cid:2) 2. Why would the owner of Giordano’s Pizza set his business up as a sole pro- prietorship and not a partnership? Discuss the advantages of the two forms of business organizations. LO6 Integration of Financial Statements P 9. Below are three independent sets of financial statements with several amounts missing. Income Statement Set X Set Y Set Z Revenues $1,100 $ g $240 Expenses a 5,200 m Net income $ b $ h $ 80 Statement of Owner’s Equity Beginning balance $2,900 $24,400 $240 Net income c 1,600 n Less withdrawals 200 i o Ending balance $3,000 $ j $ p Balance Sheetz Total assets $ d $31,000 $ q Liabilities $1,600 $ 5,000 $ r Owner’s equity Owner’s capital e k 280 Total liabilities and owner’s equity $ f $ l $580 Required 1. Complete each set of financial statements by determining the amounts that correspond to the letters. User insight (cid:2) 2. In what order is it necessary to prepare the financial statements and why? LO6 Preparation and Interpretation of Financial Statements P 10. Below are the financial accounts of Brad Realty. The company has just com- pleted its 10th year of operations ended December 31, 2011. Accounts Payable $ 3,600 Accounts Receivable 4,500 Cash 91,600 Commission Sales Revenue 450,000 Commissions Expense 225,000 Commissions Payable 22,700 Chapter Assignments 45 Equipment $59,000 Marketing Expense 29,200 Office Rent Expense 36,000 Owner’s Capital, December 31, 2010 50,300 Supplies 700 Supplies Expense 2,600 Telephone and Computer Expenses 5,100 Wages Expense 32,000 Withdrawals 40,000 Required 1. Prepare the income statement, statement of owner’s equity, and balance sheet for Brad Realty. There were no investments by the owner during the year. User insight (cid:2) 2. The owner is considering expansion. What other statement would be useful to the owner in assessing whether the company’s operations are generating suffi-

cient funds to support expenses? Why would it be useful? ENHANCING Your Knowledge, Skills, and Critical Thinking LO1 LO2 Business Activities and Management Functions C 1. Costco Wholesale Corporation is America’s largest membership retail company. According to its letter to stockholders: Our mission is to bring quality goods and services to our members at the lowest possible price in every market where we do business. . . . A hallmark of Costco warehouses has been the extraordinary sales volume we achieve.14 To achieve its business goals, Costco must organize its management by functions that relate to the principal activities of a business. Discuss the three basic activities Costco will engage in to achieve its goals, and suggest some examples of each. What is the role of Costco’s management? What functions must its management perform to carry out these activities? LO5 Concept of an Asset C 2. Southwest Airlines Co. is one of the most successful airlines in the United States. Its annual report contains this statement: “We are a company of People, not Planes. That is what distinguishes us from other airlines and other com- panies. At Southwest Airlines, People are our most important asset.”15 Are employees considered assets in the financial statements? Why or why not? Dis- cuss in what sense Southwest considers its employees to be assets. LO7 Generally Accepted Accounting Principles C 3. Fidelity Investments Company is a well-known mutual fund investment company. It makes investments worth billions of dollars in companies listed on the New York Stock Exchange and other stock markets. Generally accepted accounting principles (GAAP) are very important for Fidelity’s investment ana- lysts. What are generally accepted accounting principles? Why are financial state- ments that have been prepared in accordance with GAAP and audited by an independent CPA useful for Fidelity’s investment analysts? What organizations influence GAAP? Explain how they do so. 46 CHAPTER 1 Uses of Accounting Information and the Financial Statements LO7 Professional Ethics C 4. Discuss the ethical choices in the situations below. In each instance, describe the ethical dilemma, determine the alternative courses of action, and tell what you would do. 1. You are the payroll accountant for a small business. A friend asks you how much another employee is paid per hour. 2. As an accountant for the branch office of a wholesale supplier, you discover that several of the receipts the branch manager has submitted for reimburse- ment as selling expenses actually stem from nights out with his spouse. 3. You are an accountant in the purchasing department of a construction com- pany. When you arrive home from work on December 22, you find a large ham in a box marked “Happy Holidays—It’s a pleasure to work with you.” The gift is from a supplier who has bid on a contract your employer plans to award next week. 4. As an auditor with one year’s experience at a local CPA firm, you are expected to complete a certain part of an audit in 20 hours. Because of your lack of experience, you know you cannot finish the job within that time. Rather than admit this, you are thinking about working late to finish the job and not telling anyone. 5. You are a tax accountant at a local CPA firm. You help your neighbor fill out her tax return, and she pays you $200 in cash. Because there is no record of this transaction, you are considering not reporting it on your tax return. 6. The accounting firm for which you work as a CPA has just won a new client, a firm in which you own 200 shares of stock that you received as an inheri- tance from your grandmother. Because it is only a small number of shares and you think the company will be very successful, you are considering not disclosing the investment. LO6 LO7 Analysis of Four Basic Financial Statements C 5. Refer to the CVS annual report in the Supplement to Chapter 5 to answer the questions below. Keep in mind that every company, while following basic principles, adapts financial statements and terminology to its own special needs.

Therefore, the complexity of CVS’s financial statements and the terminology in them will differ somewhat from the financial statements in the text. 1. What titles does CVS give to its four basic financial statements? (Note that the word consolidated in the titles of the financial statements means that these statements combine those of several companies owned by CVS.) 2. Prove that the accounting equation works for CVS on December 31, 2008, by finding the amounts for the following equation: Assets (cid:2) Liabilities (cid:3) Shareholders’ (Owner’s) Equity. 3. What were the total revenues of CVS for the year ended December 31, 2008? 4. Was CVS profitable in the year ended December 31, 2008? How much was net income (loss) in that year, and did it increase or decrease from the year ended December 29, 2007? 5. Did the company’s cash and cash equivalents increase from December 29, 2007, to December 31, 2008? If so, by how much? In what two places in the statements can this number be found or computed? 6. Did cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities increase or decrease from 2007 to 2008? 7. Who is the auditor for the company? Why is the auditor’s report that accom- panies the financial statements important? Chapter Assignments 47 LO1 LO5 Performance Measures and Financial Statements C 6. Refer to the CVS annual report and the financial statements of Southwest Airlines Co. in the Supplement to Chapter 5 to answer these questions: 1. Which company is larger in terms of assets and in terms of revenues? What do you think is the best way to measure the size of a company? 2. Which company is more profitable in terms of net income? What is the trend of profitability over the past three years for both companies? 3. Which company has more cash? Which increased its cash the most in the last year? Which has more liquidity as measured by cash flows from operating activities? C H A P T E R 2 Analyzing Business Transactions A ll business transactions require the application of three basic Making a Statement accounting concepts: recording a transaction at the right time, placing the right value on it, and calling it by the right name. INCOME STATEMENT Most accounting frauds and mistakes violate one or more of these Revenues basic accounting concepts. What you learn in this chapter will help – Expenses you avoid making such mistakes. It will also help you recognize correct accounting practices. = Net Income STATEMENT OF LEARNING OBJECTIVES OWNER’S EQUITY Beginning Balance LO1 Explain how the concepts of recognition, valuation, and classification apply to business transactions and why they are + Net Income important factors in ethical financial reporting. (pp. 50–53) – Withdrawals = Ending Balance LO2 Explain the double-entry system and the usefulness of T accounts in analyzing business transactions. (pp. 54–57) BALANCE SHEET LO3 Demonstrate how the double-entry system is applied to Assets Liabilities common business transactions. (pp. 58–65) Owner’s LO4 Prepare a trial balance, and describe its value and Equity limitations. (pp. 65–67) A = L + OE LO5 Show how the timing of transactions affects cash flows and liquidity. (pp. 68–69) STATEMENT OF CASH FLOWS Operating activities + Investing activities + Financing activities SUPPLEMENTAL OBJECTIVE = Change in Cash + Beginning Balance SO6 Define the chart of accounts, record transactions in the general = Ending Cash Balance journal, and post transactions to the ledger. (pp. 70–75) Business transactions can affect all the financial statements. 48 DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Is there a difference between an economic event and a business PAWS AND HOOFS CLINIC transaction that should be recorded in the accounting records? After graduating from veterinary school, Larry Cox started the Paws and Hoofs Clinic. On his second day of business, he received a stand- (cid:2) Can a business transaction benefit a business even though ing order from Quarter Horse Stables to examine its horses on a no cash is received when the

monthly basis for one year. The fee for the service was to be $500 transaction takes place? per visit, or $6,000 for the year. Confident that his agreement with (cid:2) What is the difference between Quarter Horse Stables will work out, Larry is thinking of including the an asset and an expense? $6,000 in his financial statements. He believes that doing so would be a good advertisement for his business, but he must answer the questions at right to determine if this is acceptable practice. 4499 50 CHAPTER 2 Analyzing Business Transactions Measurement Business transactions are economic events that affect a company’s financial posi- Issues tion. As shown in Figure 2-1, to measure a business transaction, you must decide when the transaction occurred (the recognition issue), what value to place on LO1 Explain how the concepts the transaction (the valuation issue), and how the components of the transaction should be categorized (the classification issue). of recognition, valuation, and These three issues—recognition, valuation, and classification—underlie almost classification apply to business every major decision in financial accounting today. They are at the heart of account- transactions and why they are ing for pension plans, mergers of giant companies, and international transactions. important factors in ethical In discussing these issues, we follow generally accepted accounting principles and financial reporting. use an approach that promotes an understanding of basic accounting concepts. Keep in mind, however, that measurement issues can be controversial and resolu- tions to them are not always as cut-and-dried as the ones presented here. Recognition The recognition issue refers to the difficulty of deciding when a business transac- Study Note tion should be recorded. The resolution of this issue is important because the date In accounting, recognize means on which a transaction is recorded affects amounts in the financial statements. to record a transaction or event. To illustrate some of the factors involved in the recognition issue, suppose a company wants to purchase an office desk. The following events take place: 1. An employee sends a purchase requisition for the desk to the purchasing department. 2. The purchasing department sends a purchase order to the supplier. 3. The supplier ships the desk. 4. The company receives the desk. Study Note 5. The company receives the bill from the supplier. A purchase should usually not be recognized (recorded) before 6. The company pays the bill. title is transferred, because According to accounting tradition, a transaction should be recorded when until that point, the vendor title to merchandise passes from the supplier to the purchaser and creates an obli- has not fulfilled its contractual gation to pay. Thus, depending on the details of the shipping agreement for the obligation and the buyer has no desk, the transaction should be recognized (recorded) at the time of either event liability. 3 or 4. This is the guideline we generally use in this book. However, many small FIGURE 2-1 The Role of Measurement Issues ECONOMIC EVENTS RECOGNITION VALUATION CLASSIFICATION BUSINESS TRANSACTIONS THAT AFFECT FINANCIAL POSITION Measurement Issues 51 FOCUS ON BUSINESS PRACTICE Accounting Policies: Where Do You Find Them? The Boeing Company, one of the world’s makers of air- this question and others about companies’ accounting poli- liners, takes orders for planes years in advance. Although cies can be found in the Summary of Significant Accounting it is an important economic event to both Boeing and the Policies in their annual reports. For example, in that section buyer, neither the buyer nor the seller would record the of its annual report, Boeing states: “We recognize sales for event as a transaction. So, how do you know when compa- commercial airplane deliveries as each unit is completed nies record sales or purchase transactions? The answer to and accepted by the customer.”1 businesses that have simple accounting systems do not record a transaction until they receive a bill (event 5) or pay it (event 6), because these are the implied

points of title transfer. The predetermined time at which a transaction should be recorded is the recognition point. Although purchase requisitions and purchase orders (events 1 and 2) are eco- nomic events, they do not affect a company’s financial position, and they are not recognized in the accounting records. Even the most important economic events may not be recognized in the accounting records. Here are some more examples of economic events that should and should not be recorded as business transactions: Events That Are Not Recorded Events That Are Recorded as Transactions as Transactions A customer inquires about the A customer buys a service. availability of a service. A company hires a new employee. A company pays an employee for work performed. A company signs a contract to A company performs a service. provide a service in the future. The recognition issue can be difficult to resolve. Consider an advertising agency that is planning a major advertising campaign for a client. Employees may work on the plan several hours a day for a number of weeks. They add value to the plan as they develop it. Should this added value be recognized as the plan is being developed or at the time it is completed? Usually, the increase in value is recorded at the time the plan is finished and the client is billed for it. However, if a plan is going to take a long time to develop, the agency and the client may agree that the client will be billed at key points during its development. In that case, a transaction is recorded at each billing. Valuation Study Note The valuation issue focuses on assigning a monetary value to a business trans- action and accounting for the assets and liabilities that result from the business The value of a transaction transactions. Generally accepted accounting principles state that all business usually is based on a business document—a canceled check transactions should be valued at fair value when they occur. Fair value is defined or an invoice. as the exchange price of an actual or potential business transaction between mar- ket participants.2 This practice of recording transactions at exchange price at the 52 CHAPTER 2 Analyzing Business Transactions FOCUS ON BUSINESS PRACTICE The Challenge of Fair Value Accounting The measurement of fair value is a major challenge in merg- h ypothetical transaction that in many cases is difficult to ing international financial reporting standards (IFRS) with measure: It represents the selling price of an asset or the U.S. GAAP. Both the International Accounting Standards payment price of a liability. It does not represent the price Board (IASB) and the Financial Accounting Standards Board of acquiring the asset or assuming the liability. In practice, (FASB) are committed to this effort. Fair value is the price the potential selling price of equipment used in a factory to sell an asset or transfer a liability in an orderly market or an investment in a private company for which no ready by an arm’s-length transaction. Fair value represents a market exists may not be easy to determine. point of recognition is commonly referred to as the cost principle. It is used because the cost, or exchange price, is verifiable. For example, when Larry Cox performs the service for Quarter Horse Stables described in the Decision Point at the beginning of this chapter, he and Quarter Horse Stables will record the trans- action in their respective records at the price they have agreed on. Normally, the value of an asset is held at its initial fair value or cost until the asset is sold, expires, or is consumed. However, if there is evidence that the fair value of the asset or liability has changed, an adjustment to the initial value may be required. There are different rules for the application of fair value to different classes of assets. For example, a building or equipment remains at cost unless there is convincing evidence that the fair value is less than cost. In this case, a loss should be recorded to reduce the value from its cost to fair value. Investments,