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ACCOUNTING PRINCIPLES Generally accepted accounting principles (GAAP) have substantial authoritative 6 LEARNING OBJECTIVE support. The AICPA’s Code of Professional Conduct requires that members prepare Explain the meaning of generally financial statements in accordance with GAAP. Specifically, Rule 203 of this Code accepted accounting principles (GAAP) prohibits a member from expressing an unqualified opinion on financial statements and the role of the Codification for that contain a material departure from generally accepted accounting principles. GAAP. What is GAAP? The major sources of GAAP come from the organizations dis- cussed earlier in this chapter. It is composed of a mixture of over 2,000 documents that have been developed over the last 70 years or so. It includes APB Opinions, FASB Stan- dards, and AICPA Research Bulletins. In addition, the FASB has issued interpretations and FASB Staff Positions that modified or extended existing standards. The APB also issued interpretations of APB Opinions. Both types of interpretations are considered authoritative for purposes of determining GAAP. Since replacing the APB, the FASB has issued over 160 standards, 48 interpretations, and nearly 100 staff positions. Illustra- tion 1-4 highlights the many different types of documents that comprise GAAP. ILLUSTRATION 1-4 AICPA Accounting Interpretations FASB Implementation Guides (Q and A) GAAP Documents Widely recognized and prevalent FASB Emerging Issues Task Force AICPA AcSEC Practice industry practices Bulletins FASB Technical Bulletins AICPA Industry Audit and AICPA Statements of Position Accounting Guides FASB Standards, Interpretations, APB Opinions AICPA Accounting Research Bulletins and Staff Positions 14 Chapter 1 Financial Accounting and Accounting Standards What do the numbers mean? YOU HAVE TO STEP BACK Should the accounting profession have principles-based billions of dollars of debt and other obligations. To add fuel standards or rules-based standards? Critics of the profession to the fi re, the chief accountant of the enforcement division of today say that over the past three decades, standard-setters the SEC noted, “One can violate SEC laws and still comply have moved away from broad accounting principles aimed with GAAP.” at ensuring that companies’ fi nancial statements are fairly In short, what he is saying is that it is not enough just to presented. check the boxes. This point was reinforced by the Chief Instead, these critics say, standard-setters have moved Accountant of the SEC, who remarked that judgments should toward drafting voluminous rules that, if technically followed result in “accounting that refl ects the substance of the trans- in “check-box” fashion, may shield auditors and companies action, as well as being in accordance with the literature.” from legal liability. That has resulted in companies creating That is, you have to exercise judgment in applying GAAP to complex capital structures that comply with GAAP but hide achieve high-quality reporting. Sources: Adapted from S. Liesman, “SEC Accounting Cop’s Warning: Playing by the Rules May Not Head Off Fraud Issues,” Wall Street Journal (February 12, 2002), p. C7. See also “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System,” SEC (July 25, 2003); and E. Orenstein, “Accounting as Art vs. Science, and the Role of Professional Judgment,” Accounting Matters, FEI Financial Reporting Blog (November, 2009). FASB Codifi cation Historically, the documents that comprised GAAP varied in format, completeness, and structure. In some cases, these documents were inconsistent and difficult to interpret. As a result, financial statement preparers sometimes were not sure whether they had the right GAAP. Determining what was authoritative and what was not became difficult. In response to these concerns, the FASB developed the Financial Accounting Stan- dards Board Accounting Standards Codification (or more simply, “the Codification”).

The FASB’s primary goal in developing the Codification is to provide in one place all the authoritative literature related to a particular topic. This will simplify user access to all authoritative U.S. generally accepted accounting principles. The Codification changes the way GAAP is documented, presented, and updated. It explains what GAAP is and eliminates nonessential information such as redundant document summaries, basis for conclusions sections, and historical content. In short, the Codification integrates and synthesizes existing GAAP; it does not create new GAAP. It creates one level of GAAP, which is considered authoritative. All other accounting literature is considered non- authoritative.6 To provide easy access to this Codification, the FASB also developed the Financial Accounting Standards Board Codification Research System (CRS). CRS is an online, real-time database that provides easy access to the Codification. The Codification and the related CRS provide a topically organized structure, subdivided into topic, subtop- ics, sections, and paragraphs, using a numerical index system. For purposes of referencing authoritative GAAP material in this textbook, we will use the Codification framework. Here is an example of how the Codification framework 6The FASB Codification can be accessed at http://asc.fasb.org/home. Access to the full functionality of the Codification Research System requires a subscription. Reduced-price academic access is available through the American Accounting Association (see aaahq.org/FASB/Access.cfm). Prior to the Codification, the profession relied on FASB 162, “The Hierarchy of Generally Accepted Accounting Principles,” which defined the meaning of generally accepted accounting principles. In that document, certain documents were deemed more authoritative than others, which led to various levels of GAAP. Fortunately, the Codification does not have different levels of GAAP. Generally Accepted Accounting Principles 15 is cited, using Receivables as the example. The purpose of the search shown below is to determine GAAP for accounting for loans and trade receivables not held for sale subsequent to initial measurement. Topic Go to FASB ASC 310 to access the Receivables topic. Subtopics Go to FASB ASC 310-10 to access the Overall Subtopic of the Topic 310. Sections Go to FASB ASC 310-10-35 to access the Subsequent Measurement Section of the Subtopic 310-10. Paragraph Go to FASB ASC 310-10-35-47 to access the Loans and Trade Receiv- ables not Held for Sale paragraph of Section 310-10-35. Illustration 1-5 shows the Codification framework graphically. ILLUSTRATION 1-5 Topic FASB Codifi cation Provides a collection of related guidance on a given subject, such as receivables or leases. 310—Receivables Framework Subtopics Subset of a topic and distinguished by type 40—Troubled-Debt or scope. For example, overall and troubled-debt 10—Overall Restructurings by restructurings are two subtopics of receivables. Creditors Sections Indicate the type of content in a subtopic, 30—Initial 35—Subsequent such as initial measurement. In some Measurement Measurement cases, subsections are used but not numbered. Paragraphs This level is where you will find the substantive 47—Loans and content related to the issue researched. Trade Receivables (All other levels exist essentially to find the Not Held for Sale material related to the paragraph level content.) What happens if the Codification does not cover a certain type of transaction or event? In that case, other accounting literature should be considered, such as FASB Concept Statements, international financial reporting standards, and other professional literature. This will happen only rarely. The expectations for the Codification are high. It is hoped that the Codification will enable users to better understand what GAAP is. As a result, the time to research accounting issues and the risk of noncompliance with GAAP will be reduced, sometimes substantially. In addition, the Web-based format will make updating easier, which will

help users stay current with GAAP.7 7To increase the usefulness of the Codification for public companies, relevant authoritative content issued by the SEC is included in the Codification. In the case of SEC content, an “S” precedes the section number. 16 Chapter 1 Financial Accounting and Accounting Standards For individuals (like you) attempting to learn GAAP, the Codification will be invaluable. It streamlines and simplifies how to determine what GAAP is, which will lead See the FASB to better financial accounting and reporting. We provide references to the Codification Codification section throughout this textbook, using a numbering system. For example, a bracket with a at the end of each number, such as [1], indicates that the citation to the FASB Codification can be found in the chapter for Codification references and FASB Codification section at the end of the chapter (immediately before the assignment exercises. materials). ISSUES IN FINANCIAL REPORTING Since the implementation of GAAP may affect many interests, much discussion LEARNING OBJECTIVE 7 occurs about who should develop GAAP and to whom it should apply. We discuss Describe the impact of user groups on some of the major issues below. the rule-making process. GAAP in a Political Environment User groups are possibly the most powerful force influencing the development of GAAP. User groups consist of those most interested in or affected by accounting rules. Like lobbyists in our state and national capitals, user groups play a significant role. GAAP is as much a product of political action as it is of careful logic or empirical findings. User groups may want particular economic events accounted for or reported in a particular way, and they fight hard to get what they want. They know that the most effective way to influence GAAP is to participate in the formulation of these rules or to try to influence or persuade the formulator of them. These user groups often target the FASB, to pressure it to influence changes in the existing rules and the development of new ones.8 In fact, these pressures have been multiplying. Some influential groups demand that the accounting profession act more quickly and decisively to solve its problems. Other groups resist such action, preferring to implement change more slowly, if at all. Illustration 1-6 shows the various user groups that apply pressure. ILLUSTRATION 1-6 User Groups that Business entities Infl uence the Formulation of Accounting Standards CPAs and Financial community accounting firms (analysts, bankers, etc.) Preparers AICPA (AcSEC) FASB (e.g., Financial Executives Institute) Government Academicians (SEC, IRS, other agencies) Investing public Industry associations Generally Accepted Accounting Principles 8FASB board members acknowledged that they undertook many of the Board’s projects, such as “Accounting for Contingencies,” “Accounting for Pensions,” “Statement of Cash Flows,” and “Accounting for Derivatives,” due to political pressure. Issues in Financial Reporting 17 Should there be politics in establishing GAAP for financial accounting and report- ing? Why not? We have politics at home; at school; at the fraternity, sorority, and dormi- tory; at the office; and at church, temple, and mosque. Politics is everywhere. GAAP is part of the real world, and it cannot escape politics and political pressures. That is not to say that politics in establishing GAAP is a negative force. Considering the economic consequences9 of many accounting rules, special interest groups should vocalize their reactions to proposed rules. What the Board should not do is issue pronouncements that are primarily politically motivated. While paying attention to its constituencies, the Board should base GAAP on sound research and a conceptual frame- work that has its foundation in economic reality. Evolving Issue FAIR VALUE, FAIR CONSEQUENCES? No recent accounting issue better illustrates the economic These changes were generally supported by banks. But these consequences of accounting than the current debate over the changes produced a strong reaction from some investors,

use of fair value accounting for financial assets. Both the with one investor group complaining that the changes would FASB and the International Accounting Standards Board “effectively gut the transparent application of fair value (IASB) have standards requiring the use of fair value ac- measurement.” The group also says suspending fair value counting for financial assets, such as investments and other accounting would delay the recovery of the banking system. financial instruments. Fair value provides the most relevant Such political pressure on accounting standard-setters is and reliable information for investors about these assets not confined to the United States. For example, French Presi- and liabilities. However, in the wake of the recent credit crisis, dent Nicolas Sarkozy urged his European Union counter- some countries, their central banks, and bank regulators parts to back changes to accounting rules and give banks and want to suspend fair value accounting, based on concerns insurers some breathing space amid the market turmoil. And that use of fair value accounting, which calls for recording more recently, international finance ministers are urging the significant losses on poorly performing loans and invest- FASB and IASB to accelerate their work on accounting stan- ments, could scare investors and depositors and lead to a dards, including the fair value guidance for financial instru- “run on the bank.” ments. It is unclear whether these political pressures will For example, in 2009, Congress ordered the FASB to have an effect on fair value accounting, but there is no ques- change its accounting rules so as to reduce the losses banks tion that the issue has stirred significant worldwide political reported, as the values of their securities had crumbled. debate. In short, the numbers have consequences. Sources: Adapted from Ben Hall and Nikki Tait, “Sarkozy Seeks EU Accounting Change,” The Financial Times Limited (September 30, 2008); Floyd Norris, “Banks Are Set to Receive More Leeway on Asset Values,” The New York Times (March 31, 2009); and E. Orenstein, “G20 Finance Ministers Urge FASB, IASB Converge Key Standards by Mid-2013 at the Latest,” FEI Financial Reporting Blog (April 2012). International Perspective The Expectations Gap Foreign accounting fi rms that The Sarbanes-Oxley Act was passed in response to a string of accounting provide an audit report for a scandals at companies like Enron, Cendant, Sunbeam, Rite-Aid, Xerox, and U.S.-listed company are subject WorldCom. This law increased the resources for the SEC to combat fraud to the authority of the accounting and curb poor reporting practices.10 And the SEC has increased its policing oversight board (mandated by the Sarbanes-Oxley Act). efforts, approving new auditor independence rules and materiality guidelines 9Economic consequences means the impact of accounting reports on the wealth positions of issuers and users of financial information, and the decision-making behavior resulting from that impact. The resulting behavior of these individuals and groups could have detrimental financial effects on the providers of the financial information. See Stephen A. Zeff, “The Rise of ‘Economic Consequences’,” Journal of Accountancy (December 1978), pp. 56–63. We extend appreciation to Professor Zeff for his insights on this chapter. 10Sarbanes-Oxley Act of 2002, H. R. Rep. No. 107-610 (2002). 18 Chapter 1 Financial Accounting and Accounting Standards for financial reporting. In addition, the Sarbanes-Oxley Act introduces sweeping changes to the institutional structure of the accounting profession. The following are some of the key provisions of the legislation. • Establishes an oversight board, the Public Company Accounting Oversight Board (PCAOB), for accounting practices. The PCAOB has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules. • Implements stronger independence rules for auditors. Audit partners, for example, are required to rotate every five years, and auditors are prohibited from offering

certain types of consulting services to corporate clients. • Requires CEOs and CFOs to personally certify that financial statements and disclo- sures are accurate and complete, and requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement. • Requires audit committees to be comprised of independent members and members with financial expertise. • Requires codes of ethics for senior financial officers. In addition, Section 404 of the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting. Internal con- trols are a system of checks and balances designed to prevent and detect fraud and errors. Most companies have these systems in place, but many have never completely docu- mented them. Companies are finding that it is a costly process but perhaps badly needed. While there continues to be debate about the benefits and costs of Sarbanes-Oxley (especially for smaller companies), studies at the time of the act’s implementation pro- vide compelling evidence that there was much room for improvement. For example, one study documented 424 companies with deficiencies in internal control.11 Many problems involved closing the books, revenue recognition deficiencies, reconciling accounts, or dealing with inventory. SunTrust Bank, for example, fired three officers after discovering errors in how the company calculates its allowance for bad debts. And Visteon, a car parts supplier, said it found problems recording and managing receiv- ables from its largest customer, Ford Motor. Will these changes be enough? The expectations gap—what the public thinks accoun- tants should do and what accountants think they can do—is difficult to close. Due to the number of fraudulent reporting cases, some question whether the profession is doing enough. Although the profession can argue rightfully that accounting cannot be respon- sible for every financial catastrophe, it must continue to strive to meet the needs of society. However, efforts to meet these needs will become more costly to society. The development of a highly transparent, clear, and reliable system will require considerable resources. Financial Reporting Challenges While our reporting model has worked well in capturing and organizing financial LEARNING OBJECTIVE 8 information in a useful and reliable fashion, much still needs to be done. For Describe some of the challenges facing example, if we move to the year 2025 and look back at financial reporting today, financial reporting. we might read the following. • Nonfinancial measurements. Financial reports failed to provide some key performance measures widely used by management, such as customer satisfaction indexes, 11Leah Townsend, “Internal Control Deficiency Disclosures—Interim Alert,” Yellow Card—Interim Trend Alert (April 12, 2005), Glass, Lewis & Co., LLC. Issues in Financial Reporting 19 backlog information, reject rates on goods purchased, as well as the results of com- panies’ sustainability efforts. • Forward-looking information. Financial reports failed to provide forward-looking information needed by present and potential investors and creditors. One indi- vidual noted that financial statements in 2014 should have started with the phrase, “Once upon a time,” to signify their use of historical cost and accumulation of past events. • Soft assets. Financial reports focused on hard assets (inventory, plant assets) but failed to provide much information about a company’s soft assets (intangibles). The best assets are often intangible. Consider Microsoft’s know-how and market domi- nance, Wal-Mart’s expertise in supply chain management, and Procter & Gamble’s brand image. • Timeliness. Companies only prepared financial statements quarterly and provided audited financials annually. Little to no real-time financial statement information was available. • Understandability. Investors and market regulators were raising concerns about the complexity and lack of understandability of financial reports.

We believe each of these challenges must be met for the accounting profession to provide the type of information needed for an efficient capital allocation process. We are confident that changes will occur, based on these positive signs: • Already, some companies voluntarily disclose information deemed relevant to investors. Often such information is nonfinancial. For example, banking compa- nies now disclose data on loan growth, credit quality, fee income, operating effi- ciency, capital management, and management strategy. Increasingly, companies are preparing reports on their sustainability efforts by reporting such information as water use and conservation, carbon impacts, and labor practices. In some cases, “integrated reports” are provided, which incorporate sustainability reports into the traditional annual report, leading some to call for standards for sustainability reporting. • Initially, companies used the Internet to provide limited financial data. Now, most companies publish their annual reports in several formats on the Web. The most innovative companies offer sections of their annual reports in a format that the user can readily manipulate, such as in an electronic spreadsheet format. Companies also format their financial reports using eXtensible Business Reporting Language (XBRL), which permits quicker and lower-cost access to companies’ financial information. • More accounting standards now require the recording or disclosing of fair value information. For example, companies either record investments in stocks and bonds, debt obligations, and derivatives at fair value, or companies show information related to fair values in the notes to the financial statements. The FASB and the IASB have a converged standard on fair value measures, which should enhance the usefulness of fair value measures in financial statements. • The FASB is now working on projects that address disclosure effectiveness and a reporting framework for non-public companies. The projects could go a long way toward addressing complexity and understandability of the information in finan- cial statements, allowing for more-effective, less-complex, and flexible reporting to meet the needs of investors. 20 Chapter 1 Financial Accounting and Accounting Standards Changes in these directions will enhance the relevance of financial reporting and pro- vide useful information to financial statement readers. International Accounting Standards Former Secretary of the Treasury, Lawrence Summers, has indicated that the single most important innovation shaping the capital markets was the idea of generally accepted accounting principles. He went on to say that we need something similar internationally. We believe that the Secretary is right. Relevant and reliable financial information is a necessity for viable capital markets. Unfortunately, companies outside the United States often prepare financial statements using standards different from U.S. GAAP (or simply GAAP). As a result, international companies such as Coca-Cola, Microsoft, and IBM have to develop financial information in different ways. Beyond the additional costs these companies incur, users of the financial statements often must understand at least two sets of accounting standards. (Understanding one set is hard enough!) It is not surprising, therefore, that there is a growing demand for one set of high-quality interna- tional standards. International Presently, there are two sets of rules accepted for international use—GAAP Perspective and International Financial Reporting Standards (IFRS), issued by the London-based International Accounting Standards Board (IASB). U.S. compa- IFRS includes the standards, nies that list overseas are still permitted to use GAAP, and foreign companies referred to as International listed on U.S. exchanges are permitted to use IFRS. As you will learn, there are Financial Reporting Standards (IFRS), developed by the IASB. many similarities between GAAP and IFRS. The predecessor to the IASB Already over 115 countries use IFRS, and the European Union now requires

issued International Accounting all listed companies in Europe (over 7,000 companies) to use it. The SEC laid out Standards (IAS). a roadmap by which all U.S. companies might be required to use IFRS by 2015. Most parties recognize that global markets will best be served if only one set of accounting standards is used. For example, the FASB and the IASB formalized their commitment to the convergence of GAAP and IFRS by issuing a memorandum of understanding (often referred to as the Norwalk agreement). The two Boards agreed to use their best efforts to: • Make their existing financial reporting standards fully compatible as soon as prac- ticable, and • Coordinate their future work programs to ensure that once achieved, compatibility is maintained. International As a result of this agreement, the two Boards identified a number of short- Perspective term and long-term projects that would lead to convergence. For example, one short-term project was for the FASB to issue a rule that permits a fair value op- The adoption of IFRS by U.S. tion for financial instruments. This rule was issued in 2007, and now the FASB companies would make it easier and the IASB follow the same accounting in this area. Conversely, the IASB to compare U.S. and foreign completed a project related to borrowing costs, which makes IFRS consistent companies, as well as for U.S. companies to raise capital in with GAAP. Long-term convergence projects relate to such issues as revenue foreign markets. recognition, the conceptual framework, and leases. Because convergence is such an important issue, we provide a discussion of international accounting standards at the end of each chapter called IFRS Insights. This feature will help you understand the changes that are taking place in the financial re- porting area as we move to one set of international standards. In addition, throughout the textbook, we provide International Perspectives in the margins to help you under- stand the international reporting environment. Issues in Financial Reporting 21 What do the numbers mean? CAN YOU DO THAT? One of the more diffi cult issues related to convergence and everything is prohibited even if it is permitted. And in international accounting standards is that countries have France, everything is permitted even if it is prohibited. different cultures and customs. For example, the former chair Add in countries like Japan, the United States and China, of the IASB explained it this way regarding Europe: it becomes very diffi cult to meet the needs of each of these countries.” “In the U.K. everything is permitted unless it is prohib- ited. In Germany, it is the other way around; everything With this diversity of thinking around the world, it under- is prohibited unless it is permitted. In the Netherlands, standable why accounting convergence has been so elusive. Source: Sir D. Tweedie, “Remarks at the Robert P. Maxon Lectureship,” George Washington University (April 7, 2010). Ethics in the Environment of Financial Accounting Robert Sack, a noted commentator on the subject of accounting ethics, observed, 9 LEARNING OBJECTIVE “Based on my experience, new graduates tend to be idealistic . . . thank goodness Understand issues related to ethics for that! Still it is very dangerous to think that your armor is all in place and say to and financial accounting. yourself, ‘I would have never given in to that.’ The pressures don’t explode on us; they build, and we often don’t recognize them until they have us.” These observations are particularly appropriate for anyone entering the business world. In accounting, as in other areas of business, we frequently encounter ethical dilemmas. Some of these dilemmas are simple and easy to resolve. However, many are not, requiring difficult choices among allowable alternatives. Companies that concentrate on “maximizing the bottom line,” “facing the challenges of competition,” and “stressing short-term results” place accountants in an environment of conflict and pressure. Basic questions such as, “Is this way of communicating financial

information good or bad?” “Is it right or wrong?” and “What should I do in the circum- stance?” cannot always be answered by simply adhering to GAAP or following the rules of the profession. Technical competence is not enough when encountering ethical decisions. Doing the right thing is not always easy or obvious. The pressures “to bend the Gateway to rules,” “to play the game,” or “to just ignore it” can be considerable. For example, “Will the Profession my decision affect my job performance negatively?” “Will my superiors be upset?” and Expanded Discussion of Ethical Issues in “Will my colleagues be unhappy with me?” are often questions business people face in Financial Reporting making a tough ethical decision. The decision is more difficult because there is no comprehensive ethical system to provide guidelines. Time, job, client, personal, and peer pressures can complicate the process of ethical sensitivity and selection among alternatives. Throughout this textbook, we present ethical considerations to help sensitize you to the type of situations you may encounter in the performance of your professional responsibility. Conclusion Bob Herz, former FASB chairman, believes that there are three fundamental consider- ations the FASB must keep in mind in its rule-making activities: (1) improvement in financial reporting, (2) simplification of the accounting literature and the rule-making process, and (3) international convergence. These are notable objectives, and the Board is making good progress on all three dimensions. Issues such as off-balance-sheet financing, measurement of fair values, enhanced criteria for revenue recognition, and stock option accounting are examples of where the Board has exerted leadership. Improvements in financial reporting should follow. 22 Chapter 1 Financial Accounting and Accounting Standards Also, the Board is making it easier to understand what GAAP is. GAAP has been contained in a number of different documents. The lack of a single source makes it difficult to access and understand generally accepted principles. As discussed earlier, You will the Codification now organizes existing GAAP by accounting topic regardless of its want to source (FASB Statements, APB Opinions, and so on). The codified standards are then read the considered to be GAAP and to be authoritative. All other literature will be considered IFRS INSIGHTS nonauthoritative. on pages 31–39 Finally, international convergence is underway. Some projects already are com- for discussion of pleted and differences eliminated. Many more are on the drawing board. It appears to IFRS and the inter- be only a matter of time until we will have one set of global accounting standards that national reporting will be established by the IASB. The profession has many challenges, but it has responded environment. in a timely, comprehensive, and effective manner. KEY TERMS SUMMARY OF LEARNING OBJECTIVES Accounting Principles Board (APB), 9 Accounting Research 1 Identify the major financial statements and other means of financial Bulletins, 9 reporting. Companies most frequently provide (1) the balance sheet, (2) the income Accounting Standards Updates, 12 statement, (3) the statement of cash flows, and (4) the statement of owners’ or stock- holders’ equity. Financial reporting other than financial statements may take various accrual-basis accounting, 6 forms. Examples include the president’s letter and supplementary schedules in the corporate annual report, prospectuses, reports filed with government agencies, news American Institute of Certified Public releases, management’s forecasts, and descriptions of a company’s social or environ- Accountants mental impact. (AICPA), 9 2 Explain how accounting assists in the efficient use of scarce APB Opinions, 9 resources. Accounting provides reliable, relevant, and timely information to manag- Auditing Standards ers, investors, and creditors to allow resource allocation to the most efficient enterprises. Board, 10 Accounting also provides measurements of efficiency (profitability) and financial

Committee on Accounting soundness. Procedure (CAP), 9 decision-usefulness, 6 3 Identify the objective of financial reporting. The objective of general- Emerging Issues Task purpose financial reporting is to provide financial information about the reporting Force (EITF), 12 entity that is useful to present and potential equity investors, lenders, and other credi- entity perspective, 6 tors in decisions about providing resources to the entity through equity investments expectations gap, 18 and loans or other forms of credit. Information that is decision-useful to investors may also be helpful to other users of financial reporting who are not investors. FASB Staff Positions, 13 financial accounting, 4 4 Explain the need for accounting standards. The accounting profession has Financial Accounting attempted to develop a set of standards that is generally accepted and universally prac- Standards Board ticed. Without this set of standards, each company would have to develop its own stan- (FASB), 10 dards. Readers of financial statements would have to familiarize themselves with every Financial Accounting company’s peculiar accounting and reporting practices. As a result, it would be almost Standards Board impossible to prepare statements that could be compared. Accounting Standards Codification 5 Identify the major policy-setting bodies and their role in the standard- (Codification), 14 setting process. The Securities and Exchange Commission (SEC) is a federal agency that Financial Accounting has the broad powers to prescribe, in whatever detail it desires, the accounting stan- Standards Board dards to be employed by companies that fall within its jurisdiction. The American Insti- Codification Research tute of Certified Public Accountants (AICPA) issued standards through its Committee on System (CRS), 14 Accounting Procedure and Accounting Principles Board. The Financial Accounting financial reporting, 4 Standards Board (FASB) establishes and improves standards of financial accounting and financial statements, 4 reporting for the guidance and education of the public. FASB Codifi cation 23 6 Explain the meaning of generally accepted accounting principles generally accepted (GAAP) and the role of the Codification for GAAP. Generally accepted account- accounting principles (GAAP), 7 ing principles (GAAP) are those principles that have substantial authoritative support, such as FASB standards, interpretations, and Staff Positions, APB Opinions and inter- general-purpose financial statements, 5 pretations, AICPA Accounting Research Bulletins, and other authoritative pronounce- ments. All these documents and others are now classified in one document referred to International Accounting Standards Board as the Codification. The purpose of the Codification is to simplify user access to all (IASB), 20 authoritative U.S. GAAP. The Codification changes the way GAAP is documented, International Financial presented, and updated. Reporting Standards 7 Describe the impact of user groups on the rule-making process. User (IFRS), 20 groups may want particular economic events accounted for or reported in a particular interpretations, 13 way, and they fight hard to get what they want. They especially target the FASB to influ- objective of financial ence changes in existing GAAP and in the development of new rules. Because of the reporting, 5 accelerated rate of change and the increased complexity of our economy, these pressures Public Company have been multiplying. GAAP is as much a product of political action as it is of careful Accounting Oversight logic or empirical findings. The IASB is working with the FASB toward international Board (PCAOB), 18 convergence of GAAP. Sarbanes-Oxley Act, 17 Securities and Exchange 8 Describe some of the challenges facing financial reporting. Financial Commission (SEC), 8 reports fail to provide (1) some key performance measures widely used by manage- Statements of Financial ment, (2) forward-looking information needed by investors and creditors, (3) sufficient Accounting information on a company’s soft assets (intangibles), (4) real-time financial information,

Concepts, 13 and (5) easy-to-comprehend information. Wheat Committee, 9 9 Understand issues related to ethics and financial accounting. Financial accountants are called on for moral discernment and ethical decision-making. Decisions sometimes are difficult because a public consensus has not emerged to formulate a comprehensive ethical system that provides guidelines in making ethical judgments. FASB CODIFICATION Exercises Academic access to the FASB Codification is available through university subscriptions, obtained from the American Accounting Association (at http://aaahq.org/FASB/Access.cfm), for an annual fee of $150. This subscription covers an unlimited number of students within a single institution. Once this access has been obtained by your school, you should log in (at http://aaahq.org/ ascLogin.cfm) to prepare responses to the following exercises. CE1-1 Describe the main elements of the link labeled “Help, FAQ, Learning Guide, and About the Codification.” CE1-2 Describe the procedures for providing feedback. CE1-3 Briefly describe the purpose and content of the “What’s New” link. An additional accounting research case can be found in the Using Your Judgment section, on page 30. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. 24 Chapter 1 Financial Accounting and Accounting Standards QUESTIONS 1. Differentiate broadly between financial accounting and 17. The chairman of the FASB at one time noted that “the flow managerial accounting. of standards can only be slowed if (1) producers focus less 2. Differentiate between “financial statements” and “finan- on quarterly earnings per share and tax benefits and more on quality products, and (2) accountants and lawyers rely cial reporting.” less on rules and law and more on professional judgment 3. How does accounting help the capital allocation process? and conduct.” Explain his comment. 4. What is the objective of financial reporting? 18. What is the purpose of FASB Staff Positions? 5. Briefly explain the meaning of decision-usefulness in the 19. Explain the role of the Emerging Issues Task Force in context of financial reporting. establishing generally accepted accounting principles. 6. Of what value is a common set of standards in financial 20. What is the difference between the Codification and the accounting and reporting? Codification Research System? 7. What is the likely limitation of “general-purpose financial 21. What are the primary advantages of having a Codifica- statements”? tion of generally accepted accounting principles? 8. In what way is the Securities and Exchange Commission 22. What are the sources of pressure that change and influ- concerned about and supportive of accounting principles ence the development of GAAP? and standards? 23. Some individuals have indicated that the FASB must be 9. What was the Committee on Accounting Procedure, and cognizant of the economic consequences of its pronounce- what were its accomplishments and failings? ments. What is meant by “economic consequences”? What dangers exist if politics play too much of a role in 10. For what purposes did the AICPA in 1959 create the the development of GAAP? Accounting Principles Board? 24. If you were given complete authority in the matter, how 11. Distinguish among Accounting Research Bulletins, Opin- would you propose that GAAP should be developed and ions of the Accounting Principles Board, and Statements enforced? of the Financial Accounting Standards Board. 25. One writer recently noted that 99.4 percent of all compa- 12. If you had to explain or define “generally accepted nies prepare statements that are in accordance with accounting principles or standards,” what essential char- GAAP. Why then is there such concern about fraudulent acteristics would you include in your explanation? financial reporting? 13. In what ways was it felt that the pronouncements issued 26. What is the “expectations gap”? What is the profession

by the Financial Accounting Standards Board would carry doing to try to close this gap? greater weight than the opinions issued by the Accounting 27. The Sarbanes-Oxley Act was enacted to combat fraud and Principles Board? curb poor reporting practices. What are some key provi- 14. How are FASB preliminary views and FASB exposure sions of this legislation? drafts related to FASB “statements”? 28. What are some of the major challenges facing the account- 15. Distinguish between FASB Accounting Standards Up- ing profession? dates and FASB Statements of Financial Accounting 29. How are financial accountants challenged in their work to Concepts. make ethical decisions? Is technical mastery of GAAP not 16. What is Rule 203 of the Code of Professional Conduct? sufficient to the practice of financial accounting? CONCEPTS FOR ANALYSIS CA1-1 (FASB and Standard-Setting) Presented below are four statements which you are to identify as true or false. If false, explain why the statement is false. 1. GAAP is the term used to indicate the whole body of FASB authoritative literature. 2. Any company claiming compliance with GAAP must comply with most standards and interpreta- tions but does not have to follow the disclosure requirements. 3. The primary governmental body that has influence over the FASB is the SEC. 4. The FASB has a government mandate and therefore does not have to follow due process in issuing a standard. Concepts for Analysis 25 CA1-2 (GAAP and Standard-Setting) Presented below are four statements which you are to identify as true or false. If false, explain why the statement is false. 1. The objective of financial statements emphasizes a stewardship approach for reporting financial information. 2. The purpose of the objective of financial reporting is to prepare a balance sheet, an income state- ment, a statement of cash flows, and a statement of owners’ or stockholders’ equity. 3. Because they are generally shorter, FASB interpretations are subject to less due process, compared to FASB standards. 4. The objective of financial reporting uses an entity rather than a proprietary approach in determining what information to report. CA1-3 (Financial Reporting and Accounting Standards) Answer the following multiple-choice questions. 1. GAAP stands for: (a) governmental auditing and accounting practices. (b) generally accepted attest principles. (c) government audit and attest policies. (d) generally accepted accounting principles. 2. Accounting standard-setters use the following process in establishing accounting standards: (a) Research, exposure draft, discussion paper, standard. (b) Discussion paper, research, exposure draft, standard. (c) Research, preliminary views, discussion paper, standard. (d) Research, discussion paper, exposure draft, standard. 3. GAAP is comprised of: (a) FASB standards, interpretations, and concepts statements. (b) FASB financial standards. (c) FASB standards, interpretations, EITF consensuses, and accounting rules issued by FASB prede- cessor organizations. (d) any accounting guidance included in the FASB Codification. 4. The authoritative status of the conceptual framework is as follows. (a) It is used when there is no standard or interpretation related to the reporting issues under consideration. (b) It is not as authoritative as a standard but takes precedence over any interpretation related to the reporting issue. (c) It takes precedence over all other authoritative literature. (d) It has no authoritative status. 5. The objective of financial reporting places most emphasis on: (a) reporting to capital providers. (b) reporting on stewardship. (c) providing specific guidance related to specific needs. (d) providing information to individuals who are experts in the field. 6. General-purpose financial statements are prepared primarily for: (a) internal users. (b) external users. (c) auditors. (d) government regulators. 7. Economic consequences of accounting standard-setting means: (a) standard-setters must give first priority to ensuring that companies do not suffer any adverse

effect as a result of a new standard. (b) standard-setters must ensure that no new costs are incurred when a new standard is issued. (c) the objective of financial reporting should be politically motivated to ensure acceptance by the general public. (d) accounting standards can have detrimental impacts on the wealth levels of the providers of financial information. 8. The expectations gap is: (a) what financial information management provides and what users want. (b) what the public thinks accountants should do and what accountants think they can do. (c) what the governmental agencies want from standard-setting and what the standard-setters provide. (d) what the users of financial statements want from the government and what is provided. CA1-4 (Financial Accounting) Omar Morena has recently completed his first year of studying accounting. His instructor for next semester has indicated that the primary focus will be the area of financial accounting. 26 Chapter 1 Financial Accounting and Accounting Standards Instructions (a) Differentiate between financial accounting and managerial accounting. (b) One part of financial accounting involves the preparation of financial statements. What are the financial statements most frequently provided? (c) What is the difference between financial statements and financial reporting? CA1-5 (Objective of Financial Reporting) Karen Sepan, a recent graduate of the local state university, is presently employed by a large manufacturing company. She has been asked by Jose Martinez, controller, to prepare the company’s response to a current Preliminary Views published by the Financial Accounting Standards Board (FASB). Sepan knows that the FASB has a conceptual framework, and she believes that these concept statements could be used to support the company’s response to the Preliminary Views. She has prepared a rough draft of the response citing the objective of financial reporting. Instructions (a) Identify the objective of financial reporting. (b) Describe the level of sophistication expected of the users of financial information by the objective of financial reporting. CA1-6 (Accounting Numbers and the Environment) Hardly a day goes by without an article appearing on the crises affecting many of our financial institutions in the United States. It is estimated that the savings and loan (S&L) debacle of the 1980s, for example, ended up costing $500 billion ($2,000 for every man, woman, and child in the United States). Some argue that if the S&Ls had been required to report their in- vestments at fair value instead of cost, large losses would have been reported earlier, which would have signaled regulators to close those S&Ls and, therefore, minimize the losses to U.S. taxpayers. Instructions Explain how reported accounting numbers might affect an individual’s perceptions and actions. Cite two examples. CA1-7 (Need for GAAP) Some argue that having various organizations establish accounting principles is wasteful and inefficient. Rather than mandating accounting rules, each company could voluntarily dis- close the type of information it considered important. In addition, if an investor wants additional informa- tion, the investor could contact the company and pay to receive the additional information desired. Instructions Comment on the appropriateness of this viewpoint. CA1-8 (AICPA’s Role in Rule-Making) One of the major groups that has been involved in the standard- setting process is the American Institute of Certified Public Accountants. Initially, it was the primary orga- nization that established accounting principles in the United States. Subsequently, it relinquished its power to the FASB. Instructions (a) Identify the two committees of the AICPA that established accounting principles prior to the estab- lishment of the FASB. (b) Speculate as to why these two organizations failed. In your answer, identify steps the FASB has taken to avoid failure. (c) What is the present role of the AICPA in the rule-making environment? CA1-9 (FASB Role in Rule-Making) A press release announcing the appointment of the trustees of the

new Financial Accounting Foundation stated that the Financial Accounting Standards Board (to be ap- pointed by the trustees) “. . . will become the established authority for setting accounting principles under which corporations report to the shareholders and others” (AICPA news release July 20, 1972). Instructions (a) Identify the sponsoring organization of the FASB and the process by which the FASB arrives at a decision and issues an accounting standard. (b) Indicate the major types of pronouncements issued by the FASB and the purposes of each of these pronouncements. CA1-10 (Politicization of GAAP) Some accountants have said that politicization in the development and acceptance of generally accepted accounting principles (i.e., rule-making) is taking place. Some use the term “politicization” in a narrow sense to mean the influence by governmental agencies, particularly the Securities and Exchange Commission, on the development of generally accepted accounting principles. Others use it more broadly to mean the compromise that results when the bodies responsible for developing generally accepted accounting principles are pressured by interest groups (SEC, American Accounting Association, businesses through their various organizations, Institute of Management Accountants, financial analysts, bankers, lawyers, and so on). Concepts for Analysis 27 Instructions (a) The Committee on Accounting Procedure of the AICPA was established in the mid- to late 1930s and functioned until 1959, at which time the Accounting Principles Board came into existence. In 1973, the Financial Accounting Standards Board was formed and the APB went out of existence. Do the reasons these groups were formed, their methods of operation while in existence, and the reasons for the demise of the first two indicate an increasing politicization (as the term is used in the broad sense) of accounting standard-setting? Explain your answer by indicating how the CAP, the APB, and the FASB operated or operate. Cite specific developments that tend to support your answer. (b) What arguments can be raised to support the “politicization” of accounting rule-making? (c) What arguments can be raised against the “politicization” of accounting rule-making? (CMA adapted) CA1-11 (Models for Setting GAAP) Presented below are three models for setting GAAP. 1. The purely political approach, where national legislative action decrees GAAP. 2. The private, professional approach, where GAAP is set and enforced by private professional actions only. 3. The public/private mixed approach, where GAAP is basically set by private-sector bodies that behave as though they were public agencies and whose standards to a great extent are enforced through governmental agencies. Instructions (a) Which of these three models best describes standard-setting in the United States? Comment on your answer. (b) Why do companies, financial analysts, labor unions, industry trade associations, and others take such an active interest in standard-setting? (c) Cite an example of a group other than the FASB that attempts to establish accounting standards. Speculate as to why another group might wish to set its own standards. CA1-12 (GAAP Terminology) Wayne Rogers, an administrator at a major university, recently said, “I’ve got some CDs in my IRA, which I set up to beat the IRS.” As elsewhere, in the world of accounting and finance, it often helps to be fluent in abbreviations and acronyms. Instructions Presented below is a list of common accounting acronyms. Identify the term for which each acronym stands, and provide a brief definition of each term. (a) AICPA (e) FAF (i) CPA (b) CAP (f) FASAC (j) FASB (c) ARB (g) SOP (k) SEC (d) APB (h) GAAP (l) IASB CA1-13 (Rule-Making Issues) When the FASB issues new pronouncements, the implementation date is usually 12 months from date of issuance, with early implementation encouraged. Karen Weller, controller, discusses with her financial vice president the need for early implementation of a rule that would result in a fairer presentation of the company’s financial condition and earnings. When the financial vice president

determines that early implementation of the rule will adversely affect the reported net income for the year, he discourages Weller from implementing the rule until it is required. Instructions Answer the following questions. (a) What, if any, is the ethical issue involved in this case? (b) Is the financial vice president acting improperly or immorally? (c) What does Weller have to gain by advocacy of early implementation? (d) Which stakeholders might be affected by the decision against early implementation? (CMA adapted) CA1-14 (Securities and Exchange Commission) The U.S. Securities and Exchange Commission (SEC) was created in 1934 and consists of five commissioners and a large professional staff. The SEC professional staff is organized into five divisions and several principal offices. The primary objective of the SEC is to support fair securities markets. The SEC also strives to foster enlightened stockholder participation in cor- porate decisions of publicly traded companies. The SEC has a significant presence in financial markets, the development of accounting practices, and corporation-shareholder relations, and has the power to exert influence on entities whose actions lie within the scope of its authority. 28 Chapter 1 Financial Accounting and Accounting Standards Instructions (a) Explain from where the Securities and Exchange Commission receives its authority. (b) Describe the official role of the Securities and Exchange Commission in the development of financial accounting theory and practices. (c) Discuss the interrelationship between the Securities and Exchange Commission and the Financial Accounting Standards Board with respect to the development and establishment of financial accounting theory and practices. (CMA adapted) CA1-15 (Financial Reporting Pressures) Presented below is abbreviated testimony from Troy Normand in the WorldCom case. He was a manager in the corporate reporting department and is one of five individuals who pleaded guilty. He is testifying in hopes of receiving no prison time when he is ultimately sentenced. Q. Mr. Normand, if you could just describe for the jury how the meeting started and what was said during the meeting? A. I can’t recall exactly who initiated the discussion, but right away Scott Sullivan acknowledged that he was aware we had problems with the entries, David Myers had informed him, and we were considering resigning. He said that he respected our concerns but that we weren’t being asked to do anything that he believed was wrong. He mentioned that he acknowledged that the company had lost focus quite a bit due to the preparations for the Sprint merger, and that he was putting plans in place and projects in place to try to determine where the problems were, why the costs were so high. He did say he believed that the initial statements that we produced, that the line costs in those state- ments could not have been as high as they were, that he believed something was wrong and there was no way that the costs were that high. I informed him that I didn’t believe the entry we were being asked to do was right, that I was scared, and I didn’t want to put myself in a position of going to jail for him or the company. He responded that he didn’t believe anything was wrong, nobody was going to be going to jail, but that if it later was found to be wrong, that he would be the person going to jail, not me. He asked that I stay, don’t jump off the plane, let him land it softly, that’s basically how he put it. And he mentioned that he had a discussion with Bernie Ebbers, asking Bernie to reduce projections going forward and that Bernie had refused. Q. Mr. Normand, you said that Mr. Sullivan said something about don’t jump out of the plane. What did you understand him to mean when he said that? A. Not to quit. Q. During this meeting, did Mr. Sullivan say anything about whether you would be asked to make entries like this in the future? A. Yes, he made a comment that from that point going forward we wouldn’t be asked to record any entries, high-level late adjustments, that the numbers would be the numbers.

Q. What did you understand that to be mean, the numbers would be the numbers? A. That after the preliminary statements were issued, with the exception of any normal transaction, valid transaction, we wouldn’t be asked to be recording any more late entries. Q. I believe you testified that Mr. Sullivan said something about the line cost numbers not being accurate. Did he ask you to conduct any analysis to determine whether the line cost numbers were accurate? A. No, he did not. Q. Did anyone ever ask you to do that? A. No. Q. Did you ever conduct any such analysis? A. No, I didn’t. Q. During this meeting, did Mr. Sullivan ever provide any accounting justification for the entry you were asked to make? A. No, he did not. Q. Did anything else happen during the meeting? A. I don’t recall anything else. Q. How did you feel after this meeting? A. Not much better actually. I left his office not convinced in any way that what we were asked to do was right. However, I did question myself to some degree after talking with him wondering whether I was making something more out of what was really there. Instructions Answer the following questions. (a) What appears to be the ethical issue involved in this case? (b) Is Troy Normand acting improperly or immorally? Concepts for Analysis 29 (c) What would you do if you were Troy Normand? (d) Who are the major stakeholders in this case? CA1-16 (Economic Consequences) Presented below are comments made in the financial press. Instructions Prepare responses to the requirements in each item. (a) Rep. John Dingell, at one time the ranking Democrat on the House Commerce Committee, threw his support behind the FASB’s controversial derivatives accounting standard and encouraged the FASB to adopt the rule promptly. Indicate why a member of Congress might feel obligated to comment on this proposed FASB standard. (b) In a strongly worded letter to Senator Lauch Faircloth (R-NC) and House Banking Committee Chairman Jim Leach (R-IA), the American Institute of Certified Public Accountants (AICPA) cau- tioned against government intervention in the accounting standard-setting process, warning that it had the potential of jeopardizing U.S. capital markets. Explain how government intervention could possibly affect capital markets adversely. CA1-17 (GAAP and Economic Consequences) The following letter was sent to the SEC and the FASB by leaders of the business community. Dear Sirs: The FASB has been struggling with accounting for derivatives and hedging for many years. The FASB has now developed, over the last few weeks, a new approach that it proposes to adopt as a final stan- dard. We understand that the Board intends to adopt this new approach as a final standard without exposing it for public comment and debate, despite the evident complexity of the new approach, the speed with which it has been developed and the significant changes to the exposure draft since it was released more than one year ago. Instead, the Board plans to allow only a brief review by selected par- ties, limited to issues of operationality and clarity, and would exclude questions as to the merits of the proposed approach. As the FASB itself has said throughout this process, its mission does not permit it to consider matters that go beyond accounting and reporting considerations. Accordingly, the FASB may not have ade- quately considered the wide range of concerns that have been expressed about the derivatives and hedging proposal, including concerns related to the potential impact on the capital markets, the weak- ening of companies’ ability to manage risk, and the adverse control implications of implementing costly and complex new rules imposed at the same time as other major initiatives, including the Year 2000 is- sues and a single European currency. We believe that these crucial issues must be considered, if not by the FASB, then by the Securities and Exchange Commission, other regulatory agencies, or Congress. We believe it is essential that the FASB solicit all comments in order to identify and address all material

issues that may exist before issuing a final standard. We understand the desire to bring this process to a prompt conclusion, but the underlying issues are so important to this nation’s businesses, the cus- tomers they serve and the economy as a whole that expediency cannot be the dominant consideration. As a result, we urge the FASB to expose its new proposal for public comment, following the estab- lished due process procedures that are essential to acceptance of its standards, and providing suffi- cient time to affected parties to understand and assess the new approach. We also urge the SEC to study the comments received in order to assess the impact that these proposed rules may have on the capital markets, on companies’ risk management practices, and on management and financial controls. These vital public policy matters deserve consideration as part of the Commis- sion’s oversight responsibilities. We believe that these steps are essential if the FASB is to produce the best possible accounting standard while minimizing adverse economic effects and maintaining the competitiveness of U.S. businesses in the international marketplace. Very truly yours, (This letter was signed by the chairs of 22 of the largest U.S. companies.) Instructions Answer the following questions. (a) Explain the “due process” procedures followed by the FASB in developing a financial reporting standard. (b) What is meant by the term “economic consequences” in accounting standard-setting? 30 Chapter 1 Financial Accounting and Accounting Standards (c) What economic consequences arguments are used in this letter? (d) What do you believe is the main point of the letter? (e) Why do you believe a copy of this letter was sent by the business community to influential members of the U.S. Congress? USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem Beverly Crusher, a new staff accountant, is confused because of the complexities involving accounting standard-setting. Specifically, she is confused by the number of bodies issuing financial reporting stan- dards of one kind or another and the level of authoritative support that can be attached to these reporting standards. Beverly decides that she must review the environment in which accounting standards are set, if she is to increase her understanding of the accounting profession. Beverly recalls that during her accounting education there was a chapter or two regarding the environ- ment of financial accounting and the development of GAAP. However, she remembers that her instructor placed little emphasis on these chapters. Instructions (a) Help Beverly by identifying key organizations involved in accounting rule-making. (b) Beverly asks for guidance regarding authoritative support. Please assist her by explaining what is meant by authoritative support. (c) Give Beverly a historical overview of how rule-making has evolved so that she will not feel that she is the only one to be confused. (d) What authority for compliance with GAAP has existed throughout the history of rule-making? BRIDGE TO THE PROFESSION Professional Research As a newly enrolled accounting major, you are anxious to better understand accounting institutions and sources of accounting literature. As a first step, you decide to explore the FASB Conceptual Framework. Instructions Go to the FASB website, http://www.fasb.org, to access the FASB Concepts Statements. When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.) (a) What is the objective of financial reporting? (b) What other means are there of communicating information, besides financial statements? (c) Indicate some of the users and the information they are most directly concerned with in economic decision-making. Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS Insights 31 IFRS INSIGHTS Most agree that there is a need for one set of international accounting standards.

10 LEARNING OBJECTIVE Here is why: Compare the procedures related to • Multinational corporations. Today’s companies view the entire world as their financial accounting and accounting market. For example, Coca-Cola, Intel, and McDonald’s generate more than standards under GAAP and IFRS. 50 percent of their sales outside the United States, and many foreign companies, such as Toyota, Nestlé, and Sony, fi nd their largest market to be the United States. • Mergers and acquisitions. The mergers between Fiat/Chrysler and Vodafone/ Mannesmann suggest that we will see even more such business combinations in the future. • Information technology. As communication barriers continue to topple through ad- vances in technology, companies and individuals in different countries and markets are becoming more comfortable buying and selling goods and services from one another. • Financial markets. Financial markets are of international signifi cance today. Whether it is currency, equity securities (stocks), bonds, or derivatives, there are active markets throughout the world trading these types of instruments. RELEVANT FACTS • International standards are referred to as International Financial Reporting Standards (IFRS), developed by the International Accounting Standards Board (IASB). Recent events in the global capital markets have underscored the importance of fi nancial disclosure and transparency not only in the United States but in markets around the world. As a result, many are examining which accounting and fi nancial disclosure rules should be followed. • U.S standards, referred to as generally accepted accounting principles (GAAP), are developed by the Financial Accounting Standards Board (FASB). The fact that there are differences between what is in this textbook (which is based on U.S. standards) and IFRS should not be surprising because the FASB and IASB have responded to different user needs. In some countries, the primary users of fi nancial statements are private investors; in others, the primary users are tax authorities or central government plan- ners. It appears that the United States and the international standard-setting environ- ment are primarily driven by meeting the needs of investors and creditors. • The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is a continuing debate as to whether non-U.S. companies should have to comply with this extra layer of regulation. Debate about international companies (non-U.S.) adopting SOX-type standards centers on whether the benefi ts exceed the costs. The concern is that the higher costs of SOX compliance are making the U.S. securities markets less competitive. • The textbook mentions a number of ethics violations, such as at WorldCom, AIG, and Lehman Brothers. These problems have also occurred internationally, for example, at Satyam Computer Services (India), Parmalat (Italy), and Royal Ahold (the Netherlands). • IFRS tends to be simpler in its accounting and disclosure requirements; some people say more “principles-based.” GAAP is more detailed; some people say more “rules- based.” This difference in approach has resulted in a debate about the merits of “principles-based” versus “rules-based” standards. 32 Chapter 1 Financial Accounting and Accounting Standards • The SEC allows foreign companies that trade shares in U.S. markets to fi le their IFRS fi nancial statements without reconciliation to GAAP. ABOUT THE NUMBERS World markets are becoming increasingly intertwined. International consumers drive Japanese cars, wear Italian shoes and Scottish woolens, drink Brazilian coffee and Indian tea, eat Swiss chocolate bars, sit on Danish furniture, watch U.S. movies, and use Arabian oil. The tremendous variety and volume of both exported and imported goods indicates the extensive involvement in international trade—for many companies, the world is their market. To provide some indication of the extent of globalization of economic activity, Illustration IFRS1-1 provides a listing of the top 20 global companies

in terms of sales. ILLUSTRATION IFRS1-1 Global Companies Rank Rank ($ millions) Company Country Revenues ($ millions) Company Country Revenues 1 Wal-Mart Stores U.S. 421,849 11 Total France 186,055 2 Royal Dutch Shell Netherlands 378,152 12 ConocoPhillips U.S. 184,966 3 ExxonMobil U.S. 354,674 13 Volkswagen Germany 168,041 4 BP U.K. 308,928 14 AXA France 162,236 5 Sinopec Group China 273,422 15 Fannie Mae U.S. 153,825 6 China National China 240,192 16 General Electric U.S. 151,628 Petroleum 17 ING Group Netherlands 147,052 7 State Grid China 226,294 18 Glencore Switzerland 144,978 8 Toyota Motor Japan 221,760 International 9 Japan Post Holdings Japan 203,958 19 Berkshire Hathaway U.S. 136,185 10 Chevron U.S. 196,337 20 General Motors U.S. 135,592 Source: http://money.cnn.com/magazines/fortune/global500/2011/. As capital markets are increasingly integrated, companies have greater flexibility in deciding where to raise capital. In the absence of market integration, there can be company-specific factors that make it cheaper to raise capital and list/trade securities in one location versus another. With the integration of capital markets, the automatic link- age between the location of the company and location of the capital market is loosening. As a result, companies have expanded choices of where to raise capital, either equity or debt. The move toward adoption of International Financial Reporting Standards has and will continue to facilitate this movement. International Standard-Setting Organizations For many years, many nations have relied on their own standard-setting organizations. For example, Canada has the Accounting Standards Board, Japan has the Accounting Standards Board of Japan, Germany has the German Accounting Standards Committee, and the United States has the Financial Accounting Standards Board (FASB). The stan- dards issued by these organizations are sometimes principles-based, rules-based, tax- oriented, or business-based. In other words, they often differ in concept and objective. Starting in 2000, two major standard-setting bodies have emerged as the primary standard-setting bodies in the world. One organization is based in London, United Kingdom, and is called the International Accounting Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRS), which are used on IFRS Insights 33 most foreign exchanges. These standards may also be used by foreign companies listing on U.S. securities exchanges. As indicated earlier, IFRS is presently used in over 115 countries and is rapidly gaining acceptance in other countries as well. It is generally believed that IFRS has the best potential to provide a common plat- form on which companies can report and investors can compare financial information. As a result, our discussion focuses on IFRS and the organization involved in developing these standards—the International Accounting Standards Board (IASB). (A detailed dis- cussion of the U.S. system is provided in the chapter.) The two organizations that have a role in international standard-setting are the International Organization of Securities Commissions (IOSCO) and the IASB. International Organization of Securities Commissions (IOSCO) The International Organization of Securities Commissions (IOSCO) does not set ac- counting standards. Instead, this organization is dedicated to ensuring that the global markets can operate in an efficient and effective basis. The member agencies (such as from France, Germany, New Zealand, and the U.S. SEC) have resolved to: • Cooperate to promote high standards of regulation in order to maintain just, effi cient, and sound markets. • Exchange information on their respective experiences in order to promote the devel- opment of domestic markets. • Unite their efforts to establish standards and an effective surveillance of international securities transactions. • Provide mutual assistance to promote the integrity of the markets by a rigorous ap- plication of the standards and by effective enforcement against offenses.

A landmark year for IOSCO was 2005 when it endorsed the IOSCO Memorandum of Understanding (MOU) to facilitate cross-border cooperation, reduce global systemic risk, protect investors, and ensure fair and efficient securities markets. (For more infor- mation, go to http://www.iosco.org/.) International Accounting Standards Board (IASB) The standard-setting structure internationally is composed of four organizations—the International Accounting Standards Committee Foundation, the International Account- ing Standards Board (IASB), a Standards Advisory Council, and an International Finan- cial Reporting Interpretations Committee (IFRIC). The trustees of the International Accounting Standards Committee Foundation (IASCF) select the members of the IASB and the Standards Advisory Council, fund their activities, and generally oversee the IASB’s activities. The IASB is the major operating unit in this four-part structure. Its mis- sion is to develop, in the public interest, a single set of high-quality and understandable IFRS for general-purpose financial statements. In addition to research help from its own staff, the IASB relies on the expertise of various task force groups formed for various projects and on the Standards Advisory Council (SAC). The SAC consults with the IASB on major policy and technical issues and also helps select task force members. IFRIC develops implementation guidance for consideration by the IASB. Illustration IFRS1-2 (page 34) shows the current organiza- tional structure for the setting of international standards. As indicated, the standard-setting structure internationally is very similar to the standard-setting structure in the United States (see Illustration 1-2 on page 11). One notable difference is the size of the Board—the IASB has 14 members, while the FASB has just seven members. The larger IASB reflects the need for broader geographic repre- sentation in the international setting. 34 Chapter 1 Financial Accounting and Accounting Standards ILLUSTRATION IFRS1-2 IFRS FOUNDATION International Standard- 22 Trustees. Setting Structure Appoint, oversee, raise funds BOARD 16 Members Set technical agenda. Prove standards, exposure drafts, interpretations IFRS STANDARDS ADVISORY COUNCIL INTERPRETATIONS COMMITTEE 30 or More Members 14 Members Appoints Reports to Advises Types of Pronouncements The IASB issues three major types of pronouncements: 1. International Financial Reporting Standards. 2. Framework for Financial Reporting. 3. International Financial Reporting Interpretations. International Financial Reporting Standards. Financial accounting standards issued by the IASB are referred to as International Financial Reporting Standards (IFRS). The IASB has issued 13 of these standards to date, covering such subjects as business combi- nations and share-based payments. Prior to the IASB (formed in 2001), standard- setting on the international level was done by the International Accounting Standards Committee, which issued International Accounting Standards (IAS). The committee i ssued 41 IASs, many of which have been amended or superseded by the IASB. Those still remaining are considered under the umbrella of IFRS. Framework for Financial Reporting. As part of a long-range effort to move away from the problem-by-problem approach, the International Accounting Standards Committee (predecessor to the IASB) issued a document entitled “Framework for the Preparation and Presentation of Financial Statements” (also referred to simply as the Framework). This Framework sets forth fundamental objectives and concepts that the Board uses in developing future standards of financial reporting. The intent of the document is to form a cohesive set of interrelated concepts—a conceptual framework—that will serve as tools for solving existing and emerging problems in a consistent manner. For exam- ple, the objective of general-purpose financial reporting discussed earlier is part of this Framework. The Framework and any changes to it pass through the same due pro- cess (discussion paper, public hearing, exposure draft, etc.) as an IFRS. However, this

Framework is not an IFRS and hence does not define standards for any particular measurement or disclosure issue. Nothing in this Framework overrides any specific international accounting standard. International Financial Reporting Interpretations. Interpretations issued by the Inter- national Financial Reporting Interpretations Committee (IFRIC) are also considered IFRS Insights 35 authoritative and must be followed. These interpretations cover (1) newly identified financial reporting issues not specifically dealt with in IFRS, and (2) issues where unsatis- factory or conflicting interpretations have developed, or seem likely to develop, in the absence of authoritative guidance. The IFRIC has issued over 15 of these interpretations to date. In keeping with the IASB’s own approach to setting standards, the IFRIC applies a principles-based approach in providing interpretative guidance. To this end, the IFRIC looks first to the Framework for the Preparation and Presentation of Financial Statements as the foundation for formulating a consensus. It then looks to the principles articulated in the applicable standard, if any, to develop its interpretative guidance and to determine that the proposed guidance does not conflict with provisions in IFRS. IFRIC helps the IASB in many ways. For example, emerging issues often attract public attention. If not resolved quickly, they can lead to financial crises and scandal. They can also undercut public confidence in current reporting practices. Similar to the EITF in the United States, IFRIC can address controversial accounting problems as they arise. It determines whether it can resolve them or whether to involve the IASB in solving them. In essence, it becomes a “problem filter” for the IASB. Thus, the IASB will hopefully work on more pervasive long-term problems, while the IFRIC deals with short-term emerging issues. Hierarchy of IFRS Because it is a private organization, the IASB has no regulatory mandate and therefore no enforcement mechanism. Similar to the U.S. setting, in which the Securities and Exchange Commission enforces the use of FASB standards for public companies, the IASB relies on other regulators to enforce the use of its standards. For example, effective January 1, 2005, the European Union required publicly traded member country companies to use IFRS. Certain changes have been implemented with respect to use of IFRS in the United States. For example, under American Institute of Certified Public Accountants (AICPA) rules, a member of the AICPA can only report on financial statements prepared in a ccordance with standards promulgated by standard-setting bodies designated by the AICPA Council. In May 2008, the AICPA Council voted to designate the IASB in London as an international accounting standard-setter for purposes of establishing international financial accounting and reporting principles, and to make related amendments to its rules to provide AICPA members with the option to use IFRS. Any company indicating that it is preparing its financial statements in conformity with IFRS must use all of the standards and interpretations. The following hierarchy is used to determine what recognition, valuation, and disclosure requirements should be used. Companies first look to: 1. International Financial Reporting Standards; 2. International Accounting Standards; and 3. Interpretations originated by the International Financial Reporting Interpretations Committee (IFRIC) or the former Standing Interpretations Committee (SIC). In the absence of a standard or an interpretation, the following sources in descending order are used: (1) the requirements and guidance in standards and interpretations dealing with similar and related issues; (2) the Framework for financial reporting; and (3) most recent pronouncements of other standard-setting bodies that use a similar con- ceptual framework to develop accounting standards, other accounting literature, and accepted industry practices, to the extent they do not conflict with the above. The over-

riding requirement of IFRS is that the financial statements provide a fair presentation (often referred to as a “true and fair view”). Fair representation is assumed to occur if a company follows the guidelines established in IFRS. 36 Chapter 1 Financial Accounting and Accounting Standards International Accounting Convergence The SEC recognizes that the establishment of a single, widely accepted set of high- quality accounting standards benefits both global capital markets and U.S. investors. U.S. investors will make better-informed investment decisions if they obtain high-quality financial information from U.S. companies that are more comparable to the presently available information from non-U.S. companies operating in the same industry or line of business. Thus, the SEC appears committed to move to IFRS, assuming that certain conditions are met. These conditions are spelled out in a document, referred to as the “Roadmap” and in a policy statement issued by the SEC in early 2010.12 The FASB and the IASB have been working diligently to (1) make their existing finan- cial reporting standards fully compatible as soon as is practicable, and (2) coordinate their future work programs to ensure that once achieved, compatibility is maintained. This process is referred to as convergence, and the Boards have made significant progress in developing high-quality converged standards. However, much work needs to be done. The Boards have identified the issuance of converged standards on financial instruments (investments), revenue, and leases as a key milestone in the convergence process. SEC Staff Paper on Incorporation of IFRS. The SEC has monitored the convergence pro- cess through a staff Work Plan, which considers specific areas and factors relevant to a commission determination as to whether, when, and how the current financial reporting system for U.S. companies should be transitioned to a system incorporating IFRS. Execu- tion of the Work Plan (which addresses such areas as independence of standard- setting, investor understanding of IFRS, and auditor readiness), combined with the completion of the convergence projects of the FASB and the IASB according to their current work plan, will position the SEC to make a decision on required use of IFRS by U.S. issuers. In July 2012, the SEC staff issued its final report related to the Work Plan elements.13 The main thrust of the report is that we will have to wait and see for a commission deci- sion on required use of IFRS in the United States. Although the Staff Report did not set out to answer the fundamental question of whether transitioning to IFRS is in the best interests of the U.S. securities markets generally and U.S. investors specifically, it appears that it is unlikely companies would be required to change to IFRS in the near future. Rather, there would be a transition period in which this would be accomplished. With respect to this transition, the SEC staff has suggested gradual incorporation of IFRS into the U.S. financial reporting system.14 The approach to incorporation is an “endorsement approach.” Rather than adopting IFRS at a point in time (sometimes referred to as a “big bang”), the endorsement approach specifies that the FASB and IASB continue their convergence efforts (over a 5–7-year transition period) to align GAAP and IFRS. As a result, these converged standards (which are also IFRS) will be incorporated into GAAP. At the end of this period, a U.S. company that is compliant with GAAP would also be compliant with IFRS. Following the transition period, there would be an ongoing endorsement period of IFRS by the FASB to determine if newly issued IFRS will become part of GAAP. Illustration IFRS1-3 shows the timeline for the international accounting convergence process. 12 “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with Interna- tional Financial Reporting Standards by U.S. Issuers,” SEC Release No. 33-8982 (November 14, 2008), and “Statement in Support of Convergence and Global Accounting Standards,” SEC

Release Nos. 33-9109; 34-61578 (February 24, 2010). 13 “Work Plan for the Consideration of Incorporating International Financial Reporting Stan- dards into the Financial Reporting System for U.S. Issuers: Final Staff Report SEC” (July 13, 2012), http://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-final-report.pdf. 14SEC Staff Paper, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers: Exploring a Possible Method of Incorporation” (May 26, 2011), available at www.sec.gov. IFRS Insights 37 Foreign issuers SEC issues SEC Policy SEC staff Transition period Ongoing allowed to file in U.S. Roadmap Statement report on endorsement period without reconciliation (Work Plan) Work Plan 2008 2009 2010 2011 2012 2013 2014 2017 FASB and IASB Work on Convergence Projects ILLUSTRATION IFRS1-3 Transition Period. In the transition period, the FASB and SEC will execute a transition International Accounting plan for evaluating IFRS for incorporation into GAAP. The transition plan groups IFRS Convergence Timeline into one of three categories, as summarized in Illustration IFRS1-4. Category Transition Plan 1. IFRS subject to current active The FASB and IASB target completion of active projects (e.g., financial instruments, revenue convergence projects. recognition, and leases) in 2013. 2. IFRS included on the IASB’s The FASB evaluates other standards that the IASB is likely to issue in the near term to determine current standard-setting agenda. potential differences from GAAP. The FASB will review the individual standards to determine how best to incorporate the standards into GAAP. 3. All other existing IFRS not The FASB assesses the IFRS not subject to current standard-setting plans for potential subject to current standard- incorporation into GAAP. Prospective application of new requirements will be permitted setting and areas not addressed whenever possible after giving consideration to comparability, reliability, cost and benefit, by IFRS. and other relevant factors. ILLUSTRATION IFRS1-4 As indicated, in the transition period, the FASB will continue to work with the IASB in Transition Period a convergence process to develop converged standards and to evaluate other existing Elements IFRS for incorporation in GAAP. Ongoing Endorsement Period. After the transition period, the FASB will continue to have an active role in international standard-setting. This role would differ considerably from the FASB’s current standard-setting role and responsibilities. Most significantly, the FASB would participate along with other constituents in the IASB’s process for developing IFRS rather than serving as the principal body responsible for developing new accounting standards or modifying existing standards in GAAP. However, in the ongoing endorsement process, the FASB retains the authority to modify or add to the requirements of newly issued IFRS. Under the endorsement approach, the SEC maintains its oversight of the FASB as the designated U.S. standard-setter. As a result, the SEC staff could issue guidance similar to its process for issuing staff accounting bulletins, although the staff expects that these occurrences would be rare. Summary. Incorporation of IFRS through the endorsement approach works toward the goal of a single set of high-quality, globally accepted accounting standards, while doing so in a practical manner and in a way that minimizes both the cost and effort needed to incorporate IFRS into the U.S. financial reporting system. The gradual implementation of IFRS reduces adoption costs. Importantly, this IFRS incorporation approach retains GAAP as the basis of financial reporting for U.S. issuers. This avoids the complexities and costs associated with changing the many references to GAAP in U.S. laws and con- tracts. Based on the endorsement approach, which has been generally well-received by 38 Chapter 1 Financial Accounting and Accounting Standards the financial reporting community in the United States, any U.S. incorporation of IFRS

in GAAP will occur over several years. ON THE HORIZON Financial statements prepared according to IFRS have become an important standard around the world for communicating financial information to investors and creditors. The SEC and the FASB are working with their international counterparts to achieve the goal of a single set of high-quality financial reporting standards for use around the world. While there are still many bumps in the road to the establishment of one set of worldwide standards, we are optimistic that this goal can be achieved, which will be of value to all. IFRS SELF-TEST QUESTIONS 1. IFRS stands for: (a) International Federation of Reporting Services. (b) Independent Financial Reporting Standards. (c) International Financial Reporting Standards. (d) Integrated Financial Reporting Services. 2. The major key players on the international side are the: (a) IASB and FASB. (c) SEC and FASB. (b) IOSCO and the SEC. (d) IASB and IOSCO. 3. IFRS is comprised of: (a) International Financial Reporting Standards and FASB Financial Reporting Standards. (b) International Financial Reporting Standards, International Accounting Standards, and Interna- tional Accounting Interpretations. (c) International Accounting Standards and International Accounting Interpretations. (d) FASB Financial Reporting Standards and International Accounting Standards. 4. The authoritative status of the Framework for the Preparation and Presentation of Financial State- ments is as follows: (a) It is used when there is no standard or interpretation related to the reporting issues under consideration. (b) It is not as authoritative as a standard but takes precedence over any interpretation related to the reporting issue. (c) It takes precedence over all other authoritative literature. (d) It has no authoritative status. 5. Which of the following statements is true? (a) The IASB has the same number of members as the FASB. (b) The IASB structure has both advisory and interpretation functions, but no trustees. (c) The IASB has been in existence longer than the FASB. (d) The IASB structure is quite similar to the FASB’s, except the IASB has a larger number of board members. IFRS CONCEPTS AND APPLICATION IFRS1-1 Who are the two key international players in the development of international accounting standards? Explain their role. IFRS1-2 What might explain the fact that different accounting standard-setters have developed account- ing standards that are sometimes quite different in nature? IFRS1-3 What is the benefit of a single set of high-quality accounting standards? IFRS1-4 Briefly describe FASB/IASB convergence process and the principles that guide their convergence efforts. IFRS Insights 39 Financial Reporting Case IFRS1-5 The following comments were made at an Annual Conference of the Financial Executives Insti- tute (FEI). There is an irreversible movement toward the harmonization of financial reporting throughout the world. The international capital markets require an end to: 1. The confusion caused by international companies announcing different results depending on the set of accounting standards applied. 2. Companies in some countries obtaining unfair commercial advantages from the use of particular national accounting standards. 3. The complications in negotiating commercial arrangements for international joint ventures caused by different accounting requirements. 4. The inefficiency of international companies having to understand and use a myriad of different accounting standards depending on the countries in which they operate and the countries in which they raise capital and debt. Executive talent is wasted on keeping up to date with numerous sets of accounting standards and the never-ending changes to them. 5. The inefficiency of investment managers, bankers, and financial analysts as they seek to compare financial reporting drawn up in accordance with different sets of accounting standards. Instructions (a) What is the International Accounting Standards Board? (b) What stakeholders might benefit from the use of International Accounting Standards?

(c) What do you believe are some of the major obstacles to convergence? Professional Research IFRS1-6 As a newly enrolled accounting major, you are anxious to better understand accounting institu- tions and sources of accounting literature. As a first step, you decide to explore the IASB’s Framework for the Preparation and Presentation of Financial Statements. Instructions Access the IASB Framework at the IASB website (http://eifrs.iasb.org/ ). (Click on the IFRS tab and then reg- ister for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.) (a) What is the objective of financial reporting? (b) What other means are there of communicating information, besides financial statements? (c) Indicate some of the users and the information they are most directly concerned with in economic decision-making. International Financial Reporting Problem Marks and Spencer plc IFRS1-7 The financial statements of Marks and Spencer plc (M&S) are available at the book’s compan- ion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks-and- Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What is the company’s main line of business? (b) In what countries does the company operate? (c) What is the address of the company’s corporate headquarters? (d) What is the company’s reporting currency? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. c 2. d 3. b 4. a 5. d Remember to check the book’s companion website to fi nd additional resources for this chapter. Conceptual Framework for Financial Reporting 1 Describe the usefulness of a conceptual framework. 5 Define the basic elements of financial statements. 2 Describe the FASB’s efforts to construct a 6 Describe the basic assumptions of accounting. conceptual framework. 7 Explain the application of the basic principles of 3 Understand the objective of financial reporting. accounting. 4 Identify the qualitative characteristics of accounting 8 Describe the impact that the cost constraint has information. on reporting accounting information. What Is It? Everyone agrees that accounting needs a framework—a conceptual framework, so to speak—that will help guide the development of standards. To understand the importance of developing this framework, let’s see how you would respond in the following two situations. How would you answer the following questions? 1. Should Phil N. Tropic recognize his lottery ticket as an asset in his financial statements? 2. Assuming that Phil N. Tropic recognizes the lottery ticket as an asset, at what amount should it be reported? Some possible answers are $150, $100, and $90. RETPAHC 2 LEARNING OBJECTIVES After studying this chapter, you should be able to: Situation 1: “Taking a Long Shot . . . ” To supplement donations collected from its general community solicitation, Tri-Cities United Charities holds an annual lottery sweepstakes. In this year’s sweepstakes, United Charities is offering a grand prize of $1,000,000 to a single winning ticket holder. A total of 10,000 tickets have been printed, and United Charities plans to sell all the tickets at a price of $150 each. Since its inception, the sweepstakes has attracted area-wide interest, and United Charities has always been able to meet its sales target. However, in the unlikely event that it might fail to sell a suffi- cient number of tickets to cover the grand prize, United Charities has reserved the right to cancel the sweepstakes and to refund the price of the tickets to holders. In recent years, a fairly active secondary market for tickets has developed. This year, buying–selling prices have varied between $75 and $95 before stabilizing at about $90. When the tickets first went on sale this year, multimillionaire Phil N. Tropic, well-known in Tri- Cities civic circles as a generous but sometimes eccentric donor, bought one of the tickets from United

Charities, paying $150 cash. CONCEPTUAL FOCUS This chapter summarizes conceptual elements Situation 2: The $20 Million that will be referred to throughout subsequent chapters. Question INTERNATIONAL FOCUS The Hard Rock Mining Company has just completed the first year of operations at its new strip mine, the Lonesome Doe. > See the International Perspectives Hard Rock spent $10 million for the land and $20 million in on pages 43, 44, 54, and 55. preparing the site for mining operations. The mine is expected > Read the IFRS Insights on to operate for 20 years. Hard Rock is subject to environmental pages 78–81 for a discussion of: statutes requiring it to restore the Lonesome Doe mine site on —Financial statement elements completion of mining operations. — Conceptual framework Work Plan Based on its experience and industry data, as well as cur- rent technology, Hard Rock forecasts that restoration will cost about $10 million when it is undertaken. Of those costs, about $4 million is for restoring the topsoil that was removed in pre- paring the site for mining operations (prior to opening the mine). The rest is directly proportional to the depth of the mine, which in turn is directly proportional to the amount of ore extracted. How would you answer the following questions? 1. Should Hard Rock recognize a liability for site restoration in conjunction with the opening of the Lonesome Doe Mine? If so, what is the amount of that liability? 2. After Hard Rock has operated the Lonesome Doe Mine for 5 years, new technology is introduced that reduces Hard Rock’s estimated future restoration costs to $7 million, $3 million of which relates to restoring the topsoil. How should Hard Rock account for this change in its estimated future liability? The answer to the questions on the two situations depends on how assets and liabilities are defined and how they should be valued. Hopefully, this chapter will provide you with a framework to resolve questions like these. Sources: Adapted from Todd Johnson and Kim Petrone, The FASB Cases on Recognition and Measurement, Second Edition (New York: John Wiley and Sons, Inc., 1996). As our opening story indicates, users of financial statements can face PREVIEW OF CHAPTER 2 difficult questions about the recognition and measurement of finan- cial items. To help develop the type of financial information that can be used to answer these questions, financial accounting and reporting relies on a conceptual framework. In this chapter, we discuss the basic concepts underlying the conceptual framework as follows. Conceptual Framework for Financial Reporting Third Level: Conceptual First Level: Second Level: Recognition and Framework Basic Objective Fundamental Concepts Measurement Concepts • Need • Qualitative characteristics • Basic assumptions • Development • Basic elements • Basic principles • Overview • Cost constraint • Summary of the structure 41 42 Chapter 2 Conceptual Framework for Financial Reporting CONCEPTUAL FRAMEWORK A conceptual framework establishes the concepts that underlie financial reporting. LEARNING OBJECTIVE 1 A conceptual framework is a coherent system of concepts that flow from an objective. Describe the usefulness of a The objective identifies the purpose of financial reporting. The other concepts conceptual framework. provide guidance on (1) identifying the boundaries of financial reporting; (2) select- ing the transactions, other events, and circumstances to be represented; (3) how they should be recognized and measured; and (4) how they should be summarized and reported.1 Need for a Conceptual Framework Why do we need a conceptual framework? First, to be useful, rule-making should build on and relate to an established body of concepts. A soundly developed conceptual framework thus enables the FASB to issue more useful and consistent pronouncements over time; a coherent set of standards should result. Indeed, without the guidance provided by a soundly developed framework, standard-setting ends up being based on individual concepts developed by each member of the standard-setting body. The

following observation by a former standard-setter highlights the problem. “As our professional careers unfold, each of us develops a technical conceptual framework. Some individual frameworks are sharply defined and firmly held; others are vague and weakly held; still others are vague and firmly held. . . . At one time or another, most of us have felt the discomfort of listening to somebody buttress a preconceived conclusion by building a convoluted chain of shaky reasoning. Indeed, perhaps on occasion we have voiced such thinking ourselves. . . . My experience . . . taught me many lessons. A major one was that most of us have a natural tendency and an incredible talent for processing new facts in such a way that our prior conclusions remain intact.2 In other words, standard-setting that is based on personal conceptual frameworks will lead to different conclusions about identical or similar issues than it did previously. As a result, standards will not be consistent with one another, and past decisions may not be indicative of future ones. Furthermore, the framework should increase financial statement users’ understanding of and confidence in financial reporting. It should en- hance comparability among companies’ financial statements. Second, as a result of a soundly developed conceptual framework, the profession should be able to more quickly solve new and emerging practical problems by refer- ring to an existing framework of basic theory. For example, Sunshine Mining sold two issues of bonds. It can redeem them either with $1,000 in cash or with 50 ounces of silver, whichever is worth more at maturity. Both bond issues have a stated interest rate of 8.5 percent. At what amounts should Sunshine or the buyers of the bonds record them? What is the amount of the premium or discount on the bonds? And how should Sunshine amortize this amount, if the bond redemption payments are to be made in silver (the future value of which is unknown at the date of issuance)? Consider that 1 “Chapter 1, The Objective of General Purpose Financial Reporting” and “Chapter 3, Qualita- tive Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010). Recall from our discussion in Chapter 1 that while the conceptual framework and any changes to it pass through the same due process (discussion paper, public hearing, exposure draft, etc.) as do the other FASB pronouncements, the framework is not authoritative. That is, the framework does not define standards for any particular measurement or disclosure issue, and nothing in the framework overrides any specific FASB pronouncement that is included in the Codification. 2 C. Horngren, “Uses and Limitations of a Conceptual Framework,” Journal of Accountancy (April 1981), p. 90. Conceptual Framework 43 Sunshine cannot know, at the date of issuance, the value of future silver bond redemp- tion payments. It is difficult, if not impossible, for the FASB to prescribe the proper accounting treatment quickly for situations like this or like those represented in our opening story. Practicing accountants, however, must resolve such problems on a daily basis. How? Through good judgment and with the help of a universally accepted conceptual frame- work, practitioners can quickly focus on an acceptable treatment. What do the numbers mean? WHAT’S YOUR PRINCIPLE? The need for a conceptual framework is highlighted by reporting by barely achieving 3 percent outside equity own- accounting scandals such as those at Enron and Lehman ership, a requirement in an obscure accounting rule inter- Brothers. To restore public confi dence in the fi nancial report- pretation. Enron’s fi nancial engineers were able to structure ing process, many have argued that regulators should move transactions to achieve a desired accounting treatment, even toward principles-based rules. They believe that companies if that accounting treatment did not refl ect the transaction’s exploited the detailed provisions in rules-based pronounce- true nature. Under principles-based rules, hopefully top

ments to manage accounting reports, rather than report the management’s fi nancial reporting focus will shift from dem- economic substance of transactions. For example, many of the onstrating compliance with rules to demonstrating that a off–balance-sheet arrangements of Enron avoided transparent company has attained the objective of fi nancial reporting. Development of a Conceptual Framework Over the years, numerous organizations developed and published their own 2 LEARNING OBJECTIVE conceptual frameworks, but no single framework was universally accepted and Describe the FASB’s efforts to construct relied on in practice. In 1976, the FASB began to develop a conceptual framework a conceptual framework. that would be a basis for setting accounting rules and for resolving financial reporting controversies. The FASB has since issued seven Statements of Financial Accounting Concepts that relate to financial reporting for business enterprises.3 They are as follows. 1. SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” International presents the goals and purposes of accounting (superseded by SFAC No. 8, Perspective Chapter 1). The IASB has also issued a con- 2. SFAC No. 2, “Qualitative Characteristics of Accounting Information,” ex- ceptual framework. The FASB amines the characteristics that make accounting information useful (super- and the IASB have agreed on a seded by SFAC No. 8, Chapter 3). joint project to develop a com- 3. SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” mon and improved conceptual provides defi nitions of items in fi nancial statements, such as assets, liabili- framework. The project is being conducted in phases. Phase A ties, revenues, and expenses (superseded by SFAC No. 6). on objectives and qualitative 4. SFAC No. 5, “Recognition and Measurement in Financial Statements of characteristics was issued in Business Enterprises,” sets forth fundamental recognition and measure- 2010. ment criteria and guidance on what information should be formally incor- porated into fi nancial statements and when. 5. SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3 and expands its scope to include not-for-profi t organizations. 3The FASB also issued a Statement of Financial Accounting Concepts that relates to nonbusiness organizations: “Objectives of Financial Reporting by Nonbusiness Organizations,” Statement of Financial Accounting Concepts No. 4 (December 1980). 44 Chapter 2 Conceptual Framework for Financial Reporting International 6. SFAC No. 7, “Using Cash Flow Information and Present Value in Accounting Perspective Measurements,” provides a framework for using expected future cash fl ows and present values as a basis for measurement. SFAC No. 8 is the product of a joint conceptual framework 7. SFAC No. 8, Chapter 1, “The Objective of General Purpose Financial Report- project of the FASB and IASB. ing,” and Chapter 3, “Qualitative Characteristics of Useful Financial Infor- mation,” replaces SFAC No. 1 and No. 2. Overview of the Conceptual Framework Illustration 2-1 provides an overview of the FASB’s conceptual framework.4 ILLUSTRATION 2-1 Framework for Financial Reporting Recognition, Measurement, and Disclosure Concepts Third level: The "how"— implementation ASSUMPTIONS PRINCIPLES CONSTRAINT QUALITATIVE ELEMENTS CHARACTERISTICS Second level: Bridge between of of levels 1 and 3 financial accounting statements information OBJECTIVE First level: The "why"—purpose of of accounting financial reporting The first level identifies the objective of financial reporting—that is, the purpose of financial reporting. The second level provides the qualitative characteristics that make accounting information useful and the elements of financial statements (assets, liabili- ties, and so on). The third level identifies the recognition, measurement, and disclosure concepts used in establishing and applying accounting standards and the specific con- cepts to implement the objective. These concepts include assumptions, principles, and a cost constraint that describe the present reporting environment. We examine these three

levels of the conceptual framework next. 4Adapted from William C. Norby, The Financial Analysts Journal (March–April 1982), p. 22. Second Level: Fundamental Concepts 45 FIRST LEVEL: BASIC OBJECTIVE The objective of financial reporting is the foundation of the conceptual frame- 3 LEARNING OBJECTIVE work. Other aspects of the framework—qualitative characteristics, elements of fi- Understand the objective of financial nancial statements, recognition, measurement, and disclosure—flow logically reporting. from the objective. Those aspects of the framework help to ensure that financial reporting achieves its objective. The objective of general-purpose financial reporting is to provide financial informa- tion about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit. Information that is decision- useful to capital providers may also be useful to other users of financial reporting, who are not capital providers.5 As indicated in Chapter 1, to provide information to decision-makers, companies prepare general-purpose financial statements. General-purpose financial reporting helps users who lack the ability to demand all the financial information they need from an entity and therefore must rely, at least partly, on the information provided in finan- cial reports. However, an implicit assumption is that users need reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This point is important. It means that financial statement pre- parers assume a level of competence on the part of users. This assumption impacts the way and the extent to which companies report information. SECOND LEVEL: FUNDAMENTAL CONCEPTS The objective (first level) focuses on the purpose of financial reporting. Later, we 4 LEARNING OBJECTIVE will discuss the ways in which this purpose is implemented (third level). What, then, is the purpose of the second level? The second level provides conceptual Identify the qualitative characteristics of accounting information. building blocks that explain the qualitative characteristics of accounting informa- tion and define the elements of financial statements.6 That is, the second level forms a bridge between the why of accounting (the objective) and the how of accounting (recog- nition, measurement, and financial statement presentation). Qualitative Characteristics of Accounting Information Should companies like Walt Disney or Kellogg’s provide information in their financial statements on how much it costs them to acquire their assets (historical cost basis) or how much the assets are currently worth (fair value basis)? Should PepsiCo combine and show as one company the four main segments of its business, or should it report PepsiCo Beverages, Frito Lay, Quaker Foods, and PepsiCo International as four separate segments? How does a company choose an acceptable accounting method, the amount and types of information to disclose, and the format in which to present it? The answer: By determining which alternative provides the most useful information for decision- making purposes (decision-usefulness). The FASB identified the qualitative character- istics of accounting information that distinguish better (more useful) information from 5 “Chapter 1, The Objective of General Purpose Financial Reporting,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), par. OB2. 6 “Chapter 3, Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010). 46 Chapter 2 Conceptual Framework for Financial Reporting inferior (less useful) information for decision-making purposes. In addition, the FASB identified a cost constraint as part of the conceptual framework (discussed later in the

chapter). As Illustration 2-2 shows, the characteristics may be viewed as a hierarchy. ILLUSTRATION 2-2 Hierarchy of Accounting Primary users of CAPITAL PROVIDERS (Investors and Creditors) Qualities accounting information AND THEIR CHARACTERISTICS Constraint COST Pervasive criterion DECISION-USEFULNESS Fundamental RELEVANCE FAITHFUL REPRESENTATION qualities Ingredients of Free fundamental Predictive Confirmatory Materiality Completeness Neutrality from qualities value value error Enhancing qualities Comparability Verifiability Timeliness Understandability As indicated by Illustration 2-2, qualitative characteristics are either fundamental or enhancing characteristics, depending on how they affect the decision-usefulness of information. Regardless of classification, each qualitative characteristic contributes to the decision-usefulness of financial reporting information. However, providing useful financial information is limited by a pervasive constraint on financial reporting—cost should not exceed the benefits of a reporting practice. Fundamental Quality—Relevance Relevance is one of the two fundamental qualities that make accounting information useful for decision-making. Relevance and related ingredients of this fundamental quality are shown below. Fundamental RELEVANCE quality Ingredients of the fundamental Predictive Confirmatory Materiality quality value value To have relevance, accounting information must be capable of making a difference in a decision. Information with no bearing on a decision is irrelevant. Financial informa- tion is capable of making a difference when it has predictive value, confirmatory value, or both. Second Level: Fundamental Concepts 47 Financial information has predictive value if it has value as an input to predictive processes used by investors to form their own expectations about the future. For exam- ple, if potential investors are interested in purchasing common shares in UPS (United Parcel Service), they may analyze its current resources and claims to those resources, its dividend payments, and its past income performance to predict the amount, timing, and uncertainty of UPS’s future cash flows. Relevant information also helps users confirm or correct prior expectations; it has confirmatory value. For example, when UPS issues its year-end financial statements, it confirms or changes past (or present) expectations based on previous evaluations. It follows that predictive value and confirmatory value are interrelated. For example, infor- mation about the current level and structure of UPS’s assets and liabilities helps users predict its ability to take advantage of opportunities and to react to adverse situations. The same information helps to confirm or correct users’ past predictions about that ability. Materiality is a company-specific aspect of relevance. Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information. An individual company determines whether information is material because both the nature and/or magnitude of the item(s) to which the infor- mation relates must be considered in the context of an individual company’s financial report. Information is immaterial, and therefore irrelevant, if it would have no impact on a decision-maker. In short, it must make a difference or a company need not disclose it. Assessing materiality is one of the more challenging aspects of accounting because it requires evaluating both the relative size and importance of an item. However, it is difficult to provide firm guidelines in judging when a given item is or is not material. Materiality varies both with relative amount and with relative importance. For example, the two sets of numbers in Illustration 2-3 indicate relative size. ILLUSTRATION 2-3 Company A Company B Materiality Comparison Sales $10,000,000 $100,000 Costs and expenses 9,000,000 90,000 Income from operations $ 1,000,000 $ 10,000 Unusual gain $ 20,000 $ 5,000 During the period in question, the revenues and expenses, and therefore the net in-

comes of Company A and Company B, are proportional. Each reported an unusual gain. In looking at the abbreviated income figures for Company A, it appears insignificant whether the amount of the unusual gain is set out separately or merged with the regular operating income. The gain is only 2 percent of the operating income. If merged, it would not seriously distort the income figure. Company B has had an unusual gain of only $5,000. However, it is relatively much more significant than the larger gain realized by Company A. For Company B, an item of $5,000 amounts to 50 percent of its income from operations. Obviously, the inclusion of such an item in operating income would affect the amount of that income materially. Thus, we see the importance of the relative size of an item in determining its materiality. Companies and their auditors generally adopt the rule of thumb that anything under 5 percent of net income is considered immaterial. However, much can depend on specific rules. For example, one market regulator indicates that a company may use this percentage for an initial assessment of materiality, but it must also consider other factors.7 For example, companies can no longer fail to record items in order to meet 7“Materiality,” SEC Staff Accounting Bulletin No. 99 (Washington, D.C.: SEC, 1999). The auditing profession also adopted this same concept of materiality. See “Audit Risk and Materiality in Conducting an Audit,” Statement on Auditing Standards No. 47 (New York: AICPA, 1983), par. 6. 48 Chapter 2 Conceptual Framework for Financial Reporting consensus analysts’ earnings numbers, preserve a positive earnings trend, convert a loss to a profit or vice versa, increase management compensation, or hide an illegal transac- tion like a bribe. In other words, companies must consider both quantitative and qualitative factors in determining whether an item is material. Thus, it is generally not feasible to specify uniform quantitative thresholds at which an item becomes material. Rather, materiality judgments should be made in the context of the nature and the amount of an item. Materiality factors into a great many internal accounting decisions, too. Examples of such judgments that companies must make in- clude the amount of classification required in a subsidiary expense ledger, the degree of accuracy required in allocating expenses among the departments of a company, and the extent to which adjustments should be made for accrued and deferred items. Only by the exercise of good judgment and professional expertise can reasonable and appro- priate answers be found with respect to materiality issues. What do the numbers mean? LIVING IN A MATERIAL WORLD The fi rst line of defense for many companies caught “cook- incorrect accounting. In some cases, the restatements did not ing the books” had been to argue that a questionable ac- meet traditional materiality thresholds. Don Nicholaisen, then counting item is immaterial. That defense did not work so SEC chief accountant, observed that whether the amount is well in the wake of accounting meltdowns at Enron and material or not, some transactions appear to be “fl at out in- Global Crossing and the tougher rules on materiality issued tended to mislead investors.” In essence he is saying that any by the SEC (SAB 99). wrong accounting for a transaction can represent important For example, the SEC alleged in a case against Sunbeam information to the users of fi nancial statements. that the company’s many immaterial adjustments added up to Responding to new concerns about materiality, blue-chip a material misstatement that misled investors about the com- companies such as IBM and General Electric are providing pany’s fi nancial position. More recently, the SEC called for a expanded disclosures of transactions that used to fall below number of companies, such as Jack in the Box, McDonald’s, the materiality radar. As a result, some good may yet come and AIG, to restate prior fi nancial statements for the effects of from the recent accounting failures.

Sources: Adapted from K. Brown and J. Weil, “A Lot More Information Is ‘Material’ After Enron,” Wall Street Journal Online (February 22, 2002); S. D. Jones and R. Gibson, “Restaurants Serve Up Restatements,” Wall Street Journal (January 26, 2005), p. C3; and R. McTauge, “Nicholaisen Says Restatement Needed When Deal Lacks Business Purpose,” Securities Regulation & Law Reporter (May 9, 2005). Fundamental Quality—Faithful Representation Faithful representation is the second fundamental quality that makes accounting infor- mation useful for decision-making. Faithful representation and related ingredients of this fundamental quality are shown below. Fundamental FAITHFUL REPRESENTATION quality Ingredients of the fundamental Completeness Neutrality Free from error quality Second Level: Fundamental Concepts 49 Faithful representation means that the numbers and descriptions match what really existed or happened. Faithful representation is a necessity because most users have neither the time nor the expertise to evaluate the factual content of the informa- tion. For example, if General Motors’ income statement reports sales of $60,510 million when it had sales of $40,510 million, then the statement fails to faithfully represent the proper sales amount. To be a faithful representation, information must be complete, neutral, and free of material error. Completeness. Completeness means that all the information that is necessary for faith- ful representation is provided. An omission can cause information to be false or mis- leading and thus not be helpful to the users of financial reports. For example, when Citigroup fails to provide information needed to assess the value of its subprime loan receivables (toxic assets), the information is not complete and therefore not a faithful representation of their values. Neutrality. Neutrality means that a company cannot select information to favor one set of interested parties over another. Unbiased information must be the overriding consid- eration. For example, in the notes to financial statements, tobacco companies such as R.J. Reynolds should not suppress information about the numerous lawsuits that have been filed because of tobacco-related health concerns—even though such disclosure is damaging to the company. Neutrality in rule-making has come under increasing attack. Some argue that the FASB should not issue pronouncements that cause undesirable economic effects on an industry or company. We disagree. Accounting rules (and the standard-setting process) must be free from bias, or we will no longer have credible financial statements. Without credible financial statements, individuals will no longer use this information. An anal- ogy demonstrates the point: Many individuals bet on boxing matches because such con- tests are assumed not to be fixed. But nobody bets on wrestling matches. Why? Because the public assumes that wrestling matches are rigged. If financial information is biased (rigged), the public will lose confidence and no longer use it.8 Free from Error. An information item that is free from error will be a more accurate (faithful) representation of a financial item. For example, if JPMorgan Chase misstates its loan losses, its financial statements are misleading and not a faithful representation of its financial results. However, faithful representation does not imply total freedom from error. This is because most financial reporting measures involve estimates of v arious types that incorporate management’s judgment. For example, management 8Sometimes, in practice, it has been acceptable to invoke prudence or conservatism as a justifica- tion for an accounting treatment under conditions of uncertainty. Prudence or conservatism means when in doubt, choose the solution that will be least likely to overstate assets or income and/or understate liabilities or expenses. The framework indicates that prudence or conserva- tism generally is in conflict with the quality of neutrality. This is because being prudent or conservative likely leads to a bias in the reported financial position and financial performance.

In fact, introducing biased understatement of assets (or overstatement of liabilities) in one period frequently leads to overstating financial performance in later periods—a result that cannot be described as prudent. This is inconsistent with neutrality, which encompasses freedom from bias. Accordingly, the framework does not include prudence or conservatism as desirable qualities of financial reporting information. See “Chapter 3, Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), paras. BC3.27–BC3.29. 50 Chapter 2 Conceptual Framework for Financial Reporting must estimate the amount of uncollectible accounts to determine bad debt expense. And determination of depreciation expense requires estimation of useful lives of plant and equipment, as well as the salvage value of the assets. What do the numbers mean? SHOW ME THE EARNINGS! The emergence of new-economy businesses on the Internet c ustomers” at its website. After all, new businesses call for has led to the development of new measures of performance. new performance measures, right? When Priceline.com splashed on the dot-com scene, it touted Not necessarily. In fact, these indicators failed to show any steady growth in a measure called “unique offers by users” consistent relationship between profi ts and website visits. to explain its heady stock price. To draw investors to its Eventually, as the graphs below show, the profi ts never ma- stock, Drugstore.com focused on the number of “unique terialized, stock prices fell, and the dot-com bubble burst. PRICELINE.COM DRUGSTORE.COM Net unique offers by users Unique customers 3.0 million 2.0 million 1.5 2.0 1.0 1.0 0.5 0 0 I II III IV I II III IV I II III IV I II III IV 1999 2000 1999 2000 Stock price Stock price $120 a share $40 a share 30 80 20 2000-IV 2000-IV 40 close close 10 $1.03 $2.13 0 0 I II III IV I II III IV I II III IV I II III IV 1999 2000 1999 2000 Some have not learned a lesson from this experience. Face- company failed to exceed analysts’ expectations for its earn- book, one of the hottest IPOs of the recent social media craze, ings. The result? The stock dropped to an all-time low. gave investors a big jolt when it reported its fi rst earnings The lesson for investors? Keep an eye on reliable fi nan- after going public. While its revenues from online advertisers cial measures of performance and be sure to count the ex- were up 32 percent compared to the prior year’s quarter, its penses and net income, rather than focusing on only the top marketing and sales expenses increased dramatically and the line. Sources: Story and graphs adapted from Gretchen Morgenson, “How Did They Value Stocks? Count the Absurd Ways,” New York Times (March 18, 2001), section 3, p. 1; and B. Stone, “Facebook Bellyfl ops Into Its First Earnings Report,” www.businessweek.com (July 26, 2012). Enhancing Qualities Enhancing qualitative characteristics are complementary to the fundamental qualitative characteristics. These characteristics distinguish more-useful information from less- useful information. Enhancing characteristics, shown below, are comparability, verifi- ability, timeliness, and understandability. Second Level: Fundamental Concepts 51 Fundamental RELEVANCE FAITHFUL REPRESENTATION qualities Ingredients of Free fundamental Predictive Confirmatory Materiality Completeness Neutrality from qualities value value error Enhancing qualities Comparability Verifiability Timeliness Understandability Comparability. Information that is measured and reported in a similar manner for dif- ferent companies is considered comparable. Comparability enables users to identify the real similarities and differences in economic events between companies. For example, historically the accounting for pensions in Japan differed from that in the United States. In Japan, companies generally recorded little or no charge to income for these costs. U.S. companies recorded pension cost as incurred. As a result, it is difficult to compare and

evaluate the financial results of Toyota or Honda to General Motors or Ford. Investors can only make valid evaluations if comparable information is available. Another type of comparability, consistency, is present when a company applies the same accounting treatment to similar events, from period to period. Through such ap- plication, the company shows consistent use of accounting standards. The idea of con- sistency does not mean, however, that companies cannot switch from one accounting method to another. A company can change methods, but it must first demonstrate that the newly adopted method is preferable to the old. If approved, the company must then disclose the nature and effect of the accounting change, as well as the justification for it, in the financial statements for the period in which it made the change.9 When a change in accounting principles occurs, the auditor generally refers to it in an explanatory para- graph of the audit report. This paragraph identifies the nature of the change and refers the reader to the note in the financial statements that discusses the change in detail.10 Verifiability. Verifiability occurs when independent measurers, using the same methods, obtain similar results. Verifiability occurs in the following situations. 1. Two independent auditors count PepsiCo’s inventory and arrive at the same physi- cal quantity amount for inventory. Verifi cation of an amount for an asset therefore can occur by simply counting the inventory (referred to as direct verifi cation). 2. Two independent auditors compute PepsiCo’s inventory value at the end of the year using the FIFO method of inventory valuation. Verifi cation may occur by checking the inputs (quantity and costs) and recalculating the outputs (ending inventory value) us- ing the same accounting convention or methodology (referred to as indirect verifi cation). Timeliness. Timeliness means having information available to decision-makers before it loses its capacity to influence decisions. Having relevant information available sooner 9Surveys indicate that users highly value consistency. They note that a change tends to destroy the comparability of data before and after the change. Some companies assist users to under- stand the pre- and post-change data. Generally, however, users say they lose the ability to analyze over time. GAAP guidelines (discussed in Chapter 22) on accounting changes are designed to improve the comparability of the data before and after the change. 10These provisions are specified in “Reports on Audited Financial Statements,” Statement on Auditing Standards No. 58 (New York: AICPA, April 1988), par. 34. 52 Chapter 2 Conceptual Framework for Financial Reporting can enhance its capacity to influence decisions. A lack of timeliness, on the other hand, can rob information of its usefulness. For example, if Dell waited to report its interim results until nine months after the period, the information would be much less useful for decision-making purposes. Understandability. Decision-makers vary widely in the types of decisions they make, how they make decisions, the information they already possess or can obtain from other sources, and their ability to process the information. For information to be useful, there must be a connection (linkage) between these users and the decisions they make. This link, understandability, is the quality of information that lets reasonably informed users see its significance. Understandability is enhanced when information is classified, characterized, and presented clearly and concisely. For example, assume that Google issues a three-months’ report that shows interim earnings have declined significantly. This interim report provides relevant and faithfully represented information for decision-making purposes. Some users, upon reading the re- port, decide to sell their shares. Other users, however, do not understand the report’s con- tent and significance. They are surprised when Google declares a smaller year-end dividend and the share price declines. Thus, although Google presented highly relevant information

that was a faithful representation, it was useless to those who did not understand it. Thus, users of financial reports are assumed to have a reasonable knowledge of business and economic activities. In making decisions, users also should review and analyze the information with reasonable diligence. Information that is relevant and faithfully represented should not be excluded from financial reports solely because it is too complex or difficult for some users to understand without assistance.11 Basic Elements An important aspect of developing any theoretical structure is the body of basic LEARNING OBJECTIVE 5 elements or definitions to be included in it. Accounting uses many terms with Define the basic elements of financial distinctive and specific meanings. These terms constitute the language of business statements. or the jargon of accounting. One such term is asset. Is it merely something we own? Or is an asset something we have the right to use, as in the case of leased equipment? Or is it anything of value used by a company to generate revenues—in which case, should we also consider the manag- ers of a company as an asset? As this example and the lottery ticket example in the opening story illustrate, it therefore seems necessary to develop basic definitions for the elements of financial statements. SFAC No. 6 defines the 10 interrelated elements that most directly relate to measuring the performance and financial status of a business enterprise. We list them on the next page for review and information purposes; you need not memorize these definitions at this point. We will explain and examine each of these elements in more detail in subsequent chapters. The FASB classifies the elements into two distinct groups. The first group of three elements—assets, liabilities, and equity—describes amounts of resources and claims to resources at a moment in time. The other seven elements describe transactions, events, and circumstances that affect a company during a period of time. The first class, af- fected by elements of the second class, provides at any time the cumulative result of all changes. This interaction is referred to as “articulation.” That is, key figures in one finan- cial statement correspond to balances in another. 11“Chapter 3, Qualitative Characteristics of Useful Financial Information,” Statement of Financial Accounting Concepts No. 8 (Norwalk, Conn.: FASB, September 2010), paras. QC30–QC31. Third Level: Recognition and Measurement Concepts 53 ELEMENTS OF FINANCIAL STATEMENTS ASSETS. Probable future economic benefi ts obtained or controlled by a particular entity as a result of past transactions or events. LIABILITIES. Probable future sacrifi ces of economic benefi ts arising from present obliga- tions of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. EQUITY. Residual interest in the assets of an entity that remains after deducting its liabili- ties. In a business enterprise, the equity is the ownership interest. INVESTMENTS BY OWNERS. Increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (or equity) in it. Assets are most commonly received as investments by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise. DISTRIBUTIONS TO OWNERS. Decreases in net assets of a particular enterprise result- ing from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interests (or equity) in an enterprise. COMPREHENSIVE INCOME. Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. REVENUES. Infl ows or other enhancements of assets of an entity or settlement of its liabili-

ties (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. EXPENSES. Outfl ows or other using up of assets or incurrences of liabilities (or a combina- tion of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. GAINS. Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners. LOSSES. Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.12 THIRD LEVEL: RECOGNITION AND MEASUREMENT CONCEPTS The third level of the framework consists of concepts that implement the basic 6 LEARNING OBJECTIVE objective of level one. These concepts explain how companies should recognize, Describe the basic assumptions measure, and report financial elements and events. The FASB sets forth most of of accounting. these in its Statement of Financial Accounting Concepts No. 5, “Recognition and Mea- surement in Financial Statements of Business Enterprises.” According to SFAC No. 5, to be recognized, an item (event or transaction) must meet the definition of an “element of 12“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, December 1985), pp. ix and x. 54 Chapter 2 Conceptual Framework for Financial Reporting financial statements” as defined in SFAC No. 6 and must be measurable. Most aspects of current practice follow these recognition and measurement concepts. The accounting profession continues to use the concepts in SFAC No. 5 as opera- tional guidelines. Here, we identify the concepts as basic assumptions, principles, and a cost constraint. Not everyone uses this classification system, so focus your attention more on understanding the concepts than on how we classify and organize them. These concepts serve as guidelines in responding to controversial financial reporting issues. Basic Assumptions Four basic assumptions underlie the financial accounting structure: (1) economic entity, (2) going concern, (3) monetary unit, and (4) periodicity. We’ll look at each in turn. International Economic Entity Assumption Perspective The economic entity assumption means that economic activity can be identified with a particular unit of accountability. In other words, a company keeps its Phase D of the conceptual activity separate and distinct from its owners and any other business unit.13 At the framework convergence project addresses the reporting entity. most basic level, the economic entity assumption dictates that Panera Bread Company record the company’s financial activities separate from those of its own- ers and managers. Equally important, financial statement users need to be able to distinguish the activities and elements of different companies, such as General Motors, Ford, and Chrysler. If users could not distinguish the activities of different com- panies, how would they know which company financially outperformed the other? The entity concept does not apply solely to the segregation of activities among com- peting companies, such as Home Depot and Lowe’s. An individual, department, divi- sion, or an entire industry could be considered a separate entity if we choose to define it in this manner. Thus, the entity concept does not necessarily refer to a legal entity. A parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes does not violate the economic entity assumption.14 What do the numbers mean? WHOSE COMPANY IS IT? The importance of the entity assumption is illustrated by company funds to pay for an apartment and chef for the

scandals involving W. R. Grace and, more recently, Adelphia. company chairman. As a result of these transactions, these In both cases, senior company employees entered into trans- insiders benefi tted at the expense of shareholders. Addition- actions that blurred the line between the employee’s fi nan- ally, the fi nancial statements failed to disclose the transac- cial interests and those of the company. At Adelphia, among tions. Such disclosure would have allowed shareholders to many other self-dealings, the company guaranteed over sort out the impact of the employee transactions on company $2 billion of loans to the founding family. W. R. Grace used results. 13Recently, the FASB has proposed to link the definition of an entity to its financial reporting objective. That is, a reporting entity is described as a circumscribed area of business activity of interest to present and potential equity investors, lenders, and other capital providers. See IASB/FASB, “The Reporting Entity,” Exposure Draft ED/2010/2: Conceptual Framework for Finan- cial Reporting (March 2010). 14The concept of the entity is changing. For example, defining the “outer edges” of companies is now harder. Public companies often consist of multiple public subsidiaries, each with joint ventures, licensing arrangements, and other affiliations. Increasingly, companies form and dissolve joint ventures or customer-supplier relationships in a matter of months or weeks. These “virtual companies” raise accounting issues about how to account for the entity. As discussed in footnote 13, the FASB (and IASB) is addressing these issues in the entity phase of its conceptual framework project. Third Level: Recognition and Measurement Concepts 55 Going Concern Assumption Most accounting methods rely on the going concern assumption—that the company will have a long life. Despite numerous business failures, most companies have a fairly high continuance rate. As a rule, we expect companies to last long enough to fulfill their objectives and commitments. This assumption has significant implications. The historical cost principle would be of limited usefulness if we assume eventual liquidation. Under a liquidation approach, for example, a company would better state asset values at net realizable value (sales price less costs of disposal) than at acquisition cost. Depreciation and amortization policies are justifiable and appropriate only if we assume some permanence to the company. If a company adopts the liquidation approach, the current/noncurrent clas- sification of assets and liabilities loses much of its significance. Labeling anything a fixed or long-term asset would be difficult to justify. Indeed, listing liabilities on the basis of priority in liquidation would be more reasonable. The going concern assumption applies in most business situations. Only where liquidation appears imminent is the assumption inapplicable. In these cases, a total revaluation of assets and liabilities can provide information that closely approximates the company’s net realizable value. You will learn more about accounting problems related to a company in liquidation in advanced accounting courses.15 Monetary Unit Assumption The monetary unit assumption means that money is the common denominator International of economic activity and provides an appropriate basis for accounting measure- Perspective ment and analysis. That is, the monetary unit is the most effective means of Due to their experiences with expressing to interested parties changes in capital and exchanges of goods and persistent infl ation, several services. The monetary unit is relevant, simple, universally available, under- South American countries standable, and useful. Application of this assumption depends on the even produce “constant-currency” more basic assumption that quantitative data are useful in communicating fi nancial reports. Typically, com- economic information and in making rational economic decisions. panies in these countries use a In the United States, accounting ignores price-level changes (inflation and general price-level index to ad-

deflation) and assumes that the unit of measure—the dollar—remains reasonably just for the effects of infl ation. stable. We therefore use the monetary unit assumption to justify adding 1984 dollars to 2014 dollars without any adjustment. The FASB in SFAC No. 5 indicated that it expects the dollar, unadjusted for inflation or deflation, to continue to be used to measure items recognized in financial statements. Only if circumstances change dramatically (such as if the United States experiences high inflation similar to that in many South American countries) will the FASB again consider “inflation accounting.” Periodicity Assumption To measure the results of a company’s activity accurately, we would need to wait until it liquidates. Decision-makers, however, cannot wait that long for such information. Users need to know a company’s performance and economic status on a timely basis so that 15 In response to minimal guidance addressing when it is appropriate to apply, or how to apply, the liquidation basis of accounting, the FASB recently issued a Proposed Accounting Standards Update, “Presentation of Financial Statements (Topic 205)—The Liquidation Basis of Accounting” (July 2, 2012). In brief, companies would prepare financial statements using the liquidation basis of accounting when liquidation is imminent (when either a plan for liquidation has been approved or a plan for liquidation is being imposed by other forces, such as involuntary bankruptcy). If liquidation accounting is used, financial statements should reflect relevant information about a company’s resources and obligations in liquidation by measuring and presenting assets and liabilities at the amount of cash or other consideration that the company expects to collect or pay in liquidation, along with disclosures about the plan for liquidation, the methods and significant assumptions used to measure assets and liabilities, the type and amount of costs and income accrued, and the expected duration of liquidation. 56 Chapter 2 Conceptual Framework for Financial Reporting they can evaluate and compare firms, and take appropriate actions. Therefore, compa- nies must report information periodically. The periodicity (or time period) assumption implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly. The shorter the time period, the more difficult it is to determine the proper net in- come for the period. A month’s results usually prove less verifiable than a quarter’s results, and a quarter’s results are likely to be less verifiable than a year’s results. Inves- tors desire and demand that a company quickly process and disseminate information. Yet the quicker a company releases the information, the more likely the information will include errors. This phenomenon provides an interesting example of the trade-off between timeliness and accuracy (free from error) in preparing financial data. The problem of defining the time period becomes more serious as product cycles shorten and products become obsolete more quickly. Many believe that, given technol- ogy advances, companies need to provide more online, real-time financial information to ensure the availability of relevant information. Basic Principles of Accounting We generally use four basic principles of accounting to record and report trans- LEARNING OBJECTIVE 7 actions: (1) measurement, (2) revenue recognition, (3) expense recognition, and Explain the application of the basic (4) full disclosure. We look at each in turn. principles of accounting. Measurement Principle We presently have a “mixed-attribute” system that permits the use of various measure- ment bases. The most commonly used measurements are based on historical cost and fair value. Here, we discuss each. Historical Cost. GAAP requires that companies account for and report many assets and liabilities on the basis of acquisition price. This is often referred to as the historical cost principle. Historical cost has an important advantage over other valuations: It is gener-

ally thought to be verifiable. To illustrate this advantage, consider the problems if companies select current selling price instead. Companies might have difficulty establishing a value for unsold Gateway to items. Every member of the accounting department might value the assets differently. the Profession Further, how often would it be necessary to establish sales value? All companies close Expanded Discussion their accounts at least annually. But some compute their net income every month. of Accounting and Changing Prices Those companies would have to place a sales value on every asset each time they wished to determine income. Critics raise similar objections against current cost (replacement cost, present value of future cash flows) and any other basis of valuation except historical cost. What about liabilities? Do companies account for them on a cost basis? Yes, they do. Companies issue liabilities, such as bonds, notes, and accounts payable, in exchange for assets (or services), for an agreed-upon price. This price, established by the exchange transaction, is the “cost” of the liability. A company uses this amount to record the liability in the accounts and report it in financial statements. Thus, many users prefer historical cost because it provides them with a verifiable benchmark for measuring historical trends. Fair Value. Fair value is defined as “the price that would be received to sell an asset or See the FASB Codification section paid to transfer a liability in an orderly transaction between market participants at the (page 65). measurement date.” Fair value is therefore a market-based measure. [1] Recently, GAAP Third Level: Recognition and Measurement Concepts 57 has increasingly called for use of fair value measurements in the financial statements. This is often referred to as the fair value principle. Fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain indus- tries. For example, companies report many financial instruments, including derivatives, at fair value. Certain industries, such as brokerage houses and mutual funds, prepare their basic financial statements on a fair value basis. At initial acquisition, historical cost equals fair value. In subsequent periods, as mar- ket and economic conditions change, historical cost and fair value often diverge. Thus, fair value measures or estimates often provide more relevant information about the expected future cash flows related to the asset or liability. For example, when long-lived assets decline in value, a fair value measure determines any impairment loss. The FASB believes that fair value information is more relevant to users than historical cost. Fair value mea- surement, it is argued, provides better insight into the value of a company’s assets and liabilities (its financial position) and a better basis for assessing future cash flow prospects. Recently the Board has taken the additional step of giving companies the option to use fair value (referred to as the fair value option) as the basis for measurement of financial assets and financial liabilities. [2] The Board considers fair value more relevant than his- torical cost because it reflects the current cash equivalent value of financial instruments. As a result companies now have the option to record fair value in their accounts for most financial instruments, including such items as receivables, investments, and debt securities. Use of fair value in financial reporting is increasing. However, measurement based on fair value introduces increased subjectivity into accounting reports when fair value information is not readily available. To increase consistency and comparability in fair value measures, the FASB established a fair value hierarchy that provides insight into the priority of valuation techniques to use to determine fair value. As shown in Illustra- tion 2-4, the fair value hierarchy is divided into three broad levels. ILLUSTRATION 2-4 Level 1: Observable inputs that reflect quoted Least Subjective

Fair Value Hierarchy prices for identical assets or liabilities in active markets. Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data. Level 3: Unobservable inputs (for example, a company’s own data or assumptions). Most Subjective As Illustration 2-4 indicates, Level 1 is the least subjective because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is more subjec- tive and would rely on evaluating similar assets or liabilities in active markets. At the most subjective level, Level 3, much judgment is needed, based on the best information available, to arrive at a relevant and representationally faithful fair value measurement.16 16For major groups of assets and liabilities, companies must disclose (1) the fair value measure- ment and (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1, 2, or 3. Given the judgment involved, it follows that the more a company depends on Level 3 to determine fair values, the more information about the valuation process the company will need to disclose. Thus, additional disclosures are required for Level 3 measurements; we discuss these disclosures in more detail in subsequent chapters. Recently, the FASB issued additional guidance related to issues surrounding the use of fair value in financial statements (Accounting Standards Update 2011–04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS). A major benefit of the guidance is to provide a better definitional structure of what is meant by fair value and an improved understanding of how fair value should be measured. 58 Chapter 2 Conceptual Framework for Financial Reporting It is easy to arrive at fair values when markets are liquid with many traders, but fair value answers are not readily available in other situations. For example, how do you value the mortgage assets of a subprime lender such as New Century given that the market for these securities has essentially disappeared? A great deal of expertise and sound judgment will be needed to arrive at appropriate answers. GAAP also provides guidance on estimating fair values when market-related data is not available. In gen- eral, these valuation issues relate to Level 3 fair value measurements. These measure- ments may be developed using expected cash flow and present value techniques, as described in Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Informa- tion and Present Value in Accounting,” discussed in Chapter 6. As indicated above, we presently have a “mixed-attribute” system that permits the use of historical cost and fair value. Although the historical cost principle continues to be an important basis for valuation, recording and reporting of fair value information is increasing. The recent measurement and disclosure guidance should increase consis- tency and comparability when fair value measurements are used in the financial state- ments and related notes. Revenue Recognition Principle When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company satisfies this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satis- fied. To illustrate, assume that Klinke Cleaners cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Klinke should record revenue in June when it performed the service (satisfied the performance obligation) rather than in July when it received the cash. At June 30, Klinke would report a receivable on its balance sheet and revenue in its income statement for the service performed. To illustrate the revenue recognition principle in more detail, assume that Boeing Corporation signs a contract to sell airplanes to Delta Air Lines for $100 million. To

determine when to recognize revenue, Boeing uses the five steps shown in Illustration 2-5. Many revenue transactions pose few problems because the transaction is initiated and completed at the same time. However, when to recognize revenue in other certain situations is often more difficult. The risk of errors and misstatements is significant. Chapter 18 discusses revenue recognition issues in more detail.17 Expense Recognition Principle As indicated in the discussion of financial statement elements, expenses are defined as outflows or other “using up” of assets or incurring of liabilities (or a combination of both) during a period as a result of delivering or producing goods and/or performing services. It follows then that recognition of expenses is related to net changes in assets and earning revenues. In practice, the approach for recognizing expenses is, “Let the expense follow the revenues.” This approach is the expense recognition principle. To illustrate, companies recognize expenses not when they pay wages or make a product, but when the work (service) or the product actually contributes to revenue. Thus, companies tie expense recognition to revenue recognition. That is, by matching efforts (expenses) with accomplishment (revenues), the expense recognition principle 17The framework illustrated here is based on that proposed by the FASB and IASB in their joint project on revenue. See “Revenue from Contracts with Customers,” Proposed Accounting Standards Update (Revised) (Norwalk, Conn.: FASB, November 14, 2011, and January 4, 2012). The Boards hope to issue a converged standard in early 2013. Application of this new framework to many revenue arrangements results in similar revenue recognition outcomes compared to the current framework (based on earned and realized criteria). However, a new, more general model was needed to respond to the growth of revenue arrangements for which the prior model did not address. Third Level: Recognition and Measurement Concepts 59 is implemented in accordance with the definition of expense (outflows or other using up of assets or incurring of liabilities).18 ILLUSTRATION 2-5 The Five Steps of A contract is an agreement between two parties Revenue Recognition Step 1: Identify the contract(s) that creates enforceable rights or obligations. In with the customer. this case, Boeing has signed a contract to deliver A contariarcptlanes to Delta. Boeing has only one performance obligation—to Step 2: Identify the separate deliver airplanes to Delta. If Boeing also agreed to performance obligations in maintain the planes, a separate performance the contract. obligation is recorded for this promise. Transaction price is the amount of consideration that a company expects to receive from a customer Step 3: Determine the transaction in exchange for transferring a good or service. In price. this case, the transaction price is straightforward—it is $100 million. Step 4: Allocate the transaction In this case, Boeing has only one performance price to separate performance obligation—to deliver airplanes to Delta. obligations. Boeing recognizes revenue of $100 million for the Step 5: Recognize revenue when sale of the airplanes to Delta when it satisfies its each performance obligation performance obligation—the delivery of the is satisfied. airplanes to Delta. Some costs, however, are difficult to associate with revenue. As a result, some other approach must be developed. Often, companies use a “rational and systematic” alloca- tion policy that will approximate the expense recognition principle. This type of expense recognition involves assumptions about the benefits that a company receives as well as the cost associated with those benefits. For example, a company like Intel or Motorola allocates the cost of a long-lived asset over all of the accounting periods during which it uses the asset because the asset contributes to the generation of revenue throughout its useful life. Companies charge some costs to the current period as expenses (or losses) simply because they cannot determine a connection with revenue. Examples of these types of

costs are officers’ salaries and other administrative expenses. 18This approach is commonly referred to as the matching principle. However, there is much debate about the conceptual validity of the matching principle. A major concern is that matching permits companies to defer certain costs and treat them as assets on the balance sheet. In fact, these costs may not have future benefits. If abused, this principle permits the balance sheet to become a “dumping ground” for unmatched costs. 60 Chapter 2 Conceptual Framework for Financial Reporting Costs are generally classified into two groups: product costs and period costs. Product costs, such as material, labor, and overhead, attach to the product. Companies carry these costs into future periods if they recognize the revenue from the product in subsequent periods. Period costs, such as officers’ salaries and other administrative expenses, attach to the period. Companies charge off such costs in the immediate period even though benefits associated with these costs may occur in the future. Why? Because companies cannot determine a direct relationship between period costs and revenue. Illustration 2-6 summarizes these expense recognition procedures. ILLUSTRATION 2-6 Type of Cost Relationship Recognition Expense Recognition Product costs: Direct relationship between Recognize in period of revenue • Material cost and revenue. (matching). • Labor • Overhead Period costs: No direct relationship Expense as incurred. • Salaries between cost • Administrative costs and revenue. Full Disclosure Principle In deciding what information to report, companies follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. Often referred to as the full disclosure principle, it rec- ognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs. These trade-offs strive for (1) sufficient detail to dis- close matters that make a difference to users, yet (2) sufficient condensation to make the information understandable, keeping in mind costs of preparing and using it. Disclosure is not a substitute for proper accounting. As a former chief accountant of the SEC noted, “Good disclosure does not cure bad accounting any more than an adjec- tive or adverb can be used without, or in place of, a noun or verb.” Thus, for example, cash-basis accounting for cost of goods sold is misleading even if a company discloses accrual-basis amounts in the notes to the financial statements. Users find information about financial position, income, cash flows, and invest- ments in one of three places: (1) within the main body of financial statements, (2) in the notes to those statements, or (3) as supplementary information. As discussed in Chapter 1, the financial statements are the balance sheet, income statement, statement of cash flows, and statement of owners’ equity. They are a struc- tured means of communicating financial information. To be recognized in the main body of financial statements, an item should meet the definition of a basic element, be measurable with sufficient certainty, and be relevant and reliable.19 The notes to financial statements generally amplify or explain the items presented in the main body of the statements. If the main body of the financial statements gives an incomplete picture of the performance and position of the company, the notes should pro- vide the additional information needed. Information in the notes does not have to be quan- tifiable, nor does it need to qualify as an element. Notes can be partially or totally narrative. Examples of notes include descriptions of the accounting policies and methods used in measuring the elements reported in the statements, explanations of uncertainties and con- tingencies, and statistics and details too voluminous for inclusion in the statements. The notes can be essential to understanding the company’s performance and position. Supplementary information may include details or amounts that present a differ-

ent perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in faithful representation. For example, oil 19SFAC No. 5, par. 63. Third Level: Recognition and Measurement Concepts 61 and gas companies typically provide information on proven reserves as well as the related discounted cash flows. Supplementary information may also include management’s explanation of the financial information and its discussion of the significance of that information. For example, many business combinations have produced financing arrangements that de- mand new accounting and reporting practices and principles. In each of these situa- tions, the same problem must be faced: making sure the company presents enough in- formation to ensure that the reasonably prudent investor will not be misled. We discuss the content, arrangement, and display of financial statements, along with other facets of full disclosure, in Chapters 4, 5, and 24.20 What do the numbers mean? YOU MAY NEED A MAP Beyond touting nonfi nancial measures to investors (see the the positive in their results. Examples include Yahoo! and “What Do the Numbers Mean?” box on page 50), many compa- Cisco, which defi ne pro forma income after adding back pay- nies increasingly promote the performance of their companies roll tax expense. Level 8 Systems transformed an operating through the reporting of various “pro forma” earnings mea- loss into a pro forma profi t by adding back expenses for de- sures. A recent survey of newswire reports found 36 instances of preciation and amortization of intangible assets. the reporting of pro forma measures in just a three-day period. Lynn Turner, former chief accountant at the SEC, calls Pro forma measures are standard measures (such as earn- such earnings measures EBS—“Everything but Bad Stuff.” ings) that companies adjust, usually for one-time or nonre- To provide investors a more complete picture of company curring items. For example, companies usually adjust earn- profi tability, not the story preferred by management, the SEC ings for the effects of an extraordinary item. Such adjustments issued Regulation G (REG G). REG G requires companies to make the numbers more comparable to numbers reported in reconcile non-GAAP fi nancial measures to GAAP, thereby periods without the unusual item. giving investors a roadmap to analyze adjustments compa- However, rather than increasing comparability, it appears nies make to their GAAP numbers to arrive at pro forma that some companies use pro forma reporting to accentuate results. Sources: Adapted from Gretchen Morgenson, “How Did They Value Stocks? Count the Absurd Ways,” New York Times (March 18, 2001), section 3, p. 1; and Gretchen Morgenson, “Expert Advice: Focus on Profi t,” New York Times (March 18, 2001), section 3, p. 14. See also SEC Regulation G, “Conditions for Use of Non-GAAP Financial Measures,” Release No. 33–8176 (March 28, 2003). Cost Constraint In providing information with the qualitative characteristics that make it useful, compa- 8 LEARNING OBJECTIVE nies must consider an overriding factor that limits (constrains) the reporting. This is re- Describe the impact that the cost ferred to as the cost constraint (the cost-benefit relationship). That is, companies must constraint has on reporting accounting weigh the costs of providing the information against the benefits that can be derived information. from using it. Rule-making bodies and governmental agencies use cost-benefit analysis before making final their informational requirements. In order to justify requiring a par- ticular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs perceived to be associated with it. A corporate executive made the following remark to the FASB about a proposed rule: “In all my years in the financial arena, I have never seen such an absolutely ridiculous pro- posal. . . . To dignify these ‘actuarial’ estimates by recording them as assets and liabilities

would be virtually unthinkable except for the fact that the FASB has done equally stupid things in the past. . . . For God’s sake, use common sense just this once.”21 Although extreme, this remark indicates the frustration expressed by members of the business community about rule-making, and whether the benefits of a given pronouncement exceed the costs. 20Recently, the FASB started a project on disclosure effectiveness to better communicate the informa- tion that is most important to users of financial statements. The Board hopes that a sharper focus on important information will result in a reduced volume of notes to the financial statements. 21“Decision-Usefulness: The Overriding Objective,” FASB Viewpoints (October 19, 1983), p. 4. 62 Chapter 2 Conceptual Framework for Financial Reporting The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable. The costs are of several kinds: costs of collecting and processing, of disseminating, of auditing, of potential litigation, of disclosure to com- petitors, and of analysis and interpretation. Benefits to preparers may include greater management control and access to capital at a lower cost. Users may receive better information for allocation of resources, tax assessment, and rate regulation. As noted earlier, benefits are generally more difficult to quantify than are costs. The implementation of the provisions of the Sarbanes-Oxley Act illustrates the chal- lenges in assessing costs and benefits of standards. One study estimated the increased costs of complying with the new internal-control standards related to the financial reporting process to be an average of $7.8 million per company. However, the study concluded that “quantifying the benefits of improved more reliable financial reporting is not fully possible.”22 Despite the difficulty in assessing the costs and benefits of its rules, the FASB attempts to determine that each proposed pronouncement will fill a significant need and that the costs imposed to meet the rule are justified in relation to overall benefits of ILLUSTRATION 2-7 Conceptual Framework for Financial Reporting Recognition, Measurement, and Disclosure Concepts ASSUMPTIONS PRINCIPLES CONSTRAINT 1. Economic entity 1. Measurement 1. Cost 2. Going concern 2. Revenue recognition 3. Monetary unit 3. Expense recognition Third level: 4. Periodicity 4. Full disclosure The "how"— implementation QUALITATIVE CHARACTERISTICS ELEMENTS 1. Fundamental qualities A. Relevance 1. Assets (1) Predictive value 2. Liabilities (2) Confirmatory value 3. Equity (3) Materiality 4. Investment by owners Second level: Bridge B. Faithful representation 5. Distribution to owners between levels 1 and 3 (1) Completeness 6. Comprehensive income (2) Neutrality 7. Revenues (3) Free from error 8. Expenses 2. Enhancing qualities 9. Gains (1) Comparability (2) Verifiability 10. Losses (3) Timeliness (4) Understandability OBJECTIVE Provide information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in their First level: The "why"— capacity as capital purpose of accounting providers. 22Charles Rivers and Associates, “Sarbanes-Oxley Section 404: Costs and Remediation of Deficiencies,” letter from Deloitte and Touche, Ernst and Young, KPMG, and Pricewaterhouse- Coopers to the SEC (April 11, 2005). Summary of Learning Objectives 63 the resulting information. In addition, the Board seeks input on costs and benefits as You will part of its due process.23 want to read the Summary of the Structure IFRS INSIGHTS on pages 78–81 Illustration 2-7 (page 62) presents the conceptual framework discussed in this chapter. It is similar to Illustration 2-1 except that it provides additional information for each level. for discussion of We cannot overemphasize the usefulness of this conceptual framework in helping to how IFRS relates to understand many of the problem areas that we examine in later chapters. the conceptual framework. KEY TERMS SUMMARY OF LEARNING OBJECTIVES

assumption, 54 comparability, 51 completeness, 49 1 Describe the usefulness of a conceptual framework. The accounting pro- conceptual framework, 42 fession needs a conceptual framework to (1) build on and relate to an established body of confirmatory value, 47 concepts and objectives, (2) provide a framework for solving new and emerging practical conservatism, 49(n) problems, (3) increase financial statement users’ understanding of and confidence in finan- cial reporting, and (4) enhance comparability among companies’ financial statements. consistency, 51 cost constraint 2 Describe the FASB’s efforts to construct a conceptual framework. The (cost-benefit FASB issued seven Statements of Financial Accounting Concepts that relate to financial relationship), 61 reporting for business enterprises. These concept statements provide the basis for the con- economic entity ceptual framework. They include objectives, qualitative characteristics, and elements. In assumption, 54 addition, measurement and recognition concepts are developed. The FASB and the IASB elements, basic, 52 are now working on a joint project to develop an improved common conceptual frame- expense recognition work that provides a sound foundation for developing future accounting standards. principle, 58 3 Understand the objective of financial reporting. The objective of general- fair value, 56 purpose financial reporting is to provide financial information about the reporting en- fair value option, 57 tity that is useful to present and potential equity investors, lenders, and other creditors fair value principle, 57 in making decisions about providing resources to the entity. Those decisions involve faithful representation, 49 buying, selling, or holding equity and debt instruments, and providing or settling loans financial statements, 60 and other forms of credit. Information that is decision-useful to capital providers may free from error, 49 also be helpful to other users of financial reporting who are not capital providers. full disclosure principle, 60 4 Identify the qualitative characteristics of accounting information. The general-purpose financial overriding criterion by which accounting choices can be judged is decision-usefulness— reporting, 45 that is, providing information that is most useful for decision-making. Relevance and going concern faithful representation are the two fundamental qualities that make information decision- assumption, 55 useful. Relevant information makes a difference in a decision by having predictive or historical cost confirmatory value and is material. Faithful representation is characterized by complete- principle, 56 ness, neutrality, and being free from error. Enhancing qualities of useful information are matching principle, 59(n) (1) comparability, (2) verifiability, (3) timeliness, and (4) understandability. materiality, 47 5 Define the basic elements of financial statements. The basic elements of monetary unit financial statements are (1) assets, (2) liabilities, (3) equity, (4) investments by owners, assumption, 55 (5) distributions to owners, (6) comprehensive income, (7) revenues, (8) expenses, neutrality, 49 (9) gains, and (10) losses. We define these 10 elements on page 53. notes to financial statements, 60 6 Describe the basic assumptions of accounting. Four basic assumptions objective of financial underlying financial accounting are as follows. (1) Economic entity: The activity of a reporting, 45 company can be kept separate and distinct from its owners and any other business unit. period costs, 59 23For example, as part of its project on “Share-Based Payment” [3], the Board conducted a field study and surveyed commercial software providers to collect information on the costs of measuring the fair values of share-based compensation arrangements. 64 Chapter 2 Conceptual Framework for Financial Reporting periodicity (time period) (2) Going concern: The company will have a long life. (3) Monetary unit: Money is the assumption, 56 common denominator by which economic activity is conducted, and the monetary unit

predictive value, 47 provides an appropriate basis for measurement and analysis. (4) Periodicity: The eco- principles of nomic activities of a company can be divided into artificial time periods. accounting, 56 7 Explain the application of the basic principles of accounting. (1) Mea- product costs, 59 surement principle: GAAP permits the use of historical cost, fair value, and other valua- prudence, 49(n) tion bases. Although the historical cost principle (measurement based on acquisition qualitative price) continues to be an important basis for valuation, recording and reporting of fair characteristics, 45 value information is increasing. (2) Revenue recognition principle: A company recognizes relevance, 46 revenue when it satisfies a performance obligation. (3) Expense recognition principle: As a revenue recognition general rule, companies recognize expenses when the service or the product actually principle, 58 makes its contribution to revenue (commonly referred to as matching). (4) Full disclosure supplementary principle: Companies generally provide information that is of sufficient importance to information, 60 influence the judgment and decisions of an informed user. timeliness, 51 understandability, 52 8 Describe the impact that the cost constraint has on reporting accounting information. The cost of providing the information must be weighed verifiability, 51 against the benefits that can be derived from using the information. DEMONSTRATION PROBLEM Jeremy Meadow Corporation has hired you to review its accounting records prior to the closing of the revenue and expense accounts as of December 31, the end of the current fiscal year. The following informa- tion comes to your attention. 1. During the current year, Jeremy Meadow Corporation changed its policy in regard to expensing purchases of small tools. In the past, it had expensed these purchases because they amounted to less than 2% of net income. Now, the president has decided that the company should follow a policy of capitalization and subsequent depreciation. It is expected that purchases of small tools will not fluctuate greatly from year to year. 2. The company constructed a warehouse at a cost of $1,000,000. It had been depreciating the asset on a straight-line basis over 10 years. In the current year, the controller doubled depreciation expense because the replacement cost of the warehouse had increased significantly. 3. When the balance sheet was prepared, the preparer omitted detailed information as to the amount of cash on deposit in each of several banks. Only the total amount of cash under a caption “Cash in banks” was presented. 4. On July 15 of the current year, Jeremy Meadow Corporation purchased an undeveloped tract of land at a cost of $320,000. The company spent $80,000 in subdividing the land and getting it ready for sale. An appraisal of the property at the end of the year indicated that the land was now worth $500,000. Although none of the lots were sold, the company recognized revenue of $180,000, less related expenses of $80,000, for a net income on the project of $100,000. 5. For a number of years, the company used the FIFO method for inventory valuation purposes. During the current year, the president noted that all the other companies in the industry had switched to the LIFO method. The company decided not to switch to LIFO because net income would decrease $830,000. Instructions State whether or not you agree with the decisions made by Jeremy Meadow Corporation. Support your answers with reference, whenever possible, to the generally accepted principles, assumptions, and cost constraint applicable in the circumstances. Solution 1. From the facts, it is difficult to determine whether to agree or disagree. Consistency, of course, is violated in this situation although its violation may not be material. Furthermore, the change of ac- counting policies regarding the treatment of small tools cannot be judged good or bad but would depend on the circumstances. In this case, it seems that the result will be approximately the same

FASB Codifi cation 65 whether the corporation capitalizes and expenses, or simply expenses each period, since the pur- chases are fairly uniform. Perhaps from a cost standpoint (expediency), it might be best to continue the present policy rather than become involved in detailed depreciation schedules, assuming that purchases remain fairly uniform. On the other hand, the president may believe there is a significant unrecorded asset that should be shown on the balance sheet. If such is the case, capitalization and subsequent depreciation would be more appropriate. 2. Disagree. At the present time, accountants do not recognize price level or current value adjust- ments in the accounts. Hence, it is misleading to deviate from the historical cost principle because conjecture or opinion can take place. Also, depreciation is not so much a matter of valu- ation as it is a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair value. Rather, they are depreciated on the basis of a systematic charge of expired cost against revenues. 3. Agree. The full disclosure principle recognizes that reasonable condensation and summarization of the details of a corporation’s operations and financial position are essential to readability and com- prehension. Thus, in determining what is full disclosure, the accountant must decide whether omis- sion will mislead readers of the financial statements. Generally, companies present only the total amount of cash on a balance sheet unless some special circumstance is involved (such as a possible restriction on the use of the cash). In most cases, however, the company’s presentation would be considered appropriate and in accordance with the full disclosure principle. 4. Disagree. The historical cost principle indicates that companies account for assets and liabilities on the basis of cost. If sales value were selected, for example, it would be extremely difficult to establish an appraisal value for the given item without selling it. Note, too, that the revenue recognition prin- ciple provides guidance on when revenue should be recognized. Revenue should be recognized when the performance obligation is satisfied. In this case, the revenue was not recognized because the critical event, “sale of the land,” had not occurred. 5. From the facts, it is difficult to determine whether to agree or disagree with the president. The president’s approach is not a violation of any principle. Consistency requires that accounting enti- ties give accountable events the same accounting treatment from period to period for a given busi- ness enterprise. It says nothing concerning consistency of accounting principles among business enterprises. From a comparability viewpoint, it might be useful to report the information on a LIFO basis. But, as indicated above, there is no requirement to do so. FASB CODIFICATION FASB Codification References [1] FASB ASC 820-10. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).] [2] FASB ASC 825-10-25. [Predecessor literature: “The Fair Value Option for Financial Assets and Liabilities,” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, 2007).] [3] FASB ASC 718-10. [Predecessor literature: “Share-Based Payment,” Financial Accounting Standards No. 123(R) (Norwalk, Conn.: FASB, 2004).] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE2-1 Access the glossary (“Master Glossary”) at the FASB Codification website to answer the following. (a) What is the definition of fair value? (b) What is the definition of revenue? (c) What is the definition of comprehensive income? CE2-2 Briefly describe how the organization of the FASB Codification corresponds to the elements of financial statements. An additional accounting research case can be found in the Using Your Judgment section, on page 77.

66 Chapter 2 Conceptual Framework for Financial Reporting Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. QUESTIONS 1. What is a conceptual framework? Why is a conceptual influence has it had on accounting entries and framework necessary in financial accounting? methodology? 2. What is the primary objective of financial reporting? 1 4. What is the basic accounting problem created by the mon- etary unit assumption when there is significant inflation? 3. What is meant by the term “qualitative characteristics of What appears to be the FASB position on a stable mone- accounting information”? tary unit? 4. Briefly describe the two fundamental qualities of useful 1 5. The chairman of the board of directors of the company for accounting information. which you are chief accountant has told you that he has 5. How is materiality (or immateriality) related to the proper little use for accounting figures based on historical cost. presentation of financial statements? What factors and He believes that replacement values are of far more mea-sures should be considered in assessing the material- significance to the board of directors than “out-of-date ity of a misstatement in the presentation of a financial costs.” Present some arguments to convince him that ac- statement? counting data should still be based on historical cost. 6. What are the enhancing qualities of the qualitative charac- 16. What is the definition of fair value? teristics? What is the role of enhancing qualities in the conceptual framework? 17. What is the fair value option? Explain how use of the fair value option reflects application of the fair value principle. 7. According to the FASB conceptual framework, the objec- tive of financial reporting for business enterprises is based 1 8. Briefly describe the fair value hierarchy. on the needs of the users of financial statements. Explain 19. Explain the revenue recognition principle. the level of sophistication that the Board assumes about 20. What is a performance obligation, and how is it used to the users of financial statements. determine when revenue should be recognized? 8. What is the distinction between comparability and consistency? 2 1. What are the five steps used to determine the proper time to recognize revenue? 9. Why is it necessary to develop a definitional framework for the basic elements of accounting? 22. Selane Eatery operates a catering service specializing in business luncheons for large corporations. Selane requires 10. Expenses, losses, and distributions to owners are all de- customers to place their orders 2 weeks in advance of the creases in net assets. What are the distinctions among them? scheduled events. Selane bills its customers on the tenth 11. Revenues, gains, and investments by owners are all in- day of the month following the date of service and re- creases in net assets. What are the distinctions among them? quires that payment be made within 30 days of the billing 1 2. What are the four basic assumptions that underlie the date. Conceptually, when should Selane recognize reve- financial accounting structure? nue related to its catering service? 1 3. The life of a business is divided into specific time periods, 23. Mogilny Company paid $135,000 for a machine. The usually a year, to measure results of operations for each Accumulated Depreciation—Equipment account has a bal- such time period and to portray financial conditions at the ance of $46,500 at the present time. The company could sell end of each period. the machine today for $150,000. The company president (a) This practice is based on the accounting assumption believes that the company has a “right to this gain.” What that the life of the business consists of a series of time does the president mean by this statement? Do you agree? periods and that it is possible to measure accurately 24. Three expense recognition methods (associating cause and

the results of operations for each period. Comment on effect, systematic and rational allocation, and immediate the validity and necessity of this assumption. recognition) were discussed in the text under the expense rec- (b) What has been the effect of this practice on account- ognition principle. Indicate the basic nature of each of these ing? What is its relation to the accrual system? What expense recognition methods and give two examples of each. Brief Exercises 67 25. Statement of Financial Accounting Concepts No. 5 identifies be considered when new accounting standards are being four characteristics that an item must have before it is rec- proposed. ognized in the financial statements. What are these four 30. The treasurer of Landowska Co. has heard that conser- characteristics? vatism is a doctrine that is followed in accounting and, 26. Briefly describe the types of information concerning therefore, proposes that several policies be followed that financial position, income, and cash flows that might be are conservative in nature. State your opinion with provided (a) within the main body of the financial state- respect to each of the policies listed. ments, (b) in the notes to the financial statements, or (a) The company gives a 2-year warranty to its customers (c) as supplementary information. on all products sold. The estimated warranty costs in- 27. In January 2015, Janeway Inc. doubled the amount of its curred from this year’s sales should be entered as an outstanding stock by selling on the market an additional expense this year instead of an expense in the period 10,000 shares to finance an expansion of the business. You in the future when the warranty is made good. propose that this information be shown by a footnote on (b) When sales are made on account, there is always the balance sheet as of December 31, 2014. The president uncertainty about whether the accounts are collect- objects, claiming that this sale took place after December ible. Therefore, the treasurer recommends recording 31, 2014, and therefore should not be shown. Explain your the sale when the cash is received from the customers. position. (c) A personal liability lawsuit is pending against the 2 8. Describe the major constraint inherent in the presentation company. The treasurer believes there is an even of accounting information. chance that the company will lose the suit and have to 29. What are some of the costs of providing accounting infor- pay damages of $200,000 to $300,000. The treasurer recommends that a loss be recorded and a liability mation? What are some of the benefits of accounting created in the amount of $300,000. information? Describe the cost-benefit factors that should BRIEF EXERCISES 4 BE2-1 Match the qualitative characteristics below with the following statements. 1. Relevance 5. Comparability 2. Faithful representation 6. Completeness 3. Predictive value 7. Neutrality 4. Confirmatory value 8. Timeliness (a) Quality of information that permits users to identify similarities in and differences between two sets of economic phenomena. (b) Having information available to users before it loses its capacity to influence decisions. (c) Information about an economic phenomenon that has value as an input to the processes used by capital providers to form their own expectations about the future. (d) Information that is capable of making a difference in the decisions of users in their capacity as capital providers. (e) Absence of bias intended to attain a predetermined result or to induce a particular behavior. 4 BE2-2 Match the qualitative characteristics below with the following statements. 1. Timeliness 5. Faithful representation 2. Completeness 6. Relevance 3. Free from error 7. Neutrality 4. Understandability 8. Confirmatory value (a) Quality of information that assures users that information represents the economic phenomena that it purports to represent. (b) Information about an economic phenomenon that corrects past or present expectations based on previous evaluations. (c) The extent to which information is accurate in representing the economic substance of a trans- action.

(d) Includes all the information that is necessary for a faithful representation of the economic phenomena that it purports to represent. (e) Quality of information that allows users to comprehend its meaning. 68 Chapter 2 Conceptual Framework for Financial Reporting 4 BE2-3 Discuss whether the changes described in each of the cases below require recognition in the CPA’s audit report as to consistency. (Assume that the amounts are material.) (a) The company changed its inventory method to FIFO from weighted-average, which had been used in prior years. (b) The company disposed of one of the two subsidiaries that had been included in its consolidated statements for prior years. (c) The estimated remaining useful life of plant property was reduced because of obsolescence. 4 BE2-4 Identify which qualitative characteristic of accounting information is best described in each item below. (Do not use relevance and faithful representation.) (a) The annual reports of Best Buy Co. are audited by certified public accountants. (b) Black & Decker and Cannondale Corporation both use the FIFO cost flow assumption. (c) Starbucks Corporation has used straight-line depreciation since it began operations. (d) Motorola issues its quarterly reports immediately after each quarter ends. 4 BE2-5 Presented below are three different transactions related to materiality. Explain whether you would classify these transactions as material. (a) Blair Co. has reported a positive trend in earnings over the last 3 years. In the current year, it reduces its bad debt allowance to ensure another positive earnings year. The impact of this adjustment is equal to 3% of net income. (b) Hindi Co. has an extraordinary gain of $3.1 million on the sale of plant assets and a $3.3 million loss on the sale of investments. It decides to net the gain and loss because the net effect is considered immaterial. Hindi Co.’s income for the current year was $10 million. (c) Damon Co. expenses all capital equipment under $25,000 on the basis that it is immaterial. The company has followed this practice for a number of years. 5 BE2-6 For each item below, indicate to which category of elements of financial statements it belongs. (a) Retained earnings (e) Depreciation (h) Dividends (b) Sales (f) Loss on sale of equipment (i) Gain on sale of investment (c) Additional paid-in capital (g) Interest payable (j) Issuance of common stock (d) Inventory 6 BE2-7 Identify which basic assumption of accounting is best described in each item below. (a) The economic activities of FedEx Corporation are divided into 12-month periods for the purpose of issuing annual reports. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes. 7 BE2-8 Identify which basic principle of accounting is best described in each item below. (a) Norfolk Southern Corporation reports revenue in its income statement when the performance obligation is satisfied instead of when the cash is collected. (b) Yahoo! recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements. (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair value is greater. 7 BE2-9 Vande Velde Company made three investments during 2014. (1) It purchased 1,000 shares of Sastre Company, a start-up company. Vande Velde made the investment based on valuation estimates from an internally developed model. (2) It purchased 2,000 shares of GE stock, which trades on the NYSE. (3) It invested $10,000 in local development authority bonds. Although these bonds do not trade on an active market, their value closely tracks movements in U.S. Treasury bonds. Where will Vande Velde report these

investments in the fair value hierarchy? 6 BE2-10 If the going concern assumption is not made in accounting, discuss the differences in the amounts shown in the financial statements for the following items. (a) Land. (b) Unamortized bond premium. (c) Depreciation expense on equipment. (d) Inventory. (e) Prepaid insurance. Exercises 69 6 7 BE2-11 What accounting assumption, principle, or constraint would Target Corporation use in each of the 8 situations below? (a) Target was involved in litigation over the last year. This litigation is disclosed in the financial statements. (b) Target allocates the cost of its depreciable assets over the life it expects to receive revenue from these assets. (c) Target records the purchase of a new Dell PC at its cash equivalent price. 5 BE2-12 Explain how you would decide whether to record each of the following expenditures as an asset or an expense. Assume all items are material. (a) Legal fees paid in connection with the purchase of land are $1,500. (b) Eduardo, Inc. paves the driveway leading to the office building at a cost of $21,000. (c) A meat market purchases a meat-grinding machine at a cost of $3,500. (d) On June 30, Monroe and Meno, medical doctors, pay 6 months’ office rent to cover the month of July and the next 5 months. (e) Smith’s Hardware Company pays $9,000 in wages to laborers for construction on a building to be used in the business. (f) Alvarez’s Florists pays wages of $2,100 for the month an employee who serves as driver of their delivery truck. EXERCISES 1 3 E2-1 (Usefulness, Objective of Financial Reporting) Indicate whether the following statements about the conceptual framework are true or false. If false, provide a brief explanation supporting your position. (a) Accounting rule-making that relies on a body of concepts will result in useful and consistent pro- nouncements. (b) General-purpose financial reports are most useful to company insiders in making strategic business decisions. (c) Accounting standards based on individual conceptual frameworks generally will result in consis- tent and comparable accounting reports. (d) Capital providers are the only users who benefit from general-purpose financial reporting. (e) Accounting reports should be developed so that users without knowledge of economics and busi- ness can become informed about the financial results of a company. (f) The objective of financial reporting is the foundation from which the other aspects of the framework logically result. 1 3 E2-2 (Usefulness, Objective of Financial Reporting, Qualitative Characteristics) Indicate whether the following statements about the conceptual framework are true or false. If false, provide a brief explanation 4 supporting your position. (a) The fundamental qualitative characteristics that make accounting information useful are relevance and verifiability. (b) Relevant information only has predictive value, confirmatory value, or both. (c) Information that is a faithful representation is characterized as having predictive or confirmatory value. (d) Comparability pertains only to the reporting of information in a similar manner for different companies. (e) Verifiability is solely an enhancing characteristic for faithful representation. (f) In preparing financial reports, it is assumed that users of the reports have reasonable knowledge of business and economic activities. 4 8 E2-3 (Qualitative Characteristics) SFAC No. 8 identifies the qualitative characteristics that make account- ing information useful. Presented below are a number of questions related to these qualitative characteris- tics and underlying constraint. (a) What is the quality of information that enables users to confirm or correct prior expectations? (b) Identify the pervasive constraint developed in the conceptual framework. (c) The chairman of the SEC at one time noted, “If it becomes accepted or expected that accounting principles are determined or modified in order to secure purposes other than economic measure- ment, we assume a grave risk that confidence in the credibility of our financial information system

70 Chapter 2 Conceptual Framework for Financial Reporting will be undermined.” Which qualitative characteristic of accounting information should ensure that such a situation will not occur? (Do not use faithful representation.) (d) Muruyama Corp. switches from FIFO to average-cost to FIFO over a 2-year period. Which qualita- tive characteristic of accounting information is not followed? (e) Assume that the profession permits the savings and loan industry to defer losses on investments it sells because immediate recognition of the loss may have adverse economic consequences on the industry. Which qualitative characteristic of accounting information is not followed? (Do not use relevance or faithful representation.) (f) What are the two fundamental qualities that make accounting information useful for decision- making? (g) Watteau Inc. does not issue its first-quarter report until after the second quarter’s results are re- ported. Which qualitative characteristic of accounting is not followed? (Do not use relevance.) (h) Predictive value is an ingredient of which of the two fundamental qualities that make accounting information useful for decision-making purposes? (i) Duggan, Inc. is the only company in its industry to depreciate its plant assets on a straight-line basis. Which qualitative characteristic of accounting information may not be followed? (j) Roddick Company has attempted to determine the replacement cost of its inventory. Three different appraisers arrive at substantially different amounts for this value. The president, nevertheless, de- cides to report the middle value for external reporting purposes. Which qualitative characteristic of information is lacking in these data? (Do not use relevance or faithful representation.) 4 E2-4 (Qualitative Characteristics) The qualitative characteristics that make accounting information use- ful for decision-making purposes are as follows. Relevance Neutrality Verifi ability Faithful representation Completeness Understandability Predictive value Timeliness Comparability Confi rmatory value Materiality Free from error Instructions Identify the appropriate qualitative characteristic(s) to be used given the information provided below. (a) Qualitative characteristic being employed when companies in the same industry are using the same accounting principles. (b) Quality of information that confirms users’ earlier expectations. (c) Imperative for providing comparisons of a company from period to period. (d) Ignores the economic consequences of a standard or rule. (e) Requires a high degree of consensus among individuals on a given measurement. (f) Predictive value is an ingredient of this fundamental quality of information. (g) Four qualitative characteristics that are related to both relevance and faithful representation. (h) An item is not recorded because its effect on income would not change a decision. (i) Neutrality is an ingredient of this fundamental quality of accounting information. (j) Two fundamental qualities that make accounting information useful for decision-making purposes. (k) Issuance of interim reports is an example of what enhancing quality of relevance? 5 E2-5 (Elements of Financial Statements) Ten interrelated elements that are most directly related to mea- suring the performance and financial status of an enterprise are provided below. Assets Distributions to owners Expenses Liabilities Comprehensive income Gains Equity Revenues Losses Investments by owners Instructions Identify the element or elements associated with the 12 items below. (a) Arises from peripheral or incidental transactions. (b) Obligation to transfer resources arising from a past transaction. (c) Increases ownership interest. (d) Declares and pays cash dividends to owners. (e) Increases in net assets in a period from nonowner sources. (f) Items characterized by service potential or future economic benefit. (g) Equals increase in assets less liabilities during the year, after adding distributions to owners and subtracting investments by owners. (h) Arises from income statement activities that constitute the entity’s ongoing major or central operations.

(i) Residual interest in the assets of the enterprise after deducting its liabilities. Exercises 71 (j) Increases assets during a period through sale of product. (k) Decreases assets during the period by purchasing the company’s own stock. (l) Includes all changes in equity during the period, except those resulting from investments by owners and distributions to owners. 6 7 E2-6 (Assumptions, Principles, and Constraint) Presented below are the assumptions, principles, and constraint used in this chapter. 8 1. Economic entity assumption 5. M easurement principle 7. Expense recognition principle 2. Going concern assumption (historical cost) 8. Full disclosure principle 3. Monetary unit assumption 6. M easurement principle 9. Cost constraint 4. Periodicity assumption (fair value) 10. Revenue recognition principle Instructions Identify by number the accounting assumption, principle, or constraint that describes each situation below. Do not use a number more than once. (a) Allocates expenses to revenues in the proper period. (b) Indicates that fair value changes subsequent to purchase are not recorded in the accounts. (Do not use revenue recognition principle.) (c) Ensures that all relevant financial information is reported. (d) Rationale why plant assets are not reported at liquidation value. (Do not use historical cost principle.) (e) Indicates that personal and business record keeping should be separately maintained. (f) Separates financial information into time periods for reporting purposes. (g) Assumes that the dollar is the “measuring stick” used to report on financial performance. 6 7 E2-7 (Assumptions, Principles, and Constraint) Presented below are a number of operational guidelines 8 and practices that have developed over time. Instructions Select the assumption, principle, or constraint that most appropriately justifies these procedures and prac- tices. (Do not use qualitative characteristics.) (a) Fair value changes are not recognized in the accounting records. (b) Financial information is presented so that investors will not be misled. (c) Intangible assets are capitalized and amortized over periods benefited. (d) Repair tools are expensed when purchased. (e) Agricultural companies use fair value for purposes of valuing crops. (f) Each enterprise is kept as a unit distinct from its owner or owners. (g) All significant post-balance-sheet events are reported. (h) Revenue is recorded at point of sale. (i) All important aspects of bond indentures are presented in financial statements. (j) Rationale for accrual accounting. (k) The use of consolidated statements is justified. (l) Reporting must be done at defined time intervals. (m) An allowance for doubtful accounts is established. (n) Goodwill is recorded only at time of purchase. (o) A company charges its sales commission costs to expense. 7 E2-8 (Full Disclosure Principle) Presented below are a number of facts related to Weller, Inc. Assume that no mention of these facts was made in the financial statements and the related notes. Instructions Assume that you are the auditor of Weller, Inc. and that you have been asked to explain the appropriate accounting and related disclosure necessary for each of these items. (a) The company decided that, for the sake of conciseness, only net income should be reported on the income statement. Details as to revenues, cost of goods sold, and expenses were omitted. (b) Equipment purchases of $170,000 were partly financed during the year through the issuance of a $110,000 notes payable. The company offset the equipment against the notes payable and reported plant assets at $60,000. (c) Weller has reported its ending inventory at $2,100,000 in the financial statements. No other informa- tion related to inventories is presented in the financial statements and related notes. (d) The company changed its method of valuing inventories from weighted-average to FIFO. No mention of this change was made in the financial statements. 72 Chapter 2 Conceptual Framework for Financial Reporting 7 E2-9 (Accounting Principles—Comprehensive) Presented below are a number of business transactions

that occurred during the current year for Gonzales, Inc. Instructions In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles. (a) The president of Gonzales, Inc. used his expense account to purchase a new Suburban solely for personal use. The following journal entry was made. Miscellaneous Expense 29,000 Cash 29,000 (b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less estimated selling costs. The following entry was made to record this increase in value. Inventory 70,000 Sales Revenue 70,000 (c) The company is being sued for $500,000 by a customer who claims damages for personal injury ap- parently caused by a defective product. Company attorneys feel extremely confident that the com- pany will have no liability for damages resulting from the situation. Nevertheless, the company decides to make the following entry. Loss from Lawsuit 500,000 Liability for Lawsuit 500,000 (d) Because the general level of prices increased during the current year, Gonzales, Inc. determined that there was a $16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made. Depreciation Expense 16,000 Accumulated Depreciation—Equipment 16,000 (e) Gonzales, Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a consequence, goodwill arising from a purchase transaction during the current year and recorded at $800,000 was written off as follows. Retained Earnings 800,000 Goodwill 800,000 (f) Because of a “fire sale,” equipment obviously worth $200,000 was acquired at a cost of $155,000. The following entry was made. Equipment 200,000 Cash 155,000 Sales Revenue 45,000 7 E2-10 (Accounting Principles—Comprehensive) Presented below is information related to Cramer, Inc. Instructions Comment on the appropriateness of the accounting procedures followed by Cramer, Inc. (a) Depreciation expense on the building for the year was $60,000. Because the building was increasing in value during the year, the controller decided to charge the depreciation expense to retained earn- ings instead of to net income. The following entry is recorded. Retained Earnings 60,000 Accumulated Depreciation—Buildings 60,000 (b) Materials were purchased on January 1, 2014, for $120,000 and this amount was entered in the Materials account. On December 31, 2014, the materials would have cost $141,000, so the following entry is made. Inventory 21,000 Gain on Inventories 21,000 (c) During the year, the company purchased equipment through the issuance of common stock. The stock had a par value of $135,000 and a fair value of $450,000. The fair value of the equipment was not easily determinable. The company recorded this transaction as follows. Equipment 135,000 Common Stock 135,000 Concepts for Analysis 73 (d) During the year, the company sold certain equipment for $285,000, recognizing a gain of $69,000. Because the controller believed that new equipment would be needed in the near future, she decided to defer the gain and amortize it over the life of any new equipment purchased. (e) An order for $61,500 has been received from a customer for products on hand. This order was shipped on January 9, 2015. The company made the following entry in 2014. Accounts Receivable 61,500 Sales Revenue 61,500 EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. CONCEPTS FOR ANALYSIS CA2-1 (Conceptual Framework—General) Wayne Cooper has some questions regarding the theoretical framework in which GAAP is set. He knows that the FASB and other predecessor organizations have at- tempted to develop a conceptual framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that accounting rules seem to be established after the fact rather than before. He

thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework. Wayne feels that some of his anxiety about accounting theory and accounting semantics could be al- leviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work. By doing this, he hopes to develop an appropriate connection between theory and practice. Instructions (a) Help Wayne recognize the purpose of and benefit of a conceptual framework. (b) Identify any Statements of Financial Accounting Concepts issued by the FASB that may be helpful to Wayne in developing his theoretical background. CA2-2 (Conceptual Framework—General) The Financial Accounting Standards Board (FASB) has devel- oped a conceptual framework for financial accounting and reporting. The FASB has issued eight Statements of Financial Accounting Concepts. These statements are intended to set forth the objective and fundamentals that will be the basis for developing financial accounting and reporting standards. The objective identifies the goals and purposes of financial reporting. The fundamentals are the underlying concepts of financial ac- counting that guide the selection of transactions, events, and circumstances to be accounted for; their recogni- tion and measurement; and the means of summarizing and communicating them to interested parties. The purpose of the statement on qualitative characteristics is to examine the characteristics that make accounting information useful. These characteristics or qualities of information are the ingredients that make information useful and the qualities to be sought when accounting choices are made. Instructions (a) Identify and discuss the benefits that can be expected to be derived from the FASB’s conceptual framework study. (b) What is the most important quality for accounting information as identified in the conceptual framework? Explain why it is the most important. (c) Statement of Financial Accounting Concepts No. 8 describes a number of key characteristics or qualities for accounting information. Briefly discuss the importance of any three of these qualities for finan- cial reporting purposes. (CMA adapted) CA2-3 (Objective of Financial Reporting) Homer Winslow and Jane Alexander are discussing various aspects of the FASB’s concepts statement on the objective of financial reporting. Homer indicates that this pronouncement provides little, if any, guidance to the practicing professional in resolving accounting con- troversies. He believes that the statement provides such broad guidelines that it would be impossible to 74 Chapter 2 Conceptual Framework for Financial Reporting apply the objective to present-day reporting problems. Jane concedes this point but indicates that the objec- tive is still needed to provide a starting point for the FASB in helping to improve financial reporting. Instructions (a) Indicate the basic objective established in the conceptual framework. (b) What do you think is the meaning of Jane’s statement that the FASB needs a starting point to resolve accounting controversies? CA2-4 (Qualitative Characteristics) Accounting information provides useful information about business transactions and events. Those who provide and use financial reports must often select and evaluate ac- counting alternatives. The FASB statement on qualitative characteristics of accounting information exam- ines the characteristics of accounting information that make it useful for decision-making. It also points out that various limitations inherent in the measurement and reporting process may necessitate trade-offs or sacrifices among the characteristics of useful information. Instructions (a) Describe briefly the following characteristics of useful accounting information. (1) Relevance. (4) Comparability. (2) Faithful representation. (5) Consistency. (3) Understandability. (b) For each of the following pairs of information characteristics, give an example of a situation in

which one of the characteristics may be sacrificed in return for a gain in the other. (1) Relevance and faithful representation. (3) Comparability and consistency. (2) Relevance and consistency. (4) Relevance and understandability. (c) What criterion should be used to evaluate trade-offs between information characteristics? CA2-5 (Revenue Recognition Principle) After the presentation of your report on the examination of the financial statements to the board of directors of Piper Publishing Company, one of the new directors expresses surprise that the income statement assumes that an equal proportion of the revenue is recog- nized with the publication of every issue of the company’s magazine. She feels that the “crucial event” in the process of earning revenue in the magazine business is the cash sale of the subscription. She says that she does not understand why most of the revenue cannot be “recognized” in the period of the cash sale. Instructions Discuss the propriety of timing the recognition of revenue in Piper Publishing Company’s accounts with: (a) The cash sale of the magazine subscription. (b) The publication of the magazine every month. (c) Both events, by recognizing a portion of the revenue with the cash sale of the magazine subscription and a portion of the revenue with the publication of the magazine every month. CA2-6 (Expense Recognition Principle) An accountant must be familiar with the concepts involved in determining earnings of a business entity. The amount of earnings reported for a business entity is depen- dent on the proper recognition, in general, of revenues and expenses for a given time period. In some situ- ations, costs are recognized as expenses at the time of product sale. In other situations, guidelines have been developed for recognizing costs as expenses or losses by other criteria. Instructions (a) Explain the rationale for recognizing costs as expenses at the time of product sale. (b) What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain. (c) In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense? Explain. (d) Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset cost. Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost. (e) Identify the conditions under which it would be appropriate to treat a cost as a loss. (AICPA adapted) CA2-7 (Expense Recognition Principle) Accountants try to prepare income statements that are as accu- rate as possible. A basic requirement in preparing accurate income statements is to record costs and reve- nues properly. Proper recognition of costs and revenues requires that costs resulting from typical business operations be recognized in the period in which they expired. Instructions (a) List three criteria that can be used to determine whether such costs should appear as charges in the income statement for the current period. Concepts for Analysis 75 (b) As generally presented in financial statements, the following items or procedures have been criticized as improperly recognizing costs. Briefly discuss each item from the viewpoint of matching costs with revenues and suggest corrective or alternative means of presenting the financial information. (1) Receiving and handling costs. (2) Cash discounts on purchases. CA2-8 (Expense Recognition Principle) Daniel Barenboim sells and erects shell houses, that is, frame structures that are completely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work necessary to make the shell houses livable dwellings. Barenboim buys shell houses from a manufacturer in unassembled packages consisting of all lumber,

roofing, doors, windows, and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Barenboim buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of $30,000 to $44,000 including the cost of the unassembled packages. The chief element of cost of the display houses is the unassembled packages, inasmuch as erection is a short, low-cost operation. Old sample models are torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package. Instructions (a) A choice must be made between (1) expensing the costs of sample display houses in the periods in which the expenditure is made and (2) spreading the costs over more than one period. Discuss the advantages of each method. (b) Would it be preferable to amortize the cost of display houses on the basis of (1) the passage of time or (2) the number of shell houses sold? Explain. (AICPA adapted) CA2-9 (Qualitative Characteristics) Recently, your uncle, Carlos Beltran, who knows that you always have your eye out for a profitable investment, has discussed the possibility of your purchasing some cor- porate bonds. He suggests that you may wish to get in on the “ground floor” of this deal. The bonds being issued by Neville Corp. are 10-year debentures which promise a 40% rate of return. Neville manufactures novelty/party items. You have told Neville that, unless you can take a look at its financial statements, you would not feel com- fortable about such an investment. Believing that this is the chance of a lifetime, Uncle Carlos has procured a copy of Neville’s most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse these statements, and they are quite impressive. The balance sheet showed a debt-to-equity ratio of 0.10 and, for the year shown, the company reported net income of $2,424,240. The financial statements are not shown in comparison with amounts from other years. In addition, no significant note disclosures about inventory valuation, depreciation methods, loan agreements, etc. are available. Instructions Write a letter to Uncle Carlos explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you. Be sure to explain why these financial statements are neither relevant nor representationally faithful. CA2-10 (Expense Recognition Principle) Anderson Nuclear Power Plant will be “mothballed” at the end of its useful life (approximately 20 years) at great expense. The expense recognition principle requires that expenses be matched to revenue. Accountants Ana Alicia and Ed Bradley argue whether it is better to allocate the expense of mothballing over the next 20 years or ignore it until mothballing occurs. Instructions Answer the following questions. (a) What stakeholders should be considered? (b) What ethical issue, if any, underlies the dispute? (c) What alternatives should be considered? (d) Assess the consequences of the alternatives. (e) What decision would you recommend? CA2-11 (Cost Constraint) The AICPA Special Committee on Financial Reporting proposed the following constraints related to financial reporting. 1. Business reporting should exclude information outside of management’s expertise or for which management is not the best source, such as information about competitors. 76 Chapter 2 Conceptual Framework for Financial Reporting 2. Management should not be required to report information that would significantly harm the com- pany’s competitive position. 3. Management should not be required to provide forecasted financial statements. Rather, manage- ment should provide information that helps users forecast for themselves the company’s financial future. 4. Other than for financial statements, management need report only the information it knows. That

is, management should be under no obligation to gather information it does not have, or does not need, to manage the business. 5. Companies should present certain elements of business reporting only if users and management agree they should be reported—a concept of flexible reporting. 6. Companies should not have to report forward-looking information unless there are effective deter- rents to unwarranted litigation that discourages companies from doing so. Instructions For each item, briefly discuss how the proposed constraint addresses concerns about the costs and benefits of financial reporting. USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) Using the notes to the consolidated financial statements, determine P&G’s revenue recognition policies. Discuss the impact of trade promotions on P&G’s financial statements. (b) Give two examples of where historical cost information is reported in P&G’s financial statements and related notes. Give two examples of the use of fair value information reported in either the financial statements or related notes. (c) How can we determine that the accounting principles used by P&G are prepared on a basis consistent with those of last year? (d) What is P&G’s accounting policy related to advertising? What accounting principle does P&G follow regarding accounting for advertising? Where are advertising expenses reported in the financial statements? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website, and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What are the primary lines of business of these two companies as shown in their notes to the financial statements? (b) Which company has the dominant position in beverage sales? (c) How are inventories for these two companies valued? What cost allocation method is used to report inventory? How does their accounting for inventories affect comparability between the two companies? (d) Which company changed its accounting policies, which then affected the consistency of the financial results from the previous year? What were these changes? Using Your Judgment 77 Financial Statement Analysis Case Wal-Mart Stores, Inc. Wal-Mart Stores, Inc. provided the following disclosure in a recent annual report. New accounting pronouncement (partial) . . . the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101—“Revenue Recognition in Financial Statements” (SAB 101). This SAB deals with various revenue recognition issues, several of which are common within the retail industry. As a result of the issuance of this SAB . . . the Company is currently evaluating the effects of the SAB on its method of recognizing revenues related to layaway sales and will make any accounting method changes necessary during the first quarter of [next year]. In response to SAB 101, Wal-Mart changed its revenue recognition policy for layaway transactions, in which Wal-Mart sets aside merchandise for customers who make partial payment. Before the change, Wal-Mart recognized all revenue on the sale at the time of the layaway. After the change, Wal-Mart does not recognize revenue until customers satisfy all payment obligations and take possession of the merchandise. Instructions (a) Discuss the expected effect on income (1) in the year that Wal-Mart makes the changes in its revenue recognition policy, and (2) in the years following the change. (b) Evaluate the extent to which Wal-Mart’s previous revenue policy was consistent with the revenue recognition principle. (c) If all retailers had used a revenue recognition policy similar to Wal-Mart’s before the change, are there

any concerns with respect to the qualitative characteristic of comparability? Explain. Accounting, Analysis, and Principles William Murray achieved one of his life-long dreams by opening his own business, The Caddie Shack Driving Range, on May 1, 2014. He invested $20,000 of his own savings in the business. He paid $6,000 cash to have a small building constructed to house the operations and spent $800 on golf clubs, golf balls, and yardage signs. Murray leased 4 acres of land at a cost of $1,000 per month. (He paid the first month’s rent in cash.) During the first month, advertising costs totaled $750, of which $150 was unpaid at the end of the month. Murray paid his three nephews $400 for retrieving golf balls. He deposited in the company’s bank account all revenues from customers ($4,700). On May 15, Murray withdrew $800 in cash for personal use. On May 31, the company received a utility bill for $100 but did not immediately pay it. On May 31, the balance in the company bank account was $15,100. Murray is feeling pretty good about results for the first month, but his estimate of profitability ranges from a loss of $4,900 to a profit of $1,650. Accounting Prepare a balance sheet at May 31, 2014. Murray appropriately records any depreciation expense on a quarterly basis. How could Murray have determined that the business operated at a profit of $1,650? How could Murray conclude that the business operated at a loss of $4,900? Analysis Assume Murray has asked you to become a partner in his business. Under the partnership agreement, after paying him $10,000, you would share equally in all future profits. Which of the two income measures above would be more useful in deciding whether to become a partner? Explain. Principles What is income according to GAAP? What concepts do the differences in the three income measures for The Caddie Shack Driving Range illustrate? BRIDGE TO THE PROFESSION Professional Research Your aunt recently received the annual report for a company in which she has invested. The report notes that the statements have been prepared in accordance with “generally accepted accounting principles.” She has also heard that certain terms have special meanings in accounting relative to everyday use. She would like you to explain the meaning of terms she has come across related to accounting. 78 Chapter 2 Conceptual Framework for Financial Reporting Instructions Go to http://www.fasb.org and access the FASB Concepts Statements and respond to the following items. (Provide paragraph citations.) When you have accessed the documents, you can use the search tool in your Internet browser. (a) How is “materiality” defined in the conceptual framework? (b) The concepts statements provide several examples in which specific quantitative materiality guide- lines are provided to firms. Identity at least two of these examples. Do you think the materiality guide- lines should be quantified? Why or why not? (c) The concepts statements discuss the concept of “articulation” between financial statement elements. Briefly summarize the meaning of this term and how it relates to an entity’s financial statements. Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS The IASB and the FASB are working on a joint project to develop a common con- LEARNING OBJECTIVE 9 ceptual framework. This framework is based on the existing conceptual frame- Compare the conceptual frameworks works underlying GAAP and IFRS. The objective of this joint project is to develop underlying GAAP and IFRS. a conceptual framework that leads to standards that are principles-based and internally consistent and that leads to the most useful financial reporting. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the conceptual framework. Similarities • In 2010, the IASB and FASB completed the fi rst phase of a jointly created conceptual framework. In this fi rst phase, they agreed on the objective of fi nancial reporting and

a common set of desired qualitative characteristics. These were presented in the Chapter 2 discussion. Note that prior to this converged phase, the IASB Framework gave more emphasis to the objective of providing information on management’s performance (stewardship). • The existing conceptual frameworks underlying GAAP and IFRS are very similar. That is, they are organized in a similar manner (objective, elements, qualitative characteristics, etc.). There is no real need to change many aspects of the existing frameworks other than to converge different ways of discussing essentially the same concepts. • The converged framework should be a single document, unlike the two conceptual frameworks that presently exist. It is unlikely that the basic structure related to the concepts will change. • Both the IASB and FASB have similar measurement principles, based on historical cost and fair value. In 2011, the Boards issued a converged standard fair value measure- ment so that the defi nition of fair value, measurement techniques, and disclosures are the same between GAAP and IFRS when fair value is used in fi nancial statements. IFRS Insights 79 Differences • Although both GAAP and IFRS are increasing the use of fair value to report assets, at this point IFRS has adopted it more broadly. As examples, under IFRS, companies can apply fair value to property, plant, and equipment; natural resources; and in some cases, intangible assets. • GAAP has a concept statement to guide estimation of fair values when market-related data is not available (Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting”). The IASB has not issued a similar concept statement; it has issued a fair value standard (IFRS 13) that is converged with GAAP. • The monetary unit assumption is part of each framework. However, the unit of measure will vary depending on the currency used in the country in which the com- pany is incorporated (e.g., Chinese yuan, Japanese yen, and British pound). IFRS makes an explicit assumption that fi nancial statements are prepared on an accrual basis. • The economic entity assumption is also part of each framework, although some cul- tural differences result in differences in its application. For example, in Japan many companies have formed alliances that are so strong that they act similar to related corporate divisions although they are not actually part of the same company. ABOUT THE NUMBERS Financial Statement Elements While the conceptual framework that underlies IFRS is very similar to that used to develop GAAP, the elements identified and their definitions under IFRS are different. The IASB elements and their definitions are as follows. Assets. A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Liabilities. A present obligation of the entity arising from past events, the settle- ment of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities may be legally enforceable via a contract or law, but need not be, i.e., they can arise due to normal business practice or customs. Equity. A residual interest in the assets of the entity after deducting all its liabilities. Income. Increases in economic benefits that result in increases in equity (other than those related to contributions from shareholders). Income includes both revenues (resulting from ordinary activities) and gains. Expenses. Decreases in economic benefits that result in decreases in equity (other than those related to distributions to shareholders). Expenses includes losses that are not the result of ordinary activities. Conceptual Framework Work Plan The work on the conceptual framework is being done in phases. As discussed, Phase A related to objectives and qualitative characteristics has been issued in 2010. Work on the remaining core phases—(1) a chapter on the reporting entity (Phase D), (2) a chapter related to measurement (Phase C), and (3) elements and recognition (Phase B)—are

currently on hold as the focus is on completing key convergence projects on revenue, financial instruments, and leases. 80 Chapter 2 Conceptual Framework for Financial Reporting ON THE HORIZON The IASB and the FASB face a difficult task in attempting to update, modify, and complete a converged conceptual framework. There are many difficult issues. For example: How do we trade off characteristics such as highly relevant information that is difficult to verify? How do we define control when we are developing a definition of an asset? Is a liability the future sacrifice itself or the obligation to make the sacrifice? Should a single measure- ment method, such as historical cost or fair value, be used, or does it depend on whether it is an asset or liability that is being measured? We are optimistic that the new document will be a significant improvement over its predecessors and will lead to principles-based standards that help users of the financial statements make better decisions. IFRS SELF-TEST QUESTIONS 1. Which of the following statements about the IASB and FASB conceptual frameworks is not correct? (a) The IASB conceptual framework does not identify the element comprehensive income. (b) The existing IASB and FASB conceptual frameworks are organized in similar ways. (c) The FASB and IASB agree that the objective of financial reporting is to provide useful informa- tion to investors and creditors. (d) IFRS does not allow use of fair value as a measurement basis. 2. Which of the following statements is false? (a) The monetary unit assumption is used under IFRS. (b) Under IFRS, companies may use fair value for property, plant, and equipment. (c) The FASB and IASB are working on a joint conceptual framework project. (d) Under IFRS, there are the same number of financial statement elements as in GAAP. 3. Companies that use IFRS: (a) must report all their assets on the statement of financial position (balance sheet) at fair value. (b) may report property, plant, and equipment and natural resources at fair value. (c) may refer to a concept statement on estimating fair values when market data are not available. (d) may only use historical cost as the measurement basis in financial reporting. 4. The issues that the FASB and IASB must address in developing a common conceptual framework include all of the following except: (a) should the characteristic of relevance be traded-off in favor of information that is verifiable? (b) should a single measurement method such as historical cost be used? (c) should the common framework lead to standards that are principles-based or rules-based? (d) should the role of financial reporting focus on internal decision-making as well as providing information to assist users in decision-making? 5. With respect to the converged FASB/IASB conceptual framework: (a) work is being conducted on the framework as a whole, and it will not be issued until all parts are completed. (b) work on the framework has a higher priority than projects on revenue and leases. (c) work is being conducted on the framework in phases, and completed parts will be issued as completed. (d) the framework will not address measurement issues. IFRS CONCEPTS AND APPLICATION IFRS2-1 What two assumptions are central to the IASB conceptual framework? IFRS2-2 Do the IASB and FASB conceptual frameworks differ in terms of the role of financial reporting? Explain. IFRS2-3 What are some of the differences in elements in the IASB and FASB conceptual frameworks? IFRS2-4 What are some of the challenges to the FASB and IASB in developing a converged conceptual framework? IFRS Insights 81 Financial Reporting Case IFRS2-5 As discussed in Chapter 1, the International Accounting Standards Board (IASB) develops ac- counting standards for many international companies. The IASB also has developed a conceptual frame- work to help guide the setting of accounting standards. While the FASB and IASB have issued converged concepts statements on the objective and qualitative characteristics, other parts of their frameworks differ.

Instructions Briefly discuss the similarities and differences between the FASB and IASB conceptual frameworks as related to elements and their definitions. Professional Research IFRS2-6 Your aunt recently received the annual report for a company in which she has invested. The report notes that the statements have been prepared in accordance with IFRS. She has also heard that certain terms have special meanings in accounting relative to everyday use. She would like you to explain the meaning of terms she has come across related to accounting. Instructions Access the IASB Framework at the IASB website (http://eifrs.iasb.org/ ). (Click on the IFRS tab and then reg- ister for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to prepare responses to the following items. (Provide paragraph citations.) (a) How is “materiality” defined in the framework? (b) Briefly discuss how materiality relates to (1) the relevance of financial information, and (2) completeness. (c) Your aunt observes that under IFRS, the financial statements are prepared on the accrual basis. According to the framework, what does “accrual basis” mean? International Financial Reporting Problem Marks and Spencer plc IFRS2-7 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com- panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks- and-Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) Using the notes to the consolidated financial statements, determine M&S’s revenue recognition policies. (b) Give two examples of where historical cost information is reported in M&S’s financial state- ments and related notes. Give two examples of the use of fair value information reported in either the financial statements or related notes. (c) How can we determine that the accounting principles used by M&S are prepared on a basis con- sistent with those of last year? (d) What is M&S’s accounting policy related to refunds and loyalty schemes? Why does M&S include the accounting for refunds and loyalty schemes in its critical accounting estimates and judgments? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. d 2. d 3. b 4. d 5. c Remember to check the book’s companion website to fi nd additional resources for this chapter. The Accounting Information System RETPAHC 3 Needed: A Reliable Information System Maintaining a set of accounting records is not optional. Regulators require that businesses prepare and retain a set of records and documents that can be audited. The U.S. Foreign Corrupt Practices Act, for example, requires public com- panies to “make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets.” But beyond these two reasons, a company that fails to keep an accurate record of its business transactions may lose revenue and is more likely to operate inefficiently. One reason accurate records are not provided is because of economic crime or corruption. It is clear that economic crime remains a persistent and difficult problem for many companies. For example, it was recently estimated that 53 percent of U.S. companies experienced significant economic crime. And its global counterparts are not far behind, with a reported rate of 43 percent. While global rates appear lower, U.S. com- panies often have more strin- Asset misappropriation gent internal controls and are more likely to find and report Accounting fraud crime. Presented to the right is Bribery and corruption a chart that indicates the types of economic crime experienced in a recent period. The top four economic crimes are asset misappropria- tion, accounting fraud, bribery and corruption, and cyber- 0 10 20 30 40 50 60 70 80 crime. Cybercrime is a new % respondents who experienced economic crime in the last 12 months phenomenon as new types of

fraud are emerging in this area. Smartphones and tablet de- vices, social media, and cloud computing all offer companies interesting business opportunities but can also lead to risks related to the disclosure of sensitive and confidential data. In some of these cases, such as money laundering or infringement of intellectual property, a sound system of internal controls focused on financial accounting and reporting may not work. Nonetheless, many believe that effective internal control sends a message that a company is serious about finding not only economic crime but also errors or misstatements. As a result, many companies are taking a proactive look as to how they can better prevent both economic crime as well as basic errors in their systems. The chart on the next page indicates the percentage of companies that identified certain factors influencing their decision to implement controls to deter economic crime. emirc cimonoce fo sepyT LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Understand basic accounting terminology. 6 Prepare financial statements from the adjusted trial balance. 2 Explain double-entry rules. 7 Prepare closing entries. 3 Identify steps in the accounting cycle. 8 Prepare financial statements for a merchandising 4 Record transactions in journals, post to ledger company. accounts, and prepare a trial balance. 5 Explain the reasons for preparing adjusting entries and identify major types of adjusting entries. 72 67 24 38 24 27 23 Cybercrime 1 7 IP infringement 15 8 Money laundering 12 2011 2009 CONCEPTUAL FOCUS > See the Underlying Concepts on Reasons for Internal Controls page 90. U.S. Global INTERNATIONAL FOCUS Sarbanes-Oxley Act 99% 84% U.S. Patriot Act 85 29 Advice from external consultants 63 50 > Read the IFRS Insights on FCPA/OECD Anti-Bribery Convention 38 23 pages 153–157 for a discussion of: Public discussion/media 38 33 — Accounting system internal controls Federal sentencing guidelines 38 29 — First-time adoption of IFRS Incidents of economic crime 31 34 Local legislation 24 51 Bad experience and/or advice from What happens when companies fail to keep an law enforcement 17 36 accurate record of their business transactions? Consider Adecco, the largest international employment services company, which confirmed existence of weakness in its internal controls systems and Adecco staffing operations in certain countries. Manipulation involved such matters as reconciliation of payroll bank accounts, accounts receivable, and documen- tation in revenue recognition. These irregularities forced an indefinite delay in reporting the company’s income figures, which led to significant decline in share price. Or consider Nortel Networks Corp., which overstated and understated its reserve accounts to manage its earnings. This eventually led to the liquidation of the company. Even the use of computers is no assurance of accuracy and efficiency. “The conversion to a new system called MasterNet fouled up data processing records to the extent that Bank of America was frequently unable to produce or deliver customer statements on a timely basis,” said an executive at one of the country’s largest banks. Although these situations may occur only rarely in large organizations, they illustrate the point: Companies must properly maintain accounts and detailed records or face unnecessary costs. Sources: Adapted from “Economic Crime: People, Culture, and Controls,” The Fourth Biennial Global Economic Crime Survey (Pricewaterhouse- Coopers, 2007); and “Cybercrime: Protecting Against the Growing Threat,” Global Economic Crime Survey (PricewaterhouseCoopers, 2012). As the opening story indicates, a reliable information system is a PREVIEW OF CHAPTER 3 necessity for all companies. The purpose of this chapter is to explain and illustrate the features of an accounting information system. The content and organization of this chapter are as follows. The Accounting Information System Accounting Financial Statements The Accounting Cycle Information System for Merchandisers • Basic terminology • Identifying and recording • Income statement

• Debits and credits • Journalizing • Statement of retained earnings • Accounting equation • Posting • Balance sheet • Financial statements and • Trial balance • Closing entries ownership structure • Adjusting entries • Adjusted trial balance • Preparing financial statements • Closing • Post-closing trial balance • Reversing entries 83 84 Chapter 3 The Accounting Information System ACCOUNTING INFORMATION SYSTEM An accounting information system collects and processes transaction data and LEARNING OBJECTIVE 1 then disseminates the financial information to interested parties. Accounting in- Understand basic accounting formation systems vary widely from one business to another. Various factors terminology. shape these systems: the nature of the business and the transactions in which it engages, the size of the firm, the volume of data to be handled, and the informational demands that management and others require. As we discussed in Chapters 1 and 2, in response to the requirements of the Sarbanes-Oxley Act, companies are placing a renewed focus on their accounting systems to ensure relevant and reliable information is reported in financial statements.1 A good accounting information system helps management answer such questions as: • How much and what kind of debt is outstanding? • Were our sales higher this period than last? • What assets do we have? • What were our cash inflows and outflows? • Did we make a profit last period? • Are any of our product lines or divisions operating at a loss? • Can we safely increase our dividends to stockholders? • Is our rate of return on net assets increasing? Management can answer many other questions with the data provided by an efficient accounting system. A well-devised accounting information system benefits every type of company. Basic Terminology Financial accounting rests on a set of concepts (discussed in Chapters 1 and 2) for iden- tifying, recording, classifying, and interpreting transactions and other events relating to enterprises. You therefore need to understand the basic terminology employed in collecting accounting data. BASIC TERMINOLOGY EVENT. A happening of consequence. An event generally is the source or cause of changes in assets, liabilities, and equity. Events may be external or internal. TRANSACTION. An external event involving a transfer or exchange between two or more entities. ACCOUNT. A systematic arrangement that shows the effect of transactions and other events on a specifi c element (asset, liability, and so on). Companies keep a separate account 1A recent survey indicated nearly one in three companies view the benefits of Sarbanes-Oxley (SOX) to outweigh its costs. Approximately half of the companies believe the costs exceed the benefits of SOX to some degree. Management view their companies generally as benefiting from SOX but overall have a slightly negative view toward the legislation. In a large percentage of companies, the internal control over financial reporting has improved since SOX became a requirement. See “Where U.S.-Listed Companies Stand: Reviewing Cost, Time, Effort and Processes,” 2012 Sarbanes-Oxley Compliance Survey (Protiviti Company, May 2012). Accounting Information System 85 for each asset, liability, revenue, and expense, and for capital (owners’ equity). Because the format of an account often resembles the letter T, it is sometimes referred to as a T-account. (See Illustration 3-3, page 87.) REAL AND NOMINAL ACCOUNTS. Real (permanent) accounts are asset, liability, and equity accounts; they appear on the balance sheet. Nominal (temporary) accounts are revenue, expense, and dividend accounts; except for dividends, they appear on the income statement. Companies periodically close nominal accounts; they do not close real accounts. LEDGER. The book (or computer printouts) containing the accounts. A general ledger is a collection of all the asset, liability, owners’ equity, revenue, and expense accounts. A subsid- iary ledger contains the details related to a given general ledger account. JOURNAL. The “book of original entry” where the company initially records transactions

and selected other events. Various amounts are transferred from the book of original entry, the journal, to the ledger. Entering transaction data in the journal is known as journalizing. POSTING. The process of transferring the essential facts and fi gures from the book of orig- inal entry to the ledger accounts. TRIAL BALANCE. The list of all open accounts in the ledger and their balances. The trial balance taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial balance taken immediately after closing entries have been posted is called a post-closing (or after-closing) trial balance. Companies may prepare a trial balance at any time. ADJUSTING ENTRIES. Entries made at the end of an accounting period to bring all ac- counts up to date on an accrual basis, so that the company can prepare correct fi nancial statements. FINANCIAL STATEMENTS. Statements that refl ect the collection, tabulation, and fi nal summarization of the accounting data. Four statements are involved. (1) The balance sheet shows the fi nancial condition of the enterprise at the end of a period. (2) The income state- ment measures the results of operations during the period. (3) The statement of cash fl ows reports the cash provided and used by operating, investing, and fi nancing activities during the period. (4) The statement of retained earnings reconciles the balance of the retained earnings account from the beginning to the end of the period. CLOSING ENTRIES. The formal process by which the enterprise reduces all nominal ac- counts to zero and determines and transfers the net income or net loss to an owners’ equity account. Also known as “closing the ledger,” “closing the books,” or merely “closing.” Debits and Credits The terms debit (Dr.) and credit (Cr.) mean left and right, respectively. These terms 2 LEARNING OBJECTIVE do not mean increase or decrease, but instead describe where a company makes Explain double-entry rules. entries in the recording process. That is, when a company enters an amount on the left side of an account, it debits the account. When it makes an entry on the right side, it credits the account. When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits. The positioning of debits on the left and credits on the right is simply an accounting custom. We could function just as well if we reversed the sides. However, the United 86 Chapter 3 The Accounting Information System States adopted the custom, now the rule, of having debits on the left side of an account and credits on the right side, similar to the custom of driving on the right-hand side of the road. This rule applies to all accounts. The equality of debits and credits provides the basis for the double-entry system of recording transactions (sometimes referred to as double-entry bookkeeping). Under the universally used double-entry accounting system, a company records the dual (two- sided) effect of each transaction in appropriate accounts. This system provides a logical method for recording transactions. It also offers a means of proving the accuracy of the recorded amounts. If a company records every transaction with equal debits and cred- its, then the sum of all the debits to the accounts must equal the sum of all the credits. Illustration 3-1 presents the basic guidelines for an accounting system. Increases to all asset and expense accounts occur on the left (or debit side) and decreases on the right (or credit side). Conversely, increases to all liability and revenue accounts occur on the right (or credit side) and decreases on the left (or debit side). A company increases stock- holders’ equity accounts, such as Common Stock and Retained Earnings, on the credit side, but increases Dividends on the debit side. ILLUSTRATION 3-1 Double-Entry (Debit and Credit) Accounting Normal Balance—DDDeeebbbiiittt Normal Balance—CCCrrreeedddiiittt System Asset Accounts Liability Accounts

Debit Credit Debit Credit +++ (((iiinnncccrrreeeaaassseee))) ––– (((dddeeecccrrreeeaaassseee))) ––– (((dddeeecccrrreeeaaassseee))) +++ (((iiinnncccrrreeeaaassseee))) Expense Accounts Stockholders' Equity Accounts Debit Credit Debit Credit +++ (((iiinnncccrrreeeaaassseee))) ––– (((dddeeecccrrreeeaaassseee))) ––– (((dddeeecccrrreeeaaassseee))) +++ (((iiinnncccrrreeeaaassseee))) Revenue Accounts Debit Credit ––– (((dddeeecccrrreeeaaassseee))) +++ (((iiinnncccrrreeeaaassseee))) The Accounting Equation In a double-entry system, for every debit there must be a credit, and vice versa. This leads us, then, to the basic equation in accounting (Illustration 3-2). ILLUSTRATION 3-2 The Basic Accounting Equation Assets = Liabilities + Stockholders' Equity Illustration 3-3 expands this equation to show the accounts that make up stock- holders’ equity. The figure also shows the debit/credit rules and effects on each type of Accounting Information System 87 account. Study this diagram carefully. It will help you understand the fundamentals of the double-entry system. Like the basic equation, the expanded equation must also balance (total debits equal total credits). Basic = + Assets Liabilities Stockholders’ Equity Equation Common Retained Expanded Assets = Liabilities + Stock + Earnings – Dividends + Revenues – Expenses Equation Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Debit/Credit + – – + – + – + + – – + + – Rules ILLUSTRATION 3-3 Every time a transaction occurs, the elements of the accounting equation change. Expanded Equation and However, the basic equality remains. To illustrate, consider the following eight different Debit/Credit Rules and Effects transactions for Perez Inc. 1. Owners invest $40,000 in exchange for common stock. Assets = Liabilities + Stockholders’ Equity + 40,000 + 40,000 2. Disburse $600 cash for secretarial wages. Assets = Liabilities + Stockholders’ Equity – 600 – 600 (expense) 3. Purchase offi ce equipment priced at $5,200, giving a 10 percent promissory note in exchange. Assets = Liabilities + Stockholders’ Equity + 5,200 +5,200 4. Receive $4,000 cash for services performed. Assets = + Stockholders’ Equity Liabilities + 4,000 + 4,000 (revenue) 88 Chapter 3 The Accounting Information System 5. Pay off a short-term liability of $7,000. Assets = Liabilities + Stockholders’ Equity – 7,000 – 7,000 6. Declare a cash dividend of $5,000. = Liabilities + Stockholders’ Equity Assets + 5,000 – 5,000 7. Convert a long-term liability of $80,000 into common stock. = Liabilities + Stockholders’ Equity Assets – 80,000 + 80,000 8. Pay cash of $16,000 for a delivery van. Assets = + –16,000 Liabilities Stockholders’ Equity +16,000 Financial Statements and Ownership Structure The stockholders’ equity section of the balance sheet reports common stock and retained earnings. The income statement reports revenues and expenses. The statement of re- tained earnings reports dividends. Because a company transfers dividends, revenues, and expenses to retained earnings at the end of the period, a change in any one of these three items affects stockholders’ equity. Illustration 3-4 shows the stockholders’ equity relationships. The company’s ownership structure dictates the types of accounts that are part of or affect the equity section. A corporation commonly uses Common Stock, Paid-in Capital in Excess of Par, Dividends, and Retained Earnings accounts. A proprietorship or a partnership uses an Owner’s Capital account and an Owner’s Drawings account. An Owner’s Capital account indicates the owner’s or owners’ investment in the company. An Owner’s Drawings account tracks withdrawals by the owner(s). The Accounting Cycle 89 ILLUSTRATION 3-4 Financial Statements and Ownership Structure Balance Sheet Stockholders' Equity Common Stock Retained Earnings (investments by stockholders) (net income retained in business) Net Income or Net Loss Dividends (revenues less expenses) Income Statement Statement of Retained Earnings Illustration 3-5 summarizes and relates the transactions affecting owners’ equity to the nominal (temporary) and real (permanent) classifications and to the types of busi-

ness ownership. ILLUSTRATION 3-5 Ownership Structure Effects of Transactions on Proprietorships and Owners’ Equity Accounts Partnerships Corporations Transactions Impact on Nominal Real Nominal Real Affecting Owners’ (Temporary) (Permanent) (Temporary) (Permanent) Owners’ Equity Equity Accounts Accounts Accounts Accounts Investment by owner(s) Increase Capital Common Stock and related accounts Revenues recognized Increase Revenue Revenue j j Expenses incurred Decrease Expense Capital Expense Retained Withdrawal by owner(s) Decrease Drawing Dividends Earnings THE ACCOUNTING CYCLE Illustration 3-6 (on page 90) shows the steps in the accounting cycle. A company 3 LEARNING OBJECTIVE normally uses these accounting procedures to record transactions and prepare Identify steps in the accounting financial statements. cycle. Identifying and Recording Transactions and Other Events The first step in the accounting cycle is analysis of transactions and selected other events. The first problem is to determine what to record. Although GAAP provides guidelines, no simple rules exist that state which events a company should record. Although 90 Chapter 3 The Accounting Information System ILLUSTRATION 3-6 The Accounting Cycle Identification and Measurement of Transactions and Other Events Journalization General journal Cash receipts journal Reversing entries Cash disbursements journal (optional) Purchases journal Sales journal Other special journals THE Post-closing Posting trial balance ACCOUNTING General ledger (usually monthly) (optional) CYCLE Subsidiary ledgers (usually daily) Closing Trial balance (nominal accounts) preparation Statement preparation Adjustments Income statement Worksheet Accruals Retained earnings (optional) Prepayments Balance sheet Estimated items Cash flows Adjusted trial balance When the steps have been completed, the sequence starts over again in the next accounting period. changes in a company’s personnel or managerial policies may be important, the com- pany should not record these items in the accounts. On the other hand, a company should record all cash sales or purchases—no matter how small. The concepts we presented in Chapter 2 determine what to recognize in the ac- counts. An item should be recognized in the financial statements if it is an element, is measurable, and is relevant and representationally faithful. Consider human resources. R. G. Barry & Co. at one time reported as supplemental data total assets of $14,055,926, including $986,094 for “Net investments in human resources.” AT&T and ExxonMobil also experimented with human resource accounting. Should we value employees for balance sheet and income statement purposes? Certainly skilled employees are Underlying Concepts an important asset (highly relevant), but the problems of determining their value and measuring it reliably have not yet been solved. Consequently, human Assets are probable economic resources are not recorded. Perhaps when measurement techniques become benefi ts controlled by a particu- more sophisticated and accepted, such information will be presented, if only in lar entity as a result of a past supplemental form. transaction or event. Do human The FASB uses the phrase “transactions and other events and circumstances resources of a company meet that affect a business enterprise” to describe the sources or causes of changes in this defi nition? an entity’s assets, liabilities, and equity.2 Events are of two types. (1) External 2“Elements of Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), pp. 259–260. The Accounting Cycle 91 events involve interaction between an entity and its environment, such as a transaction with another entity, a change in the price of a good or service that an entity buys or sells, a flood or earthquake, or an improvement in technology by a competitor. (2) Internal events occur within an entity, such as using buildings and machinery in operations, or transferring or consuming raw materials in production processes. Many events have both external and internal elements. For example, hiring an em-

ployee, which involves an exchange of salary for labor, is an external event. Using the services of labor is part of production, an internal event. Further, an entity may initiate and control events, such as the purchase of merchandise or use of a machine. Or, events may be beyond its control, such as an interest rate change, theft, or a tax hike. Transactions are types of external events. They may be an exchange between two entities where each receives and sacrifices value, such as purchases and sales of goods or services. Or, transactions may be transfers in one direction only. For example, an en- tity may incur a liability without directly receiving value in exchange, such as charitable contributions. Other examples include investments by owners, distributions to owners, payment of taxes, gifts, casualty losses, and thefts. In short, a company records as many events as possible that affect its financial position. As discussed earlier in the case of human resources, it omits some events be- cause of tradition and others because of complicated measurement problems. Recently, however, the accounting profession shows more receptiveness to accepting the challenge of measuring and reporting events previously viewed as too complex and immeasurable. Journalizing A company records in accounts those transactions and events that affect its assets, 4 LEARNING OBJECTIVE liabilities, and equities. The general ledger contains all the asset, liability, and Record transactions in journals, post stockholders’ equity accounts. An account (see Illustration 3-3, on page 87) shows to ledger accounts, and prepare a trial the effect of transactions on particular asset, liability, equity, revenue, and expense balance. accounts. In practice, companies do not record transactions and selected other events origi- nally in the ledger. A transaction affects two or more accounts, each of which is on a different page in the ledger. Therefore, in order to have a complete record of each trans- action or other event in one place, a company uses a journal (also called “the book of original entry”). In its simplest form, a general journal chronologically lists transactions and other events, expressed in terms of debits and credits to accounts. Illustration 3-7 shows the technique of journalizing, using the first two transactions for Softbyte, Inc. These transactions were: September 1 S tockholders invested $15,000 cash in the corporation in exchange for shares of stock. Purchased computer equipment for $7,000 cash. The J1 indicates these two entries are on the first page of the general journal. ILLUSTRATION 3-7 GENERAL JOURNAL J1 Technique of Journalizing Date Account Titles and Explanation Ref. Debit Credit 2014 Sept. 1 Cash 15,000 Common Stock 15,000 (Issued shares of stock for cash) 1 Equipment 7,000 Cash 7,000 (Purchased equipment for cash) 92 Chapter 3 The Accounting Information System Each general journal entry consists of four parts: (1) the accounts and amounts to be debited (Dr.), (2) the accounts and amounts to be credited (Cr.), (3) a date, and (4) an explanation. A company enters debits first, followed by the credits (slightly indented). The explanation begins below the name of the last account to be credited and may take one or more lines. A company completes the “Ref.” column at the time it posts the accounts. Gateway to the Profession In some cases, a company uses special journals in addition to the general journal. Special journals summarize transactions possessing a common characteristic (e.g., cash re- Expanded Discussion of Special Journals ceipts, sales, purchases, cash payments). As a result, using them reduces bookkeeping time. Posting Transferring journal entries to the ledger accounts is called posting. Posting involves the following steps. 1. In the ledger, in the appropriate columns of the account(s) debited, enter the date, journal page, and debit amount shown in the journal. 2. In the reference column of the journal, write the account number to which the debit amount was posted. 3. In the ledger, in the appropriate columns of the account(s) credited, enter the date,

journal page, and credit amount shown in the journal. 4. In the reference column of the journal, write the account number to which the credit amount was posted. Illustration 3-8 diagrams these four steps, using the first journal entry of Softbyte, Inc. The illustration shows the general ledger accounts in standard account form. Some companies call this form the three-column form of account because it has three money ILLUSTRATION 3-8 Posting a Journal Entry GENERAL JOURNAL J1 Date Account Titles and Explanation Ref. Debit Credit 2014 Sept.1 Cash 101 15,000 Common Stock 311 15,000 (Issued shares of stock for cash) 4 1 2 GENERAL LEDGER Cash No.101 Date Explanation Ref. Debit Credit Balance 3 2014 Sept.1 J1 15,000 15,000 Common Stock No.311 Date Explanation Ref. Debit Credit Balance 2014 Sept.1 J1 15,000 15,000 Key: 1 Post to debit account–date, journal page number, and amount. 2 Enter debit account number in journal reference column. 3 Post to credit account–date, journal page number, and amount. 4 Enter credit account number in journal reference column. The Accounting Cycle 93 columns—debit, credit, and balance. The balance in the account is determined after each transaction. The explanation space and reference columns provide special information about the transaction. The boxed numbers indicate the sequence of the steps. The numbers in the “Ref.” column of the general journal refer to the ledger accounts to which a company posts the respective items. For example, the “101” placed in the column to the right of “Cash” indicates that the company posted this $15,000 item to Account No. 101 in the ledger. The posting of the general journal is completed when a company records all of the posting reference numbers opposite the account titles in the journal. Thus, the number in the posting reference column serves two purposes. (1) It indicates the ledger account number of the account involved. (2) It indicates the completion of posting for the par- ticular item. Each company selects its own numbering system for its ledger accounts. Many begin numbering with asset accounts and then follow with liabilities, owners’ equity, revenue, and expense accounts, in that order. The ledger accounts in Illustration 3-8 show the accounts after completion of the posting process. The reference J1 (General Journal, page 1) indicates the source of the data transferred to the ledger account. An Expanded Example To show an expanded example of the basic steps in the recording process, we use the October transactions of Pioneer Advertising Agency Inc. Pioneer’s accounting period is a month. Illustrations 3-9 through 3-18 show the journal entry and posting of each trans- action. For simplicity, we use a T-account form instead of the standard account form. Study the transaction analyses carefully. The purpose of transaction analysis is (1) to identify the type of account involved, and (2) to determine whether a debit or a credit is required. You should always perform this type of analysis before preparing a journal entry. Doing so will help you understand the journal entries discussed in this chapter as well as more complex journal entries in later chapters. Keep in mind that every journal entry affects one or more of the follow- ing items: assets, liabilities, stockholders’ equity, revenues, or expenses. 1. October 1: Stockholders invest $100,000 cash in an advertising venture to be known as Pioneer Advertising Agency Inc. ILLUSTRATION 3-9 Investment of Cash by Journal Oct. 1 Cash 101100,000 Entry Common Stock 311 100,000 Stockholders (Issued shares of stock for cash) Cash 101 Common Stock 311 Posting Oct. 1 100,000 Oct. 1 100,000 2. October 1: Pioneer Advertising purchases offi ce equipment costing $50,000 by sign- ing a 3-month, 12%, $50,000 note payable. ILLUSTRATION 3-10 Purchase of Offi ce Journal Oct. 1 Equipment 157 50,000 Entry Notes Payable 200 50,000 Equipment (Issued 3-month, 12% note for office equipment) Equipment 157 Notes Payable 200 Posting Oct. 1 50,000 Oct. 1 50,000 94 Chapter 3 The Accounting Information System 3. October 2: Pioneer Advertising receives a $12,000 cash advance from R. Knox, a

client, for advertising services that are expected to be completed by December 31. ILLUSTRATION 3-11 Receipt of Cash for Journal Oct. 2 Cash 10112,000 Future Service Entry Unearned Service Revenue 209 12,000 (Received cash from R. Knox for future service) Cash 101 Unearned Service Revenue 209 Posting Oct. 1 100,000 Oct. 2 12,000 2 12,000 4. October 3: Pioneer Advertising pays $9,000 offi ce rent, in cash, for October. ILLUSTRATION 3-12 Payment of Monthly Rent Journal Oct. 3 Rent Expense 729 9,000 Entry Cash 101 9,000 (Paid October rent) Cash 101 Rent Expense 729 Posting Oct.1 100,000 Oct. 3 9,000 Oct. 3 9,000 2 12,000 5. October 4: Pioneer Advertising pays $6,000 for a one-year insurance policy that will expire next year on September 30. ILLUSTRATION 3-13 Payment for Insurance Journal Oct. 4 Prepaid Insurance 130 6,000 Entry Cash 101 6,000 (Paid one-year policy; effective date October 1) Cash 101 Prepaid Insurance 130 Posting Oct.1 100,000Oct. 3 9,000 Oct. 4 6,000 2 12,000 4 6,000 6. October 5: Pioneer Advertising purchases, for $25,000 on account, an estimated 3-month supply of advertising materials from Aero Supply. ILLUSTRATION 3-14 Purchase of Supplies on Journal Oct. 5 Supplies 126 25,000 Account Entry Accounts Payable 201 25,000 (Purchased supplies on account from Aero Supply) Supplies 126 Accounts Payable 201 Posting Oct. 5 25,000 Oct. 5 25,000 7. October 9: Pioneer Advertising signs a contract with a local newspaper for advertis- ing inserts (fl yers) to be distributed starting the last Sunday in November. Pioneer The Accounting Cycle 95 will start work on the content of the fl yers in November. Payment of $7,000 is due following delivery of the Sunday papers containing the fl yers. ILLUSTRATION 3-15 A business transaction has not occurred. There is only an agreement between Pioneer Advertising and the newspaper for the services to Signing a Contract be performed in November. Therefore, no journal entry is necessary in October. 8. October 20: Pioneer Advertising’s board of directors declares and pays a $5,000 cash dividend to stockholders. ILLUSTRATION 3-16 Declaration and Payment Journal Oct. 20 Dividends 332 5,000 Entry Cash 101 5,000 of Dividend by (Declared and paid a Corporation cash dividend) Cash 101 Dividends 332 Posting Oct.1 100,000 Oct. 3 9,000 Oct. 20 5,000 2 12,000 4 6,000 20 5,000 9. October 26: Pioneer Advertising pays employee salaries and wages in cash. Employees are paid once a month, every four weeks. The total payroll is $10,000 per week, or $2,000 per day. In October, the pay period began on Monday, October 1. As a result, the pay period ended on Friday, October 26, with salaries and wages of $40,000 being paid. ILLUSTRATION 3-17 Payment of Salaries and Journal Oct. 26 Salaries and Wages Expense 72640,000 Entry Cash 101 40,000 Wages (Paid salaries to date) Cash 101 Salaries and Wages Expense 726 Oct.1 100,000 Oct.3 9,000 Oct.26 40,000 Posting 2 12,000 4 6,000 20 5,000 26 40,000 10. October 31: Pioneer Advertising receives $28,000 in cash and bills Copa Company ILLUSTRATION 3-18 $72,000 for advertising services of $100,000 performed in October. Recognize Revenue for Services Performed Oct. 31 Cash 101 28,000 Journal Accounts Receivable 112 72,000 Entry Service Revenue 400 100,000 (Recognize revenue for services performed) Cash 101 Accounts Receivable 112 Service Revenue 400 Oct.1 100,000 Oct.3 9,000 Oct. 31 72,000 Oct. 31 100,000 Posting 2 12,000 4 6,000 31 28,000 20 5,000 26 40,000 96 Chapter 3 The Accounting Information System Trial Balance A trial balance is a list of accounts and their balances at a given time. A company usually prepares a trial balance at the end of an accounting period. The trial balance lists the ac- counts in the order in which they appear in the ledger, with debit balances listed in the left column and credit balances in the right column. The totals of the two columns must agree. The trial balance proves the mathematical equality of debits and credits after post- ing. Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. A trial balance also

uncovers errors in journalizing and posting. In addition, it is useful in the preparation of financial statements. The procedures for preparing a trial balance consist of: 1. List the account titles and their balances in the appropriate debit or credit column. 2. Total the debit and credit columns. 3. Prove the equality of the two columns. Illustration 3-19 presents the trial balance prepared from the ledger of Pioneer Advertis- ing Agency Inc. Note that the total debits ($287,000) equal the total credits ($287,000). A trial balance also often shows account numbers to the left of the account titles. ILLUSTRATION 3-19 PIONEER ADVERTISING AGENCY INC. Trial Balance TRIAL BALANCE (Unadjusted) OCTOBER 31, 2014 Debit Credit Cash $ 80,000 Accounts Receivable 72,000 Supplies 25,000 Prepaid Insurance 6,000 Equipment 50,000 Notes Payable $ 50,000 Accounts Payable 25,000 Unearned Service Revenue 12,000 Common Stock 100,000 Dividends 5,000 Service Revenue 100,000 Salaries and Wages Expense 40,000 Rent Expense 9,000 $287,000 $287,000 A trial balance does not prove that a company recorded all transactions or that the ledger is correct. Numerous errors may exist even though the trial balance columns agree. For example, the trial balance may balance even when a company (1) fails to jour- nalize a transaction, (2) omits posting a correct journal entry, (3) posts a journal entry twice, (4) uses incorrect accounts in journalizing or posting, or (5) makes offsetting errors in recording the amount of a transaction. In other words, as long as a company posts equal debits and credits, even to the wrong account or in the wrong amount, the total debits will equal the total credits. Adjusting Entries LEARNING OBJECTIVE 5 Explain the reasons for preparing In order for revenues to be recorded in the period in which services are performed adjusting entries and identify major and for expenses to be recognized in the period in which they are incurred, compa- types of adjusting entries. nies make adjusting entries. In short, adjustments ensure that a company like McDonald’s follows the revenue recognition and expense recognition principles. The Accounting Cycle 97 The use of adjusting entries makes it possible to report on the balance sheet the appropriate assets, liabilities, and owners’ equity at the statement date. Adjusting entries also make it possible to report on the income statement the proper revenues and expenses for the period. However, the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This occurs for the following reasons. 1. Some events are not recorded daily because it is not effi cient to do so. Examples are the use of supplies and the earning of wages by employees. 2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transac- tions. Examples of such costs are building and equipment depreciation and rent and insurance. 3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period. Adjusting entries are required every time a company, such as Coca-Cola, prepares financial statements. At that time, Coca-Cola must analyze each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. The analysis requires a thorough understanding of Coca-Cola’s operations and the interrelationship of accounts. Because of this involved process, usually a skilled accountant prepares the adjusting entries. In gathering the adjustment data, Coca-Cola may need to make inventory counts of supplies and repair parts. Further, it may prepare supporting schedules of insurance policies, rental agreements, and other contractual commitments. Companies often prepare adjustments after the balance sheet date. How- ever, they date the entries as of the balance sheet date. Types of Adjusting Entries Adjusting entries are classified as either deferrals or accruals. Each of these classes has

two subcategories, as Illustration 3-20 shows. ILLUSTRATION 3-20 Deferrals: Categories of Adjusting 1. Prepaid expenses: Expenses paid in cash before they are used or consumed. Entries 2. Unearned revenues: Cash received before services are performed. Accruals: 1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded. 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded. We review specific examples and explanations of each type of adjustment in sub- sequent sections. We base each example on the October 31 trial balance of Pioneer Advertising Agency Inc. (Illustration 3-19). We assume that Pioneer uses an account- ing period of one month. Thus, Pioneer will make monthly adjusting entries, dated October 31. Adjusting Entries for Deferrals To defer means to postpone or delay. Deferrals are expenses or revenues that are recog- nized at a date later than the point when cash was originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues. 98 Chapter 3 The Accounting Information System If a company does not make an adjustment for these deferrals, the asset and liability are overstated, and the related expense and revenue are understated. For example, in Pioneer’s trial balance (Illustration 3-19), the balance in the asset Supplies shows only supplies purchased. This balance is overstated; the related expense account, Supplies Expense, is understated because the cost of supplies used has not been recognized. Thus, the adjusting entry for deferrals will decrease a balance sheet account and in- crease an income statement account. Illustration 3-21 shows the effects of adjusting entries for deferrals. ILLUSTRATION 3-21 Adjusting Entries for Deferrals ADJUSTING ENTRIES Prepaid Expenses Asset Expense Unadjusted Credit Debit Balance Adjusting Adjusting Entry (–) Entry (+) Unearned Revenues Liability Revenue Debit Unadjusted Credit Adjusting Balance Adjusting Entry (–) Entry (+) Prepaid Expenses. Assets paid for and recorded before a company uses them are called prepaid expenses. When expenses are prepaid, a company debits an asset account to show the service or benefit it will receive in the future. Examples of common prepay- ments are insurance, supplies, advertising, and rent. In addition, companies make pre- payments when they purchase buildings and equipment. Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use and consumption (e.g., supplies). The expiration of these costs does not require daily entries, an unnecessary and impractical task. Accordingly, a company like Walgreens usually postpones the recognition of such cost expirations until it prepares financial statements. At each statement date, Walgreens makes adjust- ing entries to record the expenses that apply to the current accounting period and to show the remaining amounts in the asset accounts. As shown above, prior to adjustment, assets are overstated and expenses are under- stated. Thus, an adjusting entry for prepaid expenses results in a debit to an expense account and a credit to an asset account. Supplies. A business may use several different types of supplies. For example, a CPA firm will use office supplies such as stationery, envelopes, and accounting paper. An The Accounting Cycle 99 advertising firm will stock advertising supplies such as graph paper, video film, and Supplies poster paper. Supplies are generally debited to an asset account when they are acquired. Recognition of supplies used is generally deferred until the adjustment process. At that Oct. 5 time, a physical inventory (count) of supplies is taken. The difference between the balance in the Supplies (asset) account and the cost of supplies on hand represents the supplies used (an expense) for the period. Supplies purchased; For example, Pioneer Advertising purchased advertising supplies costing $25,000 record asset on October 5. Pioneer therefore debited the asset Supplies. This account shows a balance of $25,000 in the October 31 trial balance (see Illustration 3-19 on page 96). An inventory

count at the close of business on October 31 reveals that $10,000 of supplies are still on hand. Thus, the cost of supplies used is $15,000 ($25,000 2 $10,000). The analysis and adjustment for advertising supplies is summarized in Illustration 3-22. Oct. 31 Supplies used; Basic The expense Supplies Expense is increased $15,000, and the asset record supplies expense Analysis Supplies is decreased $15,000. Assets = Liabilities + Stockholders’ Equity Equation (1) Supplies Supplies Expense Analysis = –$15,000 –$15,000 Debit–Credit Debits increase expenses: debit Supplies Expense $15,000. Analysis Credits decrease assets: credit Supplies $15,000. A = L + SE Journal Oct. 31 Supplies Expense 15,000 215,000 Entry Supplies 15,000 215,000 (To record supplies used) Cash Flows no effect Supplies Supplies Expense Posting Oct. 5 25,000 Oct. 31 Adj. 15,000 Oct. 31 Adj. 15,000 Oct. 31 Bal. 10,000 Oct. 31 Bal. 15,000 ILLUSTRATION 3-22 Adjustment for Supplies After adjustment, the asset account Supplies shows a balance of $10,000, which equals the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of $15,000, which equals the cost of supplies used in October. Without an adjusting entry, October expenses are understated and net income overstated by Insurance $15,000. Moreover, both assets and stockholders’ equity are overstated by $15,000 on Oct. 1 the October 31 balance sheet. Insurance. Most companies maintain fire and theft insurance on merchandise and equip- FIRE I 1N S yeU aR rANCE insurance policy ment, personal liability insurance for accidents suffered by customers, and automobile $6,000 insurance on company cars and trucks. The extent of protection against loss determines Insurance purchased; the cost of the insurance (the amount of the premium to be paid). The insurance policy record asset specifies the term and coverage. The minimum term usually covers one year, but three- Insurance Policy to five-year terms are available and may offer lower annual premiums. A company usu- Oct Nov Dec Jan $500 $500 $500 $500 ally debits insurance premiums to the asset account Prepaid Insurance when paid. At Feb March April May the financial statement date, it then debits Insurance Expense and credits Prepaid Insur- $500 $500 $500 $500 ance for the cost that expired during the period. June July Aug Sept $500 $500 $500 $500 For example, on October 4, Pioneer Advertising paid $6,000 for a one-year fire in- 1 YEAR $6,000 surance policy. Coverage began on October 1. Pioneer debited the cost of the premium to Prepaid Insurance at that time. This account still shows a balance of $6,000 in the Oct. 31 Insurance expired; October 31 trial balance. The analysis and adjustment for insurance is summarized in record insurance expense. Illustration 3-23 (page 100). 100 Chapter 3 The Accounting Information System ILLUSTRATION 3-23 Adjustment for Insurance Basic The expense Insurance Expense is increased $500, and the asset Analysis Prepaid Insurance is decreased $500. Assets = Liabilities + Stockholders’ Equity Equation (2) Prepaid Insurance Insurance Expense EAqnuaaltyiosins = Analysis !$500 !$500 Debit–Credit Debits increase expenses: debit Insurance Expense $500. Analysis Credits decrease assets: credit Prepaid Insurance $500. A = L + SE 2500 Journal Oct. 31 Insurance Expense 500 2500 Entry Prepaid Insurance 500 (To record insurance expired) Cash Flows no effect Prepaid Insurance Insurance Expense Posting Oct. 4 6,000 Oct. 31 Adj. 500 Oct. 31 Adj. 500 Oct. 31 Bal. 5,500 Oct. 31 Bal. 500 The asset Prepaid Insurance shows a balance of $5,500, which represents the unex- pired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. Without an ad- justing entry, October expenses are understated by $500 and net income overstated by $500. Moreover, both assets and stockholders’ equity also are overstated by $500 on the October 31 balance sheet. Depreciation. Companies like Caterpillar or Boeing typically own various productive

facilities, such as buildings, equipment, and motor vehicles. These assets provide a ser- vice for a number of years. The term of service is commonly referred to as the useful life of the asset. Because Caterpillar, for example, expects an asset such as a building to pro- vide service for many years, Caterpillar records the building as an asset, rather than an expense, in the year the building is acquired. Caterpillar records such assets at cost, as required by the historical cost principle. Depreciation To follow the expense recognition principle, Caterpillar reports a portion of the cost Oct. 2 of a long-lived asset as an expense during each period of the asset’s useful life. Depre- ciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. Need for depreciation adjustment. Generally accepted accounting principles (GAAP) view Equipment purchased; record asset the acquisition of productive facilities as a long-term prepayment for services. The need for making periodic adjusting entries for depreciation is, therefore, the same as we de- Equipment scribed for other prepaid expenses. That is, a company recognizes the expired cost (ex- Oct Nov Dec Jan $400 $400 $400 $400 pense) during the period and reports the unexpired cost (asset) at the end of the period. Feb March April May The primary causes of depreciation of a productive facility are actual use, deterioration $400 $400 $400 $400 due to the elements, and obsolescence. For example, at the time Caterpillar acquires an June July Aug Sept $400 $400 $400 $400 asset, the effects of these factors cannot be known with certainty. Therefore, Caterpillar Depreciation = $4,800/ must estimate them. Thus, depreciation is an estimate rather than a factual measurement year of the expired cost. Oct. 31 To estimate depreciation expense, Caterpillar often divides the cost of the asset by Depreciation recognized; its useful life. For example, if Caterpillar purchases equipment for $10,000 and expects record depreciation expense its useful life to be 10 years, Caterpillar records annual depreciation of $1,000. The Accounting Cycle 101 In the case of Pioneer Advertising, it estimates depreciation on its office equipment to be $4,800 a year (cost $50,000 less salvage value $2,000 divided by useful life of 10 years), or $400 per month. The analysis and adjustment for depreciation is summa- rized in Illustration 3-24. ILLUSTRATION 3-24 Basic The expense Depreciation Expense is increased $400, and the contra asset Adjustment for Analysis Accumulated Depreciation—Equipment is increased $400. Depreciation Assets = Liabilities + Stockholders’ Equity Equation Accumulated Analysis Depreciation—Equipment Depreciation Expense = !$400 !$400 Debits increase expenses: debit Depreciation Expense $400. Debit–Credit Credits increase contra assets: credit Accumulated Analysis Depreciation—Equipment $400. A = L + SE Oct. 31 Depreciation Expense 400 2400 Journal Accumulated Depreciation— 400 2400 Entry Equipment (To record monthly Cash Flows depreciation) no effect Equipment Oct. 2 50,000 Oct.31 Bal. 50,000 Posting Accumulated Depreciation—Equipment Depreciation Expense Oct. 31 Adj. 400 Oct. 31 Adj. 400 Oct. 31 Bal. 400 Oct. 31 Bal. 400 The balance in the Accumulated Depreciation—Equipment account will increase $400 each month. Therefore, after recording and posting the adjusting entry at November 30, the balance will be $800. Statement presentation. Accumulated Depreciation—Equipment is a contra asset account. A contra asset account offsets an asset account on the balance sheet. This means that the Accumulated Depreciation—Equipment account offsets the Equipment account on the balance sheet. Its normal balance is a credit. Pioneer uses this account instead of credit- ing Equipment in order to disclose both the original cost of the equipment and the total expired cost to date. In the balance sheet, Pioneer deducts Accumulated Depreciation— Equipment from the related asset account as follows. ILLUSTRATION 3-25 Equipment $50,000

Balance Sheet Less: Accumulated depreciation—equipment 400 $49,600 Presentation of Accumulated Depreciation The book value of any depreciable asset is the difference between its cost and its related accumulated depreciation. In Illustration 3-25, the book value of the equipment at the balance sheet date is $49,600. Note that the asset’s book value generally differs from its fair value. The reason: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset’s cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset. 102 Chapter 3 The Accounting Information System Depreciation expense identifies that portion of the asset’s cost that expired during the period (in this case, October). Without this adjusting entry, total assets, total stockholders’ equity, and net income are overstated, and depreciation expense is understated. A company records depreciation expense for each piece of equipment, such as trucks or machinery, and for all buildings. A company also establishes related accu- mulated depreciation accounts for the above, such as Accumulated Depreciation— Trucks, Accumulated Depreciation—Machinery, and Accumulated Depreciation— Buildings. Unearned Revenues. When companies receive cash before services are performed, they Unearned Revenues record a liability by increasing (crediting) a liability account called unearned revenues. Oct. 2 Thank you In other words, a company now has a performance obligation (liability) to provide ser- in advance for vice to one its customers. Items like rent, magazine subscriptions, and customer deposits your work for future service may result in unearned revenues. Airlines, such as Delta, American, I will finish by Dec. 31 and Southwest, treat receipts from the sale of tickets as unearned revenue until they provide the flight service. Tuition received prior to the start of a semester is another $12,000 example of unearned revenue. Unearned revenues are the opposite of prepaid expenses. Indeed, unearned reve- Cash is received in advance; nue on the books of one company is likely to be a prepayment on the books of the liability is recorded company that made the advance payment. For example, if we assume identical accounting periods, a landlord will have unearned rent revenue when a tenant has prepaid rent. When a company such as Intel receives payment for services to be performed in a future accounting period, it credits an unearned revenue (a liability) account to recog- Oct. 31 nize the liability that exists. Intel subsequently recognizes revenue when it performs Some service has been the service. However, making daily entries to record this revenue is impractical. Instead, performed; some revenue Intel delays recognition of revenue until the adjustment process. Then, Intel makes an is recorded adjusting entry to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period. In the typical case, liabilities are overstated and revenues are understated prior to adjustment. Thus, the adjusting entry for unearned revenues results in a debit (decrease) to a liability account and a credit (increase) to a revenue account. For example, Pioneer Advertising received $12,000 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of $12,000 in the October 31 trial balance. Based on an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recog- nize $4,000 of revenue in October. The liability (Unearned Service Revenue) is there- fore decreased and stockholders’ equity (Service Revenue) is increased, as shown in Illustration 3-26. The liability Unearned Service Revenue now shows a balance of $8,000. This amount represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue recognized in October of

$104,000. Without this adjustment, revenues and net income are understated by $4,000 in the income statement. Moreover, liabilities will be overstated and stockholders’ equity will be understated by $4,000 on the October 31 balance sheet. Adjusting Entries for Accruals The second category of adjusting entries is accruals. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the cur- rent accounting period. Without an accrual adjustment, the revenue account (and the The Accounting Cycle 103 ILLUSTRATION 3-26 Basic The liability Unearned Service Revenue is decreased $4,000, and the revenue Adjustment for Analysis Service Revenue is increased $4,000. Unearned Service Revenue Assets = Liabilities + Stockholders’ Equity Equation Unearned Analysis Service Revenue Service Revenue !$4,000 "$4,000 Debit–Credit Debits decrease liabilities: debit Unearned Service Revenue $4,000. Analysis Credits increase revenues: credit Service Revenue $4,000. A = L + SE Journal Oct. 31 Unearned Service Revenue 4,000 24,000 Entry Service Revenue 4,000 14,000 (To record revenue for services Cash Flows performed) no effect Unearned Service Revenue Service Revenue Posting Oct. 31 Adj. 4,000 O c t. 2 12,000 O ct. 3 3 1 A d j . 1 0 40 ,, 00 00 00 Oct.31 Bal. 8,000 Oct. 31 Bal. 104,000 related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an income statement account. Illustration 3-27 shows adjusting entries for accruals. ILLUSTRATION 3-27 Adjusting Entries for ADJUSTING ENTRIES Accruals Accrued Revenues Asset Revenue Debit Credit Adjusting Adjusting Entry (+) Entry (+) Accrued Expenses Expense Liability Debit Credit Adjusting Adjusting Entry (+) Entry (+) Accrued Revenues. Revenues for services performed but not yet recorded at the state- ment date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Companies do not record interest 104 Chapter 3 The Accounting Information System revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been performed and the clients will not be billed until the service has been completed. Accrued Revenues An adjusting entry records the receivable that exists at the balance sheet date and the revenue for the services performed during the period. Prior to adjustment, both My fee assets and revenues are understated. Accordingly, an adjusting entry for accrued reve- is $2,000 nues results in a debit (increase) to an asset account and a credit (increase) to a revenue account. In October, Pioneer Advertising performed services worth $2,000 that were not billed to clients on or before October 31. Because these services are not billed, they are Revenue and receivable not recorded. The accrual of unrecorded service revenue increases an asset account, are recorded for Accounts Receivable. It also increases stockholders’ equity by increasing a revenue unbilled services account, Service Revenue, as shown in Illustration 3-28. ILLUSTRATION 3-28 Accrual Adjustment for Basic The asset Accounts Receivable is increased $2,000, and the revenue Service Receivable and Revenue Analysis Revenue is increased $2,000. Accounts Assets = Liabilities + Stockholders’ Equity Equation Accounts Analysis Receivable Service Revenue = !$2,000 !$2,000 Debit–Credit Debits increase assets: debit Accounts Receivable $2,000. Analysis Credits increase revenues: credit Service Revenue $2,000. A = L + SE 12,000 Journal Oct. 31 Accounts Receivable 2,000 12,000 Entry Service Revenue 2,000 (To record revenue for services performed) Cash Flows no effect Accounts Receivable Service Revenue Oct. 1 72,000 Oct. 3 100,000

Posting 31 4,000 31 Adj. 2,000 31 Adj. 2,000 Oct. 31 Bal. 74,000 Oct. 31 Bal. 106,000 The asset Accounts Receivable shows that clients owe $74,000 at the balance sheet date. The balance of $106,000 in Service Revenue represents the total revenue for ser- vices performed by Pioneer during the month ($100,000 1 $4,000 1 $2,000). Without an adjusting entry, assets and stockholders’ equity on the balance sheet, and revenues and net income on the income statement, are understated. Accrued Expenses. Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, rent, taxes, and salaries are common examples. Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company. For example, the $2,000 accrual of service revenue by Pioneer is an accrued expense to the client that received the service. Adjustments for accrued expenses record the obligations that exist at the balance sheet date and recognize the expenses that apply to the current accounting period. Prior The Accounting Cycle 105 to adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for accrued expenses results in a debit (increase) to an expense account and a credit (increase) to a liability account. Accrued interest. Pioneer Advertising signed a three-month note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 percent. Three factors determine the amount of the interest accumulation: (1) the face value of the note; (2) the interest rate, which is always expressed as an annual rate; and (3) the length of time the note is outstanding. For Pioneer, the total interest due on the $50,000 note at its maturity date three months’ in the future is $1,500 ($50,000 3 12% 3 3/12), or $500 for one month. Illustration 3-29 shows the formula for computing interest and its application to Pioneer. Note that the formula expresses the time period as a fraction of a year. ILLUSTRATION 3-29 Formula for Computing Annual Time Interest Face Value x Interest x in Terms of = Interest of Note Rate One Year $50,000 x 12% x 1/12 = $500 As Illustration 3-30 shows, the accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases stockholders’ equity by increasing an expense account, Interest Expense. ILLUSTRATION 3-30 Basic The expense Interest Expense is increased $500, and the liability Interest Adjustment for Interest Analysis Payable is increased $500. Assets = Liabilities + Stockholders’ Equity Equation Interest Payable Interest Expense Analysis !$500 "$500 Debit–Credit Debits increase expenses: debit Interest Expense $500. Analysis Credits increase liabilities: credit Interest Payable $500. A = L + SE Journal Oct. 31 Interest Expense 500 2500 Entry Interest Payable 500 1500 (To record interest on notes payable) Cash Flows no effect Interest Expense Interest Payable Posting Oct. 31 Adj. 500 Oct. 31 Adj. 500 Oct. 31 Bal. 500 Oct. 31 Bal. 500 Interest Expense shows the interest charges for the month of October. Interest Pay- able shows the amount of interest owed at the statement date. Pioneer will not pay this amount until the note comes due at the end of three months. Why does Pioneer use the 106 Chapter 3 The Accounting Information System Interest Payable account instead of crediting Notes Payable? By recording interest payable separately, Pioneer discloses the two different types of obligations—interest and principal—in the accounts and statements. Without this adjusting entry, liabilities and interest expense are understated, and both net income and stockholders’ equity are overstated. Accrued salaries and wages. Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. For example, Pioneer Advertising last paid salaries and wages on October 26. It will not pay salaries and wages again until November 23. However, as shown in the calendar below, three work-

ing days remain in October (October 29–31). October November S M Tu W Th F S S M Tu W Th F S Start of 1 2 3 4 5 6 1 2 3 pay period 7 8 9 10 11 12 13 4 5 6 7 8 9 10 14 15 16 17 18 19 20 11 12 13 14 15 16 17 21 22 23 24 25 26 27 18 19 20 21 22 23 24 28 29 30 31 25 26 27 28 29 30 Adjustment period Payday Payday At October 31, the salaries and wages for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and wages of $10,000 for a five-day work week, or $2,000 per day. Thus, accrued salaries and wages at October 31 are $6,000 ($2,000 3 3). The analysis and adjustment process is summarized in Illustration 3-31. ILLUSTRATION 3-31 Adjustment for Salaries Basic The expense Salaries and Wages Expense is increased $6,000, and the liability and Wages Expense Analysis account Salaries and Wages Payable is increased $6,000. Assets = Liabilities + Stockholders’ Equity Equation Salaries and Wages Payable Salaries and Wages Expense Analysis !$6,000 "$6,000 Debit–Credit Debits increase expenses: debit Salaries and Wages Expense $6,000. Analysis Credits increase liabilities: credit Salaries and Wages Payable $6,000. A = L + SE 26,000 Journal Oct. 31 Salaries and Wages Expense 6,000 16,000 Entry Salaries and Wages Payable 6,000 (To record accrued salaries) Cash Flows no effect Salaries and Wages Expense Salaries and Wages Payable Oct. 26 40,000 Oct. 31 Adj. 6,000 Posting 31 Adj. 6,000 Oct. 31 Bal. 46,000 Oct.31 Bal. 6,000 The Accounting Cycle 107 After this adjustment, the balance in Salaries and Wages Expense of $46,000 (23 days 3 $2,000) is the actual salaries and wages expense for October. The balance in Salaries and Wages Payable of $6,000 is the amount of the liability for salaries and wages owed as of October 31. Without the $6,000 adjustment for salaries, both Pioneer’s expenses and liabilities are understated by $6,000. Pioneer pays salaries and wages every four weeks. Consequently, the next payday is November 23, when it will again pay total salaries and wages of $40,000. The payment consists of $6,000 of salaries and wages payable at October 31 plus $34,000 of salaries and wages expense for November (17 working days as shown in the November calen- dar 3 $2,000). Therefore, Pioneer makes the following entry on November 23. Nov. 23 A = L + SE Salaries and Wages Payable 6,000 26,000 Salaries and Wages Expense 34,000 234,000 Cash 40,000 240,000 (To record November 23 payroll) Cash Flows 240,000 This entry eliminates the liability for Salaries and Wages Payable that Pioneer recorded in the October 31 adjusting entry. This entry also records the proper amount of Salaries and Wages Expense for the period between November 1 and November 23. What do the numbers mean? AM I COVERED? Rather than purchasing insurance to cover casualty losses However, Almost Family ran into accounting problems when and other obligations, some companies “self-insure.” That is, a it failed to record an accrual of the liability for benefi ts not company decides to pay for any possible claims, as they arise, covered by its back-up insurance policy. This led to restate- out of its own resources. The company also purchases an in- ment of Almost Family’s fi scal results for the accrual of the surance policy to cover losses that exceed certain amounts. benefi t expense. For example, Almost Family, Inc., a healthcare services company, has a self-insured employee health-benefi t program. Bad debts. Proper recognition of revenues and expenses dictates recording bad debts as Bad Debts an expense of the period in which a company recognizes revenue for services performed instead of the period in which the company writes off the accounts or notes. The proper valuation of the receivable balance also requires recognition of uncollectible receivables. Proper recognition and valuation require an adjusting entry. At the end of each period, a company such as General Mills estimates the amount of receivables that will later prove to be uncollectible. General Mills bases the estimate on various factors: the amount of bad debts it experienced in past years, general eco- Oct. 31

nomic conditions, how long the receivables are past due, and other factors that indi- Uncollectible accounts; cate the extent of uncollectibility. To illustrate, assume that, based on past experience, record bad debt expense Pioneer Advertising reasonably estimates a bad debt expense for the month of $1,600. The analysis and adjustment process for bad debts is summarized in Illustration 3-32 (page 108). 108 Chapter 3 The Accounting Information System ILLUSTRATION 3-32 Adjustment for Bad Debt Basic The expense Bad Debt Expense is increased $1,600, and the contra asset Expense Analysis Allowance for Doubtful Accounts is increased $1,600. Assets = Liabilities + Stockholders’ Equity Equation Allowance for Doubtful Analysis Accounts Bad Debt Expense = !$1,600 !$1,600 Debit–Credit Debits increase expenses: debit Bad Debt Expense $1,600. Credits increase contra assets: credit Allowance for Doubtful Analysis Accounts $1,600. A = L + SE 21,600 Oct. 31 Bad Debt Expense 1,600 21,600 Journal Allowance for Doubtful 1,600 Entry Accounts Cash Flows (To record monthly bad debt expense) no effect Accounts Receivable Oct. 2 72,000 31 2,000 Posting Oct.31 Bal. 74,000 Allowance for Doubtful Accounts Bad Debt Expense Oct. 31 Adj. 1,600 Oct. 31 Adj. 1,600 Oct. 31 Bal. 1,600 Oct. 31 Bal. 1,600 A company often expresses bad debts as a percentage of the revenue on account for the period. Or, a company may compute bad debts by adjusting Allowance for Doubtful Accounts to a certain percentage of the trade accounts receivable and trade notes receivable at the end of the period. Adjusted Trial Balance After journalizing and posting all adjusting entries, Pioneer Advertising prepares another trial balance from its ledger accounts (shown in Illustration 3-33 on page 109). This trial balance is called an adjusted trial balance. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements. Preparing Financial Statements As indicated above, Pioneer Advertising can prepare financial statements LEARNING OBJECTIVE 6 directly from the adjusted trial balance. Illustrations 3-34 (page 109) and 3-35 Prepare financial statements from (page 110) show the interrelationships of data in the adjusted trial balance and the the adjusted trial balance. financial statements. As Illustration 3-34 shows, Pioneer prepares the income statement from the revenue and expense accounts. Next, it derives the retained earnings statement from the retained earnings and dividends accounts and the net income (or net loss) shown in the income statement. ILLUSTRATION 3-33 PIONEER ADVERTISING AGENCY INC. Adjusted Trial Balance ADJUSTED TRIAL BALANCE OCTOBER 31, 2014 Debit Credit Cash $ 80,000 Accounts Receivable 74,000 Allowance for Doubtful Accounts $ 1,600 Supplies 10,000 Prepaid Insurance 5,500 Equipment 50,000 Accumulated Depreciation—Equipment 400 Notes Payable 50,000 Accounts Payable 25,000 Interest Payable 500 Unearned Service Revenue 8,000 Salaries and Wages Payable 6,000 Common Stock 100,000 Dividends 5,000 Service Revenue 106,000 Salaries and Wages Expense 46,000 Supplies Expense 15,000 Rent Expense 9,000 Insurance Expense 500 ILLUSTRATION 3-34 Interest Expense 500 Preparation of the Depreciation Expense 400 Income Statement and Bad Debt Expense 1,600 Retained Earnings $297,500 $297,500 Statement from the Adjusted Trial Balance PIONEER ADVERTISING AGENCY INC. ADJUSTED TRIAL BALANCE PIONEER ADVERTISING AGENCY INC. OCTOBER 31, 2014 INCOME STATEMENT Account Debit Credit FOR THE MONTH ENDED OCTOBER 31, 2014 Cash $80,000 Accounts Receivable 74,000 Revenues Allowance for Doubtful Accounts $ 1,600 Service revenue $106,000 Supplies 10,000 Prepaid Insurance 5,500 Expenses Equipment 50,000 Salaries and wages expense $46,000 Accumulated Depreciation— Supplies expense 15,000 Equipment 400 Rent expense 9,000 Notes Payable 50,000 Insurance expense 500

Accounts Payable 25,000 Interest expense 500 Unearned Service Revenue 8,000 Depreciation expense 400 Salaries and Wages Payable 6,000 Bad debt expense 1,600 Interest Payable 500 Total expenses 73,000 Common Stock 100,000 Net income $ 33,000 Retained Earnings –0– Dividends 5,000 Service Revenue 106,000 Salaries and Wages Expense 46,000 Supplies Expense 15,000 Rent Expense 9,000 Insurance Expense 500 PIONEER ADVERTISING AGENCY INC. Interest Expense 500 RETAINED EARNINGS STATEMENT Depreciation Expense 400 FOR THE MONTH ENDED OCTOBER 31, 2014 Bad Debt Expense 1,600 $297,500 $297,500 Retained earnings, October 1 $ –0– Add: Net income 33,000 33,000 Less: Dividends 5,000 Retained earnings, October 31 $28,000 To balance sheet 110 Chapter 3 The Accounting Information System As Illustration 3-35 shows, Pioneer then prepares the balance sheet from the asset and liability accounts, the common stock account, and the ending retained earnings balance as reported in the retained earnings statement. PIONEER ADVERTISING AGENCY INC. PIONEER ADVERTISING AGENCY INC. ADJUSTED TRIAL BALANCE BALANCE SHEET OCTOBER 31, 2014 OCTOBER 31, 2014 Assets Account Debit Credit Cash $ 80,000 Cash $80,000 Accounts receivable $74,000 Accounts Receivable 74,000 Less: Allowance for doubtful accounts 1,600 72,400 Allowance for Doubtful Accounts $ 1,600 Supplies 10,000 Supplies 10,000 Prepaid insurance 5,500 Prepaid Insurance 5,500 Equipment 50,000 Equipment 50,000 Less: Accumulated Accumulated Depreciation— depreciation—equipment 400 49,600 Equipment 400 Total assets $217,500 Notes Payable 50,000 Liabilities and Stockholders’ Equity Accounts Payable 25,000 Unearned Service Revenue 8,000 Liabilities Salaries and Wages Payable 6,000 Notes payable $ 50,000 Interest Payable 500 Accounts payable 25,000 Common Stock 100,000 Unearned service revenue 8,000 Retained Earnings –0– Salaries and wages payable 6,000 Dividends 5,000 Interest payable 500 Service Revenue 106,000 Total liabilities 89,500 Salaries and Wages Expense 46,000 Stockholders’ equity Supplies Expense 15,000 Common stock 100,000 Rent Expense 9,000 Retained earnings 28,000 Insurance Expense 500 Total liabilities and Interest Expense 500 stockholders’ equity $217,500 Depreciation Expense 400 Bad Debt Expense 1,600 Balance at Oct. 31 from Retained Earnings $297,500 $297,500 Statement in Illustration 3-34 ILLUSTRATION 3-35 Preparation of the Balance Sheet from the Adjusted Trial Balance What do the numbers mean? 24/7 ACCOUNTING To achieve the vision of “24/7 accounting,” a company Two obstacles typically stand in the way of 24/7 ac- must be able to update revenue, income, and balance sheet counting: having the necessary accounting systems to close numbers every day within the quarter and publish them on the books on a daily basis, and reliability concerns associ- the Internet. Such real-time reporting responds to the de- ated with unaudited real-time data. Only a few companies mand for more timely fi nancial information made available have the necessary accounting capabilities. Cisco Systems, to all investors—not just to analysts with access to company which pioneered the concept of the 24-hour close, is one management. such company. Closing Basic Process The closing process reduces the balance of nominal (temporary) accounts to zero LEARNING OBJECTIVE 7 in order to prepare the accounts for the next period’s transactions. In the closing Prepare closing entries. process, Pioneer Advertising transfers all of the revenue and expense account balances (income statement items) to a clearing or suspense account called Income Summary. The Income Summary account matches revenues and expenses. The Accounting Cycle 111 Pioneer uses this clearing account only at the end of each accounting period. The account represents the net income or net loss for the period. It then transfers this amount (the net income or net loss) to an owners’ equity account. (For a corporation, the owners’ equity account is retained earnings; for proprietorships and partnerships, it is a capital account.) Companies post all such closing entries to the appropriate

general ledger accounts. Closing Entries In practice, companies generally prepare closing entries only at the end of a company’s annual accounting period. However, to illustrate the journalizing and posting of clos- ing entries, we will assume that Pioneer Advertising closes its books monthly. Illustra- tion 3-36 shows the closing entries at October 31. ILLUSTRATION 3-36 GENERAL JOURNAL J3 Closing Entries Date Account Titles and Explanation Debit Credit Journalized Closing Entries (1) Oct. 31 Service Revenue 106,000 Income Summary 106,000 (To close revenue account) (2) 31 Income Summary 73,000 Supplies Expense 15,000 Depreciation Expense 400 Insurance Expense 500 Salaries and Wages Expense 46,000 Rent Expense 9,000 Interest Expense 500 Bad Debt Expense 1,600 (To close expense accounts) (3) 31 Income Summary 33,000 Retained Earnings 33,000 (To close net income to retained earnings) (4) 31 Retained Earnings 5,000 Dividends 5,000 (To close dividends to retained earnings) A couple of cautions about preparing closing entries. (1) Avoid unintentionally doubling the revenue and expense balances rather than zeroing them. (2) Do not close Dividends through the Income Summary account. Dividends are not expenses, and they are not a factor in determining net income. Posting Closing Entries Illustration 3-37 (page 112) shows the posting of closing entries and the underlining (ruling) of accounts. All temporary accounts have zero balances after posting the closing entries. In addition, note that the balance in Retained Earnings represents the accumulated un- distributed earnings of Pioneer at the end of the accounting period. Pioneer reports this 112 Chapter 3 The Accounting Information System Supplies Expense 631 15,000 (2) 15,000 2 Depreciation Expense 711 400 (2) 400 Income Service Summary 350 Revenue 400 Insurance (2) 73,000 (1) 106,000 1 (1) 106,000 100,000 Expense 722 (3) 33,000 4,000 2,000 500 (2) 500 106,000 106,000 106,000 106,000 Salaries and Wages 3 Expense 726 40,000 (2) 46,000 Retained 6,000 Earnings 320 46,000 (4) 5,000 0 (3) 33,000 2 Rent Bal. 28,000 Expense 729 9,000 (2) 9,000 4 Interest Expense 905 Dividends 332 500 (2) 500 5,000 (4) 5,000 Bad Debt Expense 910 Key: 1 Close Revenues to Income Summary. 1,600 (2) 1,600 2 Close Expenses to Income Summary. 3 Close Income Summary to Retained Earnings. 4 Close Dividends to Retained Earnings. ILLUSTRATION 3-37 Posting of Closing Entries amount in the balance sheet as the ending amount reported on the retained earnings statement. As noted above, Pioneer uses the Income Summary account only in closing. It does not journalize and post entries to this account during the year. As part of the closing process, Pioneer totals, balances, and double-underlines the temporary accounts—revenues, expenses, and dividends—as shown in T-account form in Illustration 3-37. It does not close the permanent accounts—assets, liabilities, and stockholders’ equity (Common Stock and Retained Earnings). Instead, Pioneer draws a single underline beneath the current period entries for the permanent accounts. The account balance is then entered below the single underline and is carried forward to the next period (see, for example, Retained Earnings). The Accounting Cycle 113 After the closing process, each income statement account and the dividend account are balanced out to zero and are ready for use in the next accounting period. Post-Closing Trial Balance Recall that a trial balance is prepared after entering the regular transactions of the period, and that a second trial balance (the adjusted trial balance) occurs after posting the adjusting entries. A company may take a third trial balance after posting the closing entries. The trial balance after closing is called the post-closing trial balance. The pur- pose of the post-closing trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent (real)—balance sheet—accounts.

Illustration 3-38 shows the post-closing trial balance of Pioneer Advertising Agency Inc. ILLUSTRATION 3-38 PIONEER ADVERTISING AGENCY INC. Post-Closing Trial POST-CLOSING TRIAL BALANCE Balance OCTOBER 31, 2014 Account Debit Credit Cash $ 80,000 Accounts Receivable 74,000 Allowance for Doubtful Accounts $ 1,600 Supplies 10,000 Prepaid Insurance 5,500 Equipment 50,000 Accumulated Depreciation—Equipment 400 Notes Payable 50,000 Accounts Payable 25,000 Unearned Service Revenue 8,000 Salaries and Wages Payable 6,000 Interest Payable 500 Common Stock 100,000 Retained Earnings 28,000 $219,500 $219,500 A post-closing trial balance provides evidence that the company has properly jour- nalized and posted the closing entries. It also shows that the accounting equation is in balance at the end of the accounting period. However, like the other trial balances, it does not prove that Pioneer has recorded all transactions or that the ledger is correct. For example, the post-closing trial balance will balance if a transaction is not journalized and posted, or if a transaction is journalized and posted twice. Reversing Entries—An Optional Step Some accountants prefer to reverse the effects of certain adjusting entries by making a reversing entry at the beginning of the next accounting period. A reversing entry is the exact opposite of the adjusting entry made in the previous period. Use of revers- ing entries is an optional bookkeeping procedure; it is not a required step in the accounting cycle. Accordingly, we have chosen to cover this topic in Appendix 3B at the end of the chapter. 114 Chapter 3 The Accounting Information System The Accounting Cycle Summarized A summary of the steps in the accounting cycle shows a logical sequence of the account- ing procedures used during a fiscal period: 1. Enter the transactions of the period in appropriate journals. 2. Post from the journals to the ledger (or ledgers). 3. Take an unadjusted trial balance (trial balance). 4. Prepare adjusting journal entries and post to the ledger(s). 5. Take a trial balance after adjusting (adjusted trial balance). 6. Prepare the fi nancial statements from the second trial balance. 7. Prepare closing journal entries and post to the ledger(s). 8. Take a post-closing trial balance (optional). 9. Prepare reversing entries (optional) and post to the ledger(s). A company normally completes all of these steps in every fiscal period. What do the numbers mean? HEY, IT’S COMPLICATED The economic volatility of the past few years has left com- and has been steadily upgrading them over the past decade. panies hungering for more timely and uniform fi nancial Acquisitions can wreak havoc on reporting systems. Best information to help them react quickly to fast-changing Buy is choosy about when to standardize for companies it conditions. As one expert noted, companies were extremely acquires, but it sometimes has to implement new systems focused on trying to reduce costs and plan for the future bet- after international deals. ter, but a lot of them discovered that they didn’t have the in- In other situations, a major overhaul is needed. For ex- formation they needed and they didn’t have the ability to get ample, it is common for companies with a steady stream of that information. The unsteady recession environment also acquisitions to have 50 to 70 general ledger systems. In those made it risky for companies to interrupt their operations to cases, a company cannot react well unless its systems are get new systems up to speed. made compatible. So is it the big bang (major overhaul) or So what to do? Try to piecemeal upgrades each year or the piecemeal approach? It seems to depend. One thing is start a major overhaul of their internal systems? Best Buy, for certain—good accounting systems are a necessity. Without example, has standardized as many of its systems as possible one, the risk of failure is high. Source: Emily Chasan, ”The Financial-Data Dilemma,” Wall Street Journal (July 24, 2012), p. B4. FINANCIAL STATEMENTS FOR A MERCHANDISING COMPANY Pioneer Advertising Agency Inc. is a service company. In this section, we show a

LEARNING OBJECTIVE 8 detailed set of financial statements for a merchandising company, Uptown Cabinet Prepare financial statements for a Corp. The financial statements (see pages 115–116) are prepared from the adjusted merchandising company. trial balance. Income Statement The income statement for Uptown, shown in Illustration 3-39, is self-explanatory. The income statement classifies amounts into such categories as gross profit on sales, income from operations, income before taxes, and net income. Although earnings per share in- formation is required to be shown on the face of the income statement for a corporation, we omit this item here as it will be discussed more fully later in the textbook. For home- work problems, do not present earnings per share information unless required to do so. Financial Statements for a Merchandising Company 115 ILLUSTRATION 3-39 UPTOWN CABINET CORP. Income Statement for a INCOME STATEMENT Merchandising Company FOR THE YEAR ENDED DECEMBER 31, 2014 Net sales $400,000 Cost of goods sold 316,000 Gross profit on sales 84,000 Selling expenses Salaries and wages expense (sales) $20,000 Advertising expense 10,200 Total selling expenses 30,200 Administrative expenses Salaries and wages expense (general) $19,000 Depreciation expense—equipment 6,700 Property tax expense 5,300 Rent expense 4,300 Bad debt expense 1,000 Telephone and Internet expense 600 Insurance expense 360 Total administrative expenses 37,260 Total selling and administrative expenses 67,460 Income from operations 16,540 Other revenues and gains Interest revenue 800 17,340 Other expenses and losses Interest expense 1,700 Income before income taxes 15,640 Income tax 3,440 Net income $ 12,200 Statement of Retained Earnings A corporation may retain the net income earned in the business, or it may distribute it to stockholders by payment of dividends. In Illustration 3-40, Uptown added the net income earned during the year to the balance of retained earnings on January 1, thereby increasing the balance of retained earnings. Deducting dividends of $2,000 results in the ending retained earnings balance of $26,400 on December 31. ILLUSTRATION 3-40 UPTOWN CABINET CORP. Statement of Retained STATEMENT OF RETAINED EARNINGS Earnings for a FOR THE YEAR ENDED DECEMBER 31, 2014 Merchandising Company Retained earnings, January 1 $16,200 Add: Net income 12,200 28,400 Less: Dividends 2,000 Retained earnings, December 31 $26,400 Balance Sheet The balance sheet for Uptown, shown in Illustration 3-41 (page 116), is a classified balance sheet. Interest receivable, inventory, prepaid insurance, and prepaid rent are included as current assets. Uptown considers these assets current because they will be converted into 116 Chapter 3 The Accounting Information System cash or used by the business within a relatively short period of time. Uptown deducts the amount of Allowance for Doubtful Accounts from the total of accounts, notes, and interest receivable because it estimates that only $54,800 of $57,800 will be collected in cash. ILLUSTRATION 3-41 UPTOWN CABINET CORP. Balance Sheet for a BALANCE SHEET Merchandising Company AS OF DECEMBER 31, 2014 Assets Current assets Cash $ 1,200 Notes receivable $16,000 Accounts receivable 41,000 Interest receivable 800 $57,800 Less: Allowance for doubtful accounts 3,000 54,800 Inventory 40,000 Prepaid insurance 540 Prepaid rent 500 Total current assets 97,040 Property, plant, and equipment Equipment 67,000 Less: Accumulated depreciation—equipment 18,700 Total property, plant, and equipment 48,300 Total assets $145,340 Liabilities and Stockholders’ Equity Current liabilities Notes payable $ 20,000 Accounts payable 13,500 Property taxes payable 2,000 Income taxes payable 3,440 Total current liabilities 38,940 Long-term liabilities Bonds payable, due June 30, 2022 30,000 Total liabilities 68,940 Stockholders’ equity Common stock, $5.00 par value, issued and outstanding, 10,000 shares $50,000 Retained earnings 26,400 Total stockholders’ equity 76,400 Total liabilities and stockholders’ equity $145,340 In the property, plant, and equipment section, Uptown deducts the Accumulated

Depreciation—Equipment from the cost of the equipment. The difference represents the book or carrying value of the equipment. The balance sheet shows property taxes payable as a current liability because it is an obligation that is payable within a year. The balance sheet also shows other short-term liabilities such as accounts payable. The bonds payable, due in 2022, are long-term liabilities. As a result, the balance sheet shows the account in a separate section. (The company paid interest on the bonds on December 31.) Because Uptown is a corporation, the capital section of the balance sheet, called the stockholders’ equity section in the illustration, differs somewhat from the capital section for a proprietorship. Total stockholders’ equity consists of the common stock, which is the original investment by stockholders, and the earnings retained in the business. For homework purposes, unless instructed otherwise, prepare an unclassified balance sheet. Summary of Learning Objectives 117 What do the numbers mean? STATEMENTS, PLEASE The use of a worksheet at the end of each month or quarter January, the income statement taken from the adjusted trial enables a company to prepare interim fi nancial statements balance on February 28 will present the net income for two even though it closes the books only at the end of each year. months. If Google wants an income statement for only the For example, assume that Google closes its books on Decem- month of February, the company obtains it by subtracting the ber 31, but it wants monthly fi nancial statements. To do this, items in the January income statement from the correspond- at the end of January, Google prepares an adjusted trial ing items in the income statement for the two months of balance (using a worksheet as illustrated in Appendix 3C) to January and February. supply the information needed for statements for January. If Google executes such a process daily, it can realize At the end of February, it uses a worksheet again. Note “24/7 accounting” (see the “What Do the Numbers Mean?” that because Google did not close the accounts at the end of box on page 110). Closing Entries Uptown makes closing entries in its general journal as shown below. DECEMBER 31, 2014 Interest Revenue 800 Sales Revenue 400,000 Income Summary 400,800 (To close revenues to Income Summary) Income Summary 388,600 Cost of Goods Sold 316,000 Salaries and Wages Expense (sales) 20,000 Advertising Expense 10,200 Salaries and Wages Expense (general) 19,000 Depreciation Expense 6,700 Rent Expense 4,300 Property Tax Expense 5,300 Bad Debt Expense 1,000 Telephone and Internet Expense 600 Insurance Expense 360 Interest Expense 1,700 You will Income Tax Expense 3,440 want to (To close expenses to Income Summary) read the Income Summary 12,200 IFRS INSIGHTS Retained Earnings 12,200 on pages 153–157 (To close Income Summary to Retained Earnings) Retained Earnings 2,000 for discussion of Dividends 2,000 IFRS related to (To close Dividends to Retained Earnings) information systems. KEY TERMS SUMMARY OF LEARNING OBJECTIVES account, 84 accounting cycle, 89 accounting information 1 Understand basic accounting terminology. Understanding the following system, 84 eleven terms helps in understanding key accounting concepts: (1) Event. (2) Transac- accrued expenses, 104 tion. (3) Account. (4) Real and nominal accounts. (5) Ledger. (6) Journal. (7) Posting. accrued revenues, 103 (8) Trial balance. (9) Adjusting entries. (10) Financial statements. (11) Closing entries. adjusted trial 2 Explain double-entry rules. The left side of any account is the debit side; the balance, 85, 108 right side is the credit side. All asset and expense accounts are increased on the left or adjusting entry, 85, 96 118 Chapter 3 The Accounting Information System balance sheet, 85 debit side and decreased on the right or credit side. Conversely, all liability and revenue book value, 101 accounts are increased on the right or credit side and decreased on the left or debit side. closing entries, 85, 111 Stockholders’ equity accounts, Common Stock and Retained Earnings, are increased on

closing process, 110 the credit side. Dividends is increased on the debit side. contra asset account, 101 3 Identify steps in the accounting cycle. The basic steps in the accounting credit, 85 cycle are (1) identifying and measuring transactions and other events; (2) journalizing; debit, 85 (3) posting; (4) preparing an unadjusted trial balance; (5) making adjusting entries; depreciation, 100 (6) preparing an adjusted trial balance; (7) preparing financial statements; and (8) closing. double-entry 4 Record transactions in journals, post to ledger accounts, and prepare accounting, 86 a trial balance. The simplest journal form chronologically lists transactions and events event, 84 expressed in terms of debits and credits to particular accounts. The items entered in a financial statements, 85 general journal must be transferred (posted) to the general ledger. Companies should general journal, 91 prepare an unadjusted trial balance at the end of a given period after they have recorded general ledger, 85, 91 the entries in the journal and posted them to the ledger. income statement, 85 5 Explain the reasons for preparing adjusting entries and identify major journal, 85 types of adjusting entries. Adjustments achieve a proper recognition of revenues journalizing, 85 and expenses, so as to determine net income for the current period and to achieve ledger, 85 an accurate statement of end-of-the-period balances in assets, liabilities, and owners’ nominal accounts, 85 equity accounts. The major types of adjusting entries are deferrals (prepaid expenses post-closing trial and unearned revenues) and accruals (accrued revenues and accrued expenses). balance, 85, 113 posting, 85, 92 6 Prepare financial statements from the adjusted trial balance. Companies prepaid expenses, 98 can prepare financial statements directly from the adjusted trial balance. The income real accounts, 85 statement is prepared from the revenue and expense accounts. The statement of retained earnings is prepared from the retained earnings account, dividends, and net reversing entries, 113 income (or net loss). The balance sheet is prepared from the asset, liability, and equity special journals, 92 accounts. statement of cash flows, 85 7 Prepare closing entries. In the closing process, the company transfers all of statement of retained the revenue and expense account balances (income statement items) to a clearing ac- earnings, 85 count called Income Summary, which is used only at the end of the fiscal year. Revenues subsidiary ledger, 85 and expenses are matched in the Income Summary account. The net result of this match- T-account, 85 ing represents the net income or net loss for the period. That amount is then transferred transaction, 84 to an owners’ equity account (Retained Earnings for a corporation and capital accounts trial balance, 85, 96 for proprietorships and partnerships). unearned revenues, 102 8 Prepare financial statements for a merchandising company. The finan- cial statements for a merchandiser differ from those for a service company, as a merchan- diser must account for gross profit on sales. The accounting cycle, however, is performed the same. CASH-BASIS ACCOUNTING VERSUS 3A APPENDIX ACCRUAL-BASIS ACCOUNTING Most companies use accrual-basis accounting: They recognize revenue when the LEARNING OBJECTIVE 9 performance obligation is satisfied and expenses in the period incurred, without Differentiate the cash basis of regard to the time of receipt or payment of cash. accounting from the accrual basis of accounting. Some small companies and the average individual taxpayer, however, use a strict or modified cash-basis approach. Under the strict cash basis, companies record revenue only when they receive cash. They record expenses only when they Appendix 3A: Cash-Basis Accounting versus Accrual-Basis Accounting 119 disperse cash. Determining income on the cash basis rests upon collecting revenue and paying expenses. The cash basis ignores two principles: the revenue recognition principle and the expense recognition principle. Consequently, cash-basis financial

statements are not in conformity with GAAP. An illustration will help clarify the differences between accrual-basis and cash-basis accounting. Assume that Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustrations 3A-1 and 3A-2 show the net incomes for each month under cash- basis accounting and accrual-basis accounting. ILLUSTRATION 3A-1 QUALITY CONTRACTOR Income Statement—Cash INCOME STATEMENT—CASH BASIS Basis FOR THE MONTH OF January February March Total Cash receipts $–0– $22,000 $ –0– $22,000 Cash payments –0– –0– 18,000 18,000 Net income (loss) $–0– $22,000 $(18,000) $ 4,000 ILLUSTRATION 3A-2 QUALITY CONTRACTOR Income Statement— INCOME STATEMENT—ACCRUAL BASIS Accrual Basis FOR THE MONTH OF January February March Total Revenues $22,000 $–0– $–0– $22,000 Expenses 18,000 –0– –0– 18,000 Net income (loss) $ 4,000 $–0– $–0– $ 4,000 For the three months combined, total net income is the same under both cash-basis accounting and accrual-basis accounting. The difference is in the timing of revenues and expenses. The basis of accounting also affects the balance sheet. Illustrations 3A-3 and 3A-4 (page 120) show Quality Contractor’s balance sheets at each month-end under the cash basis and the accrual basis. ILLUSTRATION 3A-3 QUALITY CONTRACTOR Balance Sheets—Cash BALANCE SHEET—CASH BASIS Basis AS OF January 31 February 28 March 31 Assets Cash $–0– $22,000 $4,000 Total assets $–0– $22,000 $4,000 Liabilities and Owners’ Equity Owners’ equity $–0– $22,000 $4,000 Total liabilities and owners’ equity $–0– $22,000 $4,000 120 Chapter 3 The Accounting Information System ILLUSTRATION 3A-4 QUALITY CONTRACTOR Balance Sheets—Accrual BALANCE SHEET—ACCRUAL BASIS Basis AS OF January 31 February 28 March 31 Assets Cash $ –0– $22,000 $4,000 Accounts receivable 22,000 –0– –0– Total assets $22,000 $22,000 $4,000 Liabilities and Owners’ Equity Accounts payable $18,000 $18,000 $ –0– Owners’ equity 4,000 4,000 4,000 Total liabilities and owners’ equity $22,000 $22,000 $4,000 Analysis of Quality’s income statements and balance sheets shows the ways in which cash-basis accounting is inconsistent with basic accounting theory: 1. The cash basis understates revenues and assets from the construction and delivery of the garage in January. It ignores the $22,000 of accounts receivable, representing a near-term future cash infl ow. 2. The cash basis understates expenses incurred with the construction of the garage and the liability outstanding at the end of January. It ignores the $18,000 of accounts payable, representing a near-term future cash outfl ow. 3. The cash basis understates owners’ equity in January by not recognizing the reve- nues and the asset until February. It also overstates owners’ equity in February by not recognizing the expenses and the liability until March. In short, cash-basis accounting violates the accrual concept underlying financial reporting. The modified cash basis is a mixture of the cash basis and the accrual basis. It is based on the strict cash basis but with modifications that have substantial support, such as capitalizing and depreciating plant assets or recording inventory. This method is often followed by professional services firms (doctors, lawyers, accountants, and con- sultants) and by retail, real estate, and agricultural operations.3 CONVERSION FROM CASH BASIS TO ACCRUAL BASIS Not infrequently, companies want to convert a cash basis or a modified cash basis set of financial statements to the accrual basis for presentation to investors and creditors. To illustrate this conversion, assume that Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2014, Dr. Windsor 3Companies in the following situations might use a cash or modified cash basis. (1) A company that is primarily interested in cash flows (for example, a group of physicians that

distributes cash-basis earnings for salaries and bonuses). (2) A company that has a limited number of financial statement users (small, closely held company with little or no debt). (3) A company that has operations that are relatively straightforward (small amounts of inventory, long-term assets, or long-term debt). Appendix 3A: Cash-Basis Accounting versus Accrual-Basis Accounting 121 received $300,000 from her patients and paid $170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of $130,000 ($300,000 2 $170,000). At January 1 and December 31, 2014, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown in Illustration 3A-5. ILLUSTRATION 3A-5 January 1, 2014 December 31, 2014 Financial Information Accounts receivable $12,000 $9,000 Related to Dr. Diane Unearned service revenue –0– 4,000 Windsor Accrued liabilities 2,000 5,500 Prepaid expenses 1,800 2,700 Service Revenue Computation To convert the amount of cash received from patients to service revenue on an accrual basis, we must consider changes in accounts receivable and unearned service revenue during the year. Accounts receivable at the beginning of the year represents revenues recognized last year that are collected this year. Ending accounts receivable indicates revenues recognized this year that are not yet collected. Therefore, to compute revenue on an accrual basis, we subtract beginning accounts receivable and add ending accounts receivable, as the formula in Illustration 3A-6 shows. ILLUSTRATION 3A-6 Cash receipts 2 Beginning accounts receivable Revenue Conversion of Cash from customers 1 Ending accounts receivable 5 on an Receipts to Revenue— accrual basis u v Accounts Receivable Similarly, beginning unearned service revenue represents cash received last year for revenues recognized this year. Ending unearned service revenue results from collections this year that will be recognized as revenue next year. Therefore, to compute revenue on an accrual basis, we add beginning unearned service revenue and subtract ending unearned service revenue, as the formula in Illustration 3A-7 shows. u ILLUSTRATION 3A-7 1 Beginning unearned Revenue Conversion of Cash Cash receipts service revenue 5 on an Receipts to Revenue— from customers 2 Ending unearned accrual basis Unearned Service service revenue u Revenue Therefore, for Dr. Windsor’s dental practice, to convert cash collected from custom- ers to service revenue on an accrual basis, we would make the computations shown in Illustration 3A-8. ILLUSTRATION 3A-8 Cash receipts from customers $300,000 Conversion of Cash 2 Beginning accounts receivable $(12,000) Receipts to Service 1 Ending accounts receivable 9,000 1 Beginning unearned service revenue –0– Revenue 2 Ending unearned service revenue (4,000) (7,000) Service revenue (accrual) $293,000 122 Chapter 3 The Accounting Information System Operating Expense Computation To convert cash paid for operating expenses during the year to operating expenses on an accrual basis, we must consider changes in prepaid expenses and accrued liabilities. First, we need to recognize as this year’s expenses the amount of beginning prepaid expenses. (The cash payment for these occurred last year.) Therefore, to arrive at operat- ing expense on an accrual basis, we add the beginning prepaid expenses balance to cash paid for operating expenses. Conversely, ending prepaid expenses result from cash payments made this year for expenses to be reported next year. (Under the accrual basis, Dr. Windsor would have deferred recognizing these payments as expenses until a future period.) To convert these cash payments to operating expenses on an accrual basis, we deduct ending prepaid expenses from cash paid for expenses, as the formula in Illustration 3A-9 shows. ILLUSTRATION 3A-9 u Expenses Conversion of Cash Cash paid for 1 Beginning prepaid expenses 5 on an Payments to Expenses— operating expenses 2 Ending prepaid expenses accrual basis Prepaid Expenses u Similarly, beginning accrued liabilities result from expenses recognized last year

that require cash payments this year. Ending accrued liabilities relate to expenses recog- nized this year that have not been paid. To arrive at expenses on an accrual basis, we deduct beginning accrued liabilities and add ending accrued liabilities to cash paid for expenses, as the formula in Illustration 3A-10 shows. ILLUSTRATION 3A-10 u Expenses Conversion of Cash Cash paid for 2 Beginning accrued liabilities 5 on an Payments to Expenses— operating expenses 1 Ending accrued liabilities accrual basis Accrued Liabilities u Therefore, for Dr. Windsor’s dental practice, to convert cash paid for operating expenses to operating expenses on an accrual basis, we would make the computations shown in Illustration 3A-11. ILLUSTRATION 3A-11 Cash paid for operating expenses $170,000 Conversion of Cash Paid 1 Beginning prepaid expense $ 1,800 to Operating Expenses 2 Ending prepaid expense (2,700) 2 Beginning accrued liabilities (2,000) 1 Ending accrued liabilities 5,500 2,600 Operating expenses (accrual) $172,600 This entire conversion can be completed in worksheet form, as shown in Illustra- tion 3A-12. Appendix 3A: Cash-Basis Accounting versus Accrual-Basis Accounting 123 DDiiaannee WWiinnddssoorr..xxllss ILLUSTRATION 3A-12 Home Insert Page Layout Formulas Data Review View Conversion of Statement P18 fx of Cash Receipts and A B C D E Disbursements to Income 1 Statement 2 DIANE WINDSOR, D.D.S. 3 Conversion of Income Statement Data from Cash Basis to Accrual Basis 4 For the Year 2014 5 Cash Accrual 6 Basis Adjustments Basis 7 Account Titles Add Deduct 8 Collec!ons from customers $300,000 9 − Accounts receivable, Jan. 1 $12,000 10 + Accounts receivable, Dec. 31 $9,000 11 + Unearned service revenue, Jan. 1 — — 12 − Unearned service revenue, Dec. 31 4,000 13 Service revenue $293,000 14 Disbursement for expenses 170,000 15 + Prepaid expenses, Jan. 1 1,800 16 − Prepaid expenses, Dec. 31 2,700 17 − Accrued liabili!es, Jan. 1 2,000 18 + Accrued liabili!es, Dec. 31 5,500 19 Opera!ng expenses 172,600 20 Excess of cash collec!ons over disbursements—cash basis $130,000 21 Net income—accrual basis $120,400 22 Using this approach, we adjust collections and disbursements on a cash basis to revenue and expense on an accrual basis, to arrive at accrual net income. In any conver- sion from the cash basis to the accrual basis, depreciation or amortization is an addi- tional expense in arriving at net income on an accrual basis. THEORETICAL WEAKNESSES OF THE CASH BASIS The cash basis reports exactly when cash is received and when cash is disbursed. To many people, that information represents something concrete. Isn’t cash what it is all about? Does it make sense to invent something, design it, produce it, market and sell it, if you aren’t going to get cash for it in the end? Many frequently say, “Cash is the real bottom line,” and also, “Cash is the oil that lubricates the economy.” If so, then what is the merit of accrual accounting? Today’s economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision-makers seek timely information about a company’s future cash flows. Accrual-basis accounting provides this information by reporting the cash inflows and outflows associated with earnings activities as soon as these companies can estimate these cash flows with an acceptable degree of certainty. Receivables and pay- ables are forecasters of future cash inflows and outflows. In other words, accrual-basis accounting aids in predicting future cash flows by reporting transactions and other events with cash consequences at the time the transactions and events occur, rather than when the cash is received and paid. 124 Chapter 3 The Accounting Information System KEY TERMS SUMMARY OF LEARNING OBJECTIVE accrual-basis accounting, 118 FOR APPENDIX 3A modified cash basis, 120 strict cash basis, 118 9 Differentiate the cash basis of accounting from the accrual basis of accounting. The cash basis of accounting records revenues when cash is received and

expenses when cash is paid. The accrual basis recognizes revenue when the perfor- mance obligation is satisfied and expenses in the period incurred, without regard to the time of the receipt or payment of cash. Accrual-basis accounting is theoretically prefer- able because it provides information about future cash inflows and outflows associated with earnings activities as soon as companies can estimate these cash flows with an ac- ceptable degree of certainty. Cash-basis accounting is not in conformity with GAAP. APPENDIX 3B USING REVERSING ENTRIES Use of reversing entries simplifies the recording of transactions in the next LEARNING OBJECTIVE 10 accounting period. The use of reversing entries, however, does not change the Identify adjusting entries that amounts reported in the financial statements for the previous period. may be reversed. ILLUSTRATION OF REVERSING ENTRIES—ACCRUALS A company most often uses reversing entries to reverse two types of adjusting entries: accrued revenues and accrued expenses. To illustrate the optional use of reversing en- tries for accrued expenses, we use the following transaction and adjustment data. 1. October 24 (initial salaries and wages entry): Paid $4,000 of salaries and wages incurred between October 10 and October 24. 2. October 31 (adjusting entry): Incurred salaries and wages between October 25 and October 31 of $1,200, to be paid in the November 8 payroll. 3. November 8 (subsequent salaries and wages entry): Paid salaries and wages of $2,500. Of this amount, $1,200 applied to accrued salaries and wages payable at October 31 and $1,300 to salaries and wages payable for November 1 through November 8. Illustration 3B-1 shows the comparative entries. The comparative entries show that the first three entries are the same whether or not the company uses reversing entries. The last two entries differ. The November 1 revers- ing entry eliminates the $1,200 balance in Salaries and Wages Payable, created by the October 31 adjusting entry. The reversing entry also creates a $1,200 credit balance in the Salaries and Wages Expense account. As you know, it is unusual for an expense account to have a credit balance. However, the balance is correct in this instance. Why? Because the company will debit the entire amount of the first salaries and wages payment in the new accounting period to Salaries and Wages Expense. This debit eliminates the credit balance. The resulting debit balance in the expense account will equal the salaries and wages expense incurred in the new accounting period ($1,300 in this example). Appendix 3B: Using Reversing Entries 125 REVERSING ENTRIES NOT USED REVERSING ENTRIES USED Initial Salary Entry Oct. 24 Salaries and Wages Expense 4,000 Oct. 24 Salaries and Wages Expense 4,000 Cash 4,000 Cash 4,000 Adjusting Entry Oct. 31 Salaries and Wages Expense 1,200 Oct. 31 Salaries and Wages Expense 1,200 Salaries and Wages Payable 1,200 Salaries and Wages Payable 1,200 Closing Entry Oct. 31 Income Summary 5,200 Oct. 31 Income Summary 5,200 Salaries and Wages Expense 5,200 Salaries and Wages Expense 5,200 Reversing Entry Nov. 1 No entry is made. Nov. 1 Salaries and Wages Payable 1,200 Salaries and Wages Expense 1,200 Subsequent Salary Entry Nov. 8 Salaries and Wages Payable 1,200 Nov. 8 Salaries and Wages Expense 2,500 Salaries and Wages Expense 1,300 Cash 2,500 Cash 2,500 ILLUSTRATION 3B-1 Comparison of Entries When a company makes reversing entries, it debits all cash payments of expenses for Accruals, with and to the related expense account. This means that on November 8 (and every payday), the without Reversing Entries company debits Salaries and Wages Expense for the amount paid without regard to the existence of any accrued salaries and wages payable. Repeating the same entry simpli- fies the recording process in an accounting system. ILLUSTRATION OF REVERSING ENTRIES—DEFERRALS Up to this point, we assumed the recording of all deferrals as prepaid expense or unearned revenue. In some cases, though, a company records deferrals directly in expense or revenue accounts. When this occurs, a company may also reverse deferrals.

To illustrate the use of reversing entries for prepaid expenses, we use the following transaction and adjustment data. 1. December 10 (initial entry): Purchased $20,000 of offi ce supplies with cash. 2. December 31 (adjusting entry): Determined that $5,000 of offi ce supplies are on hand. Illustration 3B-2 (page 126) shows the comparative entries. After the adjusting entry on December 31 (regardless of whether using reversing entries), the asset account Supplies shows a balance of $5,000, and Supplies Expense shows a balance of $15,000. If the company initially debits Supplies Expense when it purchases the supplies, it then makes a reversing entry to return to the expense account the cost of unconsumed supplies. The company then continues to debit Supplies Expense for additional purchases of supplies during the next period. Deferrals are generally entered in real accounts (assets and liabilities), thus making reversing entries unnecessary. This approach is used because it is advantageous for items that a company needs to apportion over several periods (e.g., supplies and parts inventories). However, for other items that do not follow this regular pattern and that may or may not involve two or more periods, a company ordinarily enters them initially 126 Chapter 3 The Accounting Information System REVERSING ENTRIES NOT USED REVERSING ENTRIES USED Initial Purchase of Supplies Entry Dec. 10 Supplies 20,000 Dec. 10 Supplies Expense 20,000 Cash 20,000 Cash 20,000 Adjusting Entry Dec. 31 Supplies Expense 15,000 Dec. 31 Supplies 5,000 Supplies 15,000 Supplies Expense 5,000 Closing Entry Dec. 31 Income Summary 15,000 Dec. 31 Income Summary 15,000 Supplies Expense 15,000 Supplies Expense 15,000 Reversing Entry Jan. 1 No entry Jan. 1 Supplies Expense 5,000 Supplies 5,000 ILLUSTRATION 3B-2 Comparison of Entries for Deferrals, with and without Reversing in revenue or expense accounts. The revenue and expense accounts may not require Entries adjusting, and the company thus systematically closes them to Income Summary. Using the nominal accounts adds consistency to the accounting system. It also makes the recording more efficient, particularly when a large number of such transac- tions occur during the year. For example, the bookkeeper knows to expense invoice items (except for capital asset acquisitions). He or she need not worry whether an item will result in a prepaid expense at the end of the period because the company will make adjustments at the end of the period. SUMMARY OF REVERSING ENTRIES We summarize guidelines for reversing entries as follows. 1. All accruals should be reversed. 2. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed. 3. Adjusting entries for depreciation and bad debts are not reversed. Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely. SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3B 10 Identify adjusting entries that may be reversed. Reversing entries are most often used to reverse two types of adjusting entries: accrued revenues and accrued expenses. Deferrals may also be reversed if the initial entry to record the transaction is made to an expense or revenue account. Appendix 3C: Using a Worksheet: The Accounting Cycle Revisited 127 USING A WORKSHEET: THE ACCOUNTING 3C APPENDIX CYCLE REVISITED In this appendix, we provide an additional illustration of the end-of-period steps 11 LEARNING OBJECTIVE in the accounting cycle and illustrate the use of a worksheet in this process. Using Prepare a 10-column worksheet. a worksheet often facilitates the end-of-period (monthly, quarterly, or annually) accounting and reporting process. Use of a worksheet helps a company prepare the financial statements on a more timely basis. How? With a worksheet, a company need not wait until it journalizes and posts the adjusting and closing entries. A company prepares a worksheet either on columnar paper or within a computer spreadsheet. In either form, a company uses the worksheet to adjust account balances

and to prepare financial statements. The worksheet does not replace the financial statements. Instead, it is an informal device for accumulating and sorting information needed for the financial statements. Completing the worksheet provides considerable assurance that a company properly handled all of the details related to the end-of-period accounting and statement prepa- ration. The 10-column worksheet in Illustration 3C-1 (on page 128) provides columns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. WORKSHEET COLUMNS Trial Balance Columns Uptown Cabinet Corp., shown in Illustration 3C-1 (page 128), obtains data for the trial balance from its ledger balances at December 31. The amount for Inventory, $40,000, is the year-end inventory amount, which results from the application of a perpetual inventory system. Adjustments Columns After Uptown enters all adjustment data on the worksheet, it establishes the equality of the adjustment columns. It then extends the balances in all accounts to the adjusted trial balance columns. ADJUSTMENTS ENTERED ON THE WORKSHEET Items (a) through (g) below serve as the basis for the adjusting entries made in the work- sheet for Uptown shown in Illustration 3C-1. (a) Depreciation of equipment at the rate of 10 percent per year based on original cost of $67,000. (b) Estimated bad debts of one-quarter of 1 percent of sales ($400,000). (c) Insurance expired during the year $360. (d) Interest accrued on notes receivable as of December 31, $800. (e) The Rent Expense account contains $500 rent paid in advance, which is applicable to next year. (f) Property taxes accrued December 31, $2,000. (g) Income taxes payable estimated $3,440. 128 Chapter 3 The Accounting Information System UUppttoowwnn CCaabbiinneett CCoorrpp..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G H I J K 1 2 UPTOWN CABINET CORP. 3 Ten-Column Worksheet 4 For the Year Ended December 31, 2014 5 Adjusted Income Balance Trial Balance Adjustments 6 Trial Balance Statement Sheet 7 Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. 8 Cash 1,200 1,200 1,200 9 Notes receivable 16,000 16,000 16,000 10 Accounts receivable 41,000 41,000 41,000 11 Allowance for doub!ul accounts 2,000 (b) 1,000 3,000 3,000 12 Inventory 40,000 40,000 40,000 13 Prepaid insurance 900 (c) 360 540 540 14 Equipment 67,000 67,000 67,000 15 Accumulated deprecia"on— equipment 12,000 (a) 6,700 18,700 18,700 16 Notes payable 20,000 20,000 20,000 17 Accounts payable 13,500 13,500 13,500 18 Bonds payable 30,000 30,000 30,000 19 Common stock 50,000 50,000 50,000 20 Retained earnings, Jan. 1, 2014 16,200 16,200 16,200 21 Dividends 2,000 2,000 2,000 22 Sales revenue 400,000 400,000 400,000 23 Cost of goods sold 316,000 316,000 316,000 24 Salaries and wages expense (sales) 20,000 20,000 20,000 25 Adver"sing expense 10,200 10,200 10,200 26 Salaries and wages expense (general) 19,000 19,000 19,000 27 Telephone and Internet expense 600 600 600 28 Rent expense 4,800 (e) 500 4,300 4,300 29 Property tax expense 3,300 (f) 2,000 5,300 5,300 30 Interest expense 1,700 1,700 1,700 31 Totals 543,700 543,700 32 Deprecia"on expense (a) 6,700 6,700 6,700 33 Bad debt expense (b) 1,000 1,000 1,000 34 Insurance expense (c) 360 360 360 35 Interest receivable (d) 800 800 800 36 Interest revenue (d) 800 800 800 37 Prepaid rent (e) 500 500 500 38 Property taxes payable (f) 2,000 2,000 2,000 39 Income tax expense (g) 3,440 3,440 3,440 40 Income tax payable (g) 3,440 3,440 3,440 41 Totals 14,800 14,800 557,640 557,640 388,600 400,800 42 Net income 12,200 12,200 43 Totals 400,800 400,800 169,040 169,040 ILLUSTRATION 3C-1 Use of a Worksheet Appendix 3C: Using a Worksheet: The Accounting Cycle Revisited 129 The adjusting entries shown on the December 31, 2014, worksheet are as follows. (a) Depreciation Expense 6,700 Accumulated Depreciation—Equipment 6,700 (b) Bad Debt Expense 1,000 Allowance for Doubtful Accounts 1,000 (c) Insurance Expense 360 Prepaid Insurance 360 (d) Interest Receivable 800 Interest Revenue 800 (e) Prepaid Rent 500

Rent Expense 500 (f) Property Tax Expense 2,000 Property Taxes Payable 2,000 (g) Income Tax Expense 3,440 Income Taxes Payable 3,440 Uptown Cabinet transfers the adjusting entries to the Adjustments columns of the worksheet, often designating each by letter. The trial balance lists any new accounts resulting from the adjusting entries, as illustrated on the worksheet. (For example, see the accounts listed in rows 32 through 40 in Illustration 3C-1.) Uptown then totals and balances the Adjustments columns. Adjusted Trial Balance The adjusted trial balance shows the balance of all accounts after adjustment at the end of the accounting period. For example, Uptown adds the $2,000 shown opposite the Allowance for Doubtful Accounts in the Trial Balance Cr. column to the $1,000 in the Adjustments Cr. column. The company then extends the $3,000 total to the Adjusted Trial Balance Cr. column. Similarly, Uptown reduces the $900 debit opposite Prepaid Insurance by the $360 credit in the Adjustments column. The result, $540, is shown in the Adjusted Trial Balance Dr. column. Income Statement and Balance Sheet Columns Uptown extends all the debit items in the Adjusted Trial Balance columns into the Income Statement or Balance Sheet columns to the right. It similarly extends all the credit items. The next step is to total the Income Statement columns. Uptown needs the amount of net income or loss for the period to balance the debit and credit columns. The net income of $12,200 is shown in the Income Statement Dr. column because revenues exceeded expenses by that amount. Uptown then balances the Income Statement columns. The company also enters the net income of $12,200 in the Balance Sheet Cr. column as an increase in retained earnings. 130 Chapter 3 The Accounting Information System PREPARING FINANCIAL STATEMENTS FROM A WORKSHEET The worksheet provides the information needed for preparation of the financial state- ments without reference to the ledger or other records. In addition, the worksheet sorts that data into appropriate columns, which facilitates the preparation of the statements. The financial statements of Uptown Cabinet are shown in Chapter 3 (pages 115–116). KEY TERMS SUMMARY OF LEARNING OBJECTIVE worksheet, 127 FOR APPENDIX 3C 11 Prepare a 10-column worksheet. The 10-column worksheet provides col- umns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. The worksheet does not replace the financial statements. Instead, it is an informal device for accumulating and sorting information needed for the financial statements. DEMONSTRATION PROBLEM Nalezny Advertising Agency was founded by Casey Hayward in January 2005. Presented below are both the adjusted and unadjusted trial balances as of December 31, 2014. NALEZNY ADVERTISING AGENCY TRIAL BALANCE DECEMBER 31, 2014 Unadjusted Adjusted Dr. Cr. Dr. Cr. Cash $ 11,000 $ 11,000 Accounts Receivable 20,000 21,500 Supplies 8,400 5,000 Equipment 60,000 60,000 Accumulated Depreciation—Equipment $ 28,000 $ 35,000 Accounts Payable 5,000 5,000 Unearned Advertising Revenue 7,000 5,600 Salaries and Wages Payable –0– 1,300 Common Stock 10,000 10,000 Retained Earnings 4,800 4,800 Advertising Revenue 58,600 61,500 Salaries and Wages Expense 10,000 11,300 Depreciation Expense 7,000 Supplies Expense 3,400 Rent Expense 4,000 4,000 $113,400 $113,400 $123,200 $123,200 Instructions (a) Journalize the annual adjusting entries that were made. (b) Prepare an income statement for the year ending December 31, 2014, and a balance sheet at December 31. (c) Describe the remaining steps in the accounting cycle to be completed by Nalezny for 2014. Demonstration Problem 131 Solution (a) Dec. 31 Accounts Receivable 1,500 Advertising Revenue 1,500 31 Unearned Advertising Revenue 1,400 Advertising Revenue 1,400 31 Supplies Expense 3,400 Supplies 3,400 31 Depreciation Expense 7,000 Accumulated Depreciation—Equipment 7,000 31 Salaries and Wages Expense 1,300 Salaries and Wages Payable 1,300 (b) NALEZNY ADVERTISING AGENCY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Revenues

Advertising revenue $61,500 Expenses Salaries and wages expense $11,300 Depreciation expense 7,000 Rent expense 4,000 Supplies expense 3,400 Total expenses 25,700 Net income $35,800 NALEZNY ADVERTISING AGENCY BALANCE SHEET DECEMBER 31, 2014 Assets Cash $11,000 Accounts receivable 21,500 Supplies 5,000 Equipment $60,000 Less: Accumulated depreciation—equipment 35,000 25,000 Total assets $62,500 Liabilities and Stockholders’ Equity Liabilities Accounts payable $ 5,000 Unearned advertising revenue 5,600 Salaries and wage payable 1,300 Total liabilities 11,900 Stockholders’ equity Common stock $10,000 Retained earnings 40,600* 50,600 Total liabilities and stockholders’ equity $62,500 *Retained earnings, Jan. 1, 2014 $ 4,800 Add: Net income 35,800 Retained earnings, Dec. 31, 2014 $40,600 (c) Following preparation of financial statements (part (b)), Nalezny would prepare closing entries to reduce the temporary accounts to zero. Some companies prepare a post-closing trial balance and reversing entries. 132 Chapter 3 The Accounting Information System Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter. QUESTIONS 1. Give an example of a transaction that results in: (a) Prepaid Rent. (a) A decrease in an asset and a decrease in a liability. (b) Salaries and Wages Payable. (b) A decrease in one asset and an increase in another (c) Inventory. asset. (d) Accumulated Depreciation—Equipment. (c) A decrease in one liability and an increase in another (e) Equipment. liability. (f) Service Revenue. 2. Do the following events represent business transactions? (g) Salaries and Wages Expense. Explain your answer in each case. (h) Supplies. (a) A computer is purchased on account. 8. Employees are paid every Saturday for the preceding (b) A customer returns merchandise and is given credit work week. If a balance sheet is prepared on Wednesday, on account. December 31, what does the amount of wages earned (c) A prospective employee is interviewed. during the first three days of the week (12/29, 12/30, (d) The owner of the business withdraws cash from the 12/31) represent? Explain. business for personal use. 9. (a) How are the components of revenues and expenses (e) Merchandise is ordered for delivery next month. different for a merchandising company? (b) Explain the in- 3. Name the accounts debited and credited for each of the come measurement process of a merchandising company. following transactions. 1 0. What differences are there between the trial balance (a) Billing a customer for work done. before closing and the trial balance after closing with (b) Receipt of cash from customer on account. respect to the following accounts? (c) Purchase of office supplies on account. (a) Accounts Payable. (d) Purchase of 15 gallons of gasoline for the delivery (b) Expense accounts. truck. (c) Revenue accounts. 4. Why are revenue and expense accounts called temporary (d) Retained Earnings account. or nominal accounts? (e) Cash. 5. Andrea Pafko, a fellow student, contends that the double- 1 1. What are adjusting entries and why are they necessary? entry system means that each transaction must be re- corded twice. Is Andrea correct? Explain. 1 2. What are closing entries and why are they necessary? 6. Is it necessary that a trial balance be taken periodically? 1 3. Jay Hawk, maintenance supervisor for Boston Insurance What purpose does it serve? Co., has purchased a riding lawnmower and accessories 7. Indicate whether each of the following items is a real or to be used in maintaining the grounds around corporate nominal account and whether it appears in the balance headquarters. He has sent the following information to sheet or the income statement. the accounting department. Brief Exercises 133 Cost of mower and Date purchased 7/1/14 *1 5. Distinguish between cash-basis accounting and accrual-

accessories $4,000 Monthly salary of basis accounting. Why is accrual-basis accounting accept- Estimated useful life 5 yrs groundskeeper $1,100 able for most businesses and the cash-basis unacceptable Salvage value $0 Estimated annual fuel cost $150 in the preparation of an income statement and a balance sheet? Compute the amount of depreciation expense (related to the mower and accessories) that should be reported on *1 6. When salaries and wages expense for the year is com- Boston’s December 31, 2014, income statement. Assume puted, why are beginning accrued salaries and wages straight-line depreciation. subtracted from, and ending accrued salaries and wages added to, salaries and wages paid during the year? 14. Midwest Enterprises made the following entry on December 31, 2014. *1 7. List two types of transactions that would receive different accounting treatment using (a) strict cash-basis account- Interest Expense 10,000 Interest Payable 10,000 ing, and (b) a modified cash basis. (To record interest expense *1 8. What are reversing entries, and why are they used? due on loan from Anaheim National Bank) *1 9. “A worksheet is a permanent accounting record, and its What entry would Anaheim National Bank make regard- use is required in the accounting cycle.” Do you agree? ing its outstanding loan to Midwest Enterprises? Explain Explain. why this must be the case. BRIEF EXERCISES 4 BE3-1 Transactions for Mehta Company for the month of May are presented below. Prepare journal entries for each of these transactions. (You may omit explanations.) May 1 B.D. Mehta invests $4,000 cash in exchange for common stock in a small welding corporation. 3 Buys equipment on account for $1,100. 13 Pays $400 to landlord for May rent. 21 Bills Noble Corp. $500 for welding work done. 4 BE3-2 Agazzi Repair Shop had the following transactions during the first month of business as a propri- etorship. Journalize the transactions. (Omit explanations.) Aug. 2 Invested $12,000 cash and $2,500 of equipment in the business. 7 Purchased supplies on account for $500. (Debit asset account.) 12 Performed services for clients, for which $1,300 was collected in cash and $670 was billed to the clients. 15 Paid August rent $600. 19 Counted supplies and determined that only $270 of the supplies purchased on August 7 are still on hand. 4 5 BE3-3 On July 1, 2014, Crowe Co. pays $15,000 to Zubin Insurance Co. for a 3-year insurance policy. Both companies have fiscal years ending December 31. For Crowe Co., journalize the entry on July 1 and the adjusting entry on December 31. 4 5 BE3-4 Using the data in BE3-3, journalize the entry on July 1 and the adjusting entry on December 31 for Zubin Insurance Co. Zubin uses the accounts Unearned Service Revenue and Service Revenue. 4 5 BE3-5 Assume that on February 1, Procter & Gamble (P&G) paid $720,000 in advance for 2 years’ insur- ance coverage. Prepare P&G’s February 1 journal entry and the annual adjusting entry on June 30. 4 5 BE3-6 LaBouche Corporation owns a warehouse. On November 1, it rented storage space to a lessee (tenant) for 3 months for a total cash payment of $2,400 received in advance. Prepare LaBouche’s Novem- ber 1 journal entry and the December 31 annual adjusting entry. 4 5 BE3-7 Dresser Company’s weekly payroll, paid on Fridays, totals $8,000. Employees work a 5-day week. Prepare Dresser’s adjusting entry on Wednesday, December 31, and the journal entry to record the $8,000 cash payment on Friday, January 2. 5 BE3-8 Included in Gonzalez Company’s December 31 trial balance is a note receivable of $12,000. The note is a 4-month, 10% note dated October 1. Prepare Gonzalez’s December 31 adjusting entry to record $300 of accrued interest, and the February 1 journal entry to record receipt of $12,400 from the borrower. 134 Chapter 3 The Accounting Information System 5 BE3-9 Prepare the following adjusting entries at August 31 for Walgreens. (a) Interest on notes payable of $300 is accrued. (b) Services performed but unbilled total $1,400. (c) Salaries and wages earned by employees of $700 have not been recorded.

(d) Bad debt expense for year is $900. Use the following account titles: Service Revenue, Accounts Receivable, Interest Expense, Interest Payable, Salaries and Wages Expense, Salaries and Wages Payable, Allowance for Doubtful Accounts, and Bad Debt Expense. 5 BE3-10 At the end of its first year of operations, the trial balance of Alonzo Company shows Equipment $30,000 and zero balances in Accumulated Depreciation—Equipment and Depreciation Expense. Deprecia- tion for the year is estimated to be $2,000. Prepare the adjusting entry for depreciation at December 31, and indicate the balance sheet presentation for the equipment at December 31. 7 BE3-11 Side Kicks has year-end account balances of Sales Revenue $808,900; Interest Revenue $13,500; Cost of Goods Sold $556,200; Administrative Expenses $189,000; Income Tax Expense $35,100; and Divi- dends $18,900. Prepare the year-end closing entries. 9 *B E3-12 Kelly Company had cash receipts from customers in 2014 of $142,000. Cash payments for operat- ing expenses were $97,000. Kelly has determined that at January 1, accounts receivable was $13,000, and prepaid expenses were $17,500. At December 31, accounts receivable was $18,600, and prepaid expenses were $23,200. Compute (a) service revenue and (b) operating expenses. 10 *B E3-13 Assume that Best Buy made a December 31 adjusting entry to debit Salaries and Wages Expense and credit Salaries and Wages Payable for $4,200 for one of its departments. On January 2, Best Buy paid the weekly payroll of $7,000. Prepare Best Buy’s (a) January 1 reversing entry; (b) January 2 entry (assum- ing the reversing entry was prepared); and (c) January 2 entry (assuming the reversing entry was not prepared). EXERCISES 4 E3-1 (Transaction Analysis—Service Company) Beverly Crusher is a licensed CPA. During the first month of operations of her business (a sole proprietorship), the following events and transactions occurred. April 2 Invested $32,000 cash and equipment valued at $14,000 in the business. 2 Hired a secretary-receptionist at a salary of $290 per week payable monthly. 3 Purchased supplies on account $700. (Debit an asset account.) 7 Paid offi ce rent of $600 for the month. 11 Completed a tax assignment and billed client $1,100 for services rendered. (Use Service Revenue account.) 12 Received $3,200 advance on a management consulting engagement. 17 Received cash of $2,300 for services completed for Ferengi Co. 21 Paid insurance expense $110. 30 Paid secretary-receptionist $1,160 for the month. 30 A count of supplies indicated that $120 of supplies had been used. 30 Purchased a new computer for $6,100 with personal funds. (The computer will be used exclusively for business purposes.) Instructions Journalize the transactions in the general journal. (Omit explanations.) 4 E3-2 (Corrected Trial Balance) The trial balance of Wanda Landowska Company (shown on the next page) does not balance. Your review of the ledger reveals the following. (a) Each account had a normal balance. (b) The debit footings in Prepaid Insurance, Accounts Payable, and Property Tax Expense were each understated $100. (c) A transposition error was made in Accounts Receivable and Service Revenue; the correct balances for Accounts Receivable and Service Revenue are $2,750 and $6,690, respectively. (d) A debit posting to Advertising Expense of $300 was omitted. (e) A $1,500 cash drawing by the owner was debited to Owner’s Capital and credited to Cash. Exercises 135 WANDA LANDOWSKA COMPANY TRIAL BALANCE APRIL 30, 2014 Debit Credit Cash $ 4,800 Accounts Receivable 2,570 Prepaid Insurance 700 Equipment $ 8,000 Accounts Payable 4,500 Property Taxes Payable 560 Owner’s Capital 11,200 Service Revenue 6,960 Salaries and Wages Expense 4,200 Advertising Expense 1,100 Property Tax Expense 800 $20,890 $24,500 Instructions Prepare a correct trial balance. 4 E3-3 (Corrected Trial Balance) The trial balance of Blues Traveler Corporation does not balance. BLUES TRAVELER CORPORATION TRIAL BALANCE APRIL 30, 2014 Debit Credit Cash $ 5,912 Accounts Receivable 5,240 Supplies 2,967

Equipment 6,100 Accounts Payable $ 7,044 Common Stock 8,000 Retained Earnings 2,000 Service Revenue 5,200 Offi ce Expense 4,320 $24,539 $22,244 An examination of the ledger shows these errors. 1. Cash received from a customer on account was recorded (both debit and credit) as $1,380 instead of $1,830. 2. The purchase on account of a computer costing $3,200 was recorded as a debit to Office Expense and a credit to Accounts Payable. 3. Services were performed on account for a client, $2,250, for which Accounts Receivable was debited $2,250 and Service Revenue was credited $225. 4. A payment of $95 for telephone charges was entered as a debit to Office Expense and a debit to Cash. 5. The Service Revenue account was totaled at $5,200 instead of $5,280. Instructions From this information prepare a corrected trial balance. 4 E3-4 (Corrected Trial Balance) The trial balance of Watteau Co. (shown on the next page) does not balance. 136 Chapter 3 The Accounting Information System WATTEAU CO. TRIAL BALANCE JUNE 30, 2014 Debit Credit Cash $ 2,870 Accounts Receivable $ 3,231 Supplies 800 Equipment 3,800 Accounts Payable 2,666 Unearned Service Revenue 1,200 Common Stock 6,000 Retained Earnings 3,000 Service Revenue 2,380 Salaries and Wages Expense 3,400 Offi ce Expense 940 $13,371 $16,916 Each of the listed accounts should have a normal balance per the general ledger. An examination of the ledger and journal reveals the following errors. 1. Cash received from a customer on account was debited for $570, and Accounts Receivable was credited for the same amount. The actual collection was for $750. 2. The purchase of a computer printer on account for $500 was recorded as a debit to Supplies for $500 and a credit to Accounts Payable for $500. 3. Services were performed on account for a client for $890. Accounts Receivable was debited for $890 and Service Revenue was credited for $89. 4. A payment of $65 for telephone charges was recorded as a debit to Office Expense for $65 and a debit to Cash for $65. 5. When the Unearned Service Revenue account was reviewed, it was found that service revenue amounting to $325 was performed prior to June 30 (related to Unearned Service Revenue). 6. A debit posting to Salaries and Wages Expense of $670 was omitted. 7. A payment on account for $206 was credited to Cash for $206 and credited to Accounts Payable for $260. 8. A dividend of $575 was debited to Salaries and Wages Expense for $575 and credited to Cash for $575. Instructions Prepare a correct trial balance. (Note: It may be necessary to add one or more accounts to the trial balance.) 5 E3-5 (Adjusting Entries) The ledger of Duggan Rental Agency on March 31 of the current year includes the following selected accounts before adjusting entries have been prepared. Debit Credit Prepaid Insurance $ 3,600 Supplies 2,800 Equipment 25,000 Accumulated Depreciation—Equipment $ 8,400 Notes Payable 20,000 Unearned Rent Revenue 9,300 Rent Revenue 60,000 Interest Expense –0– Salaries and Wages Expense 14,000 An analysis of the accounts shows the following. 1. The equipment depreciates $250 per month. 2. One-third of the unearned rent was recognized as revenue during the quarter. 3. Interest of $500 is accrued on the notes payable. 4. Supplies on hand total $850. 5. Insurance expires at the rate of $300 per month. Exercises 137 Instructions Prepare the adjusting entries at March 31, assuming that adjusting entries are made quarterly. Additional accounts are Depreciation Expense, Insurance Expense, Interest Payable, and Supplies Expense. (Omit explanations.) 5 E3-6 (Adjusting Entries) Karen Weller, D.D.S., opened a dental practice on January 1, 2014. During the first month of operations, the following transactions occurred. 1. Performed services for patients who had dental plan insurance. At January 31, $750 of such services was performed but not yet billed to the insurance companies. 2. Utility expenses incurred but not paid prior to January 31 totaled $520. 3. Purchased dental equipment on January 1 for $80,000, paying $20,000 in cash and signing a $60,000,

3-year note payable. The equipment depreciates $400 per month. Interest is $500 per month. 4. Purchased a one-year malpractice insurance policy on January 1 for $12,000. 5. Purchased $1,600 of dental supplies. On January 31, determined that $500 of supplies were on hand. Instructions Prepare the adjusting entries on January 31. (Omit explanations.) Account titles are Accumulated Depreciation—Equipment, Depreciation Expense, Service Revenue, Accounts Receivable, Insurance Expense, Interest Expense, Interest Payable, Prepaid Insurance, Supplies, Supplies Expense, Utilities Expense, and Accounts Payable. 5 E3-7 (Analyze Adjusted Data) A partial adjusted trial balance of Piper Company at January 31, 2014, shows the following. PIPER COMPANY ADJUSTED TRIAL BALANCE JANUARY 31, 2014 Debit Credit Supplies $ 700 Prepaid Insurance 2,400 Salaries and Wages Payable $ 800 Unearned Service Revenue 750 Supplies Expense 950 Insurance Expense 400 Salaries and Wages Expense 1,800 Service Revenue 2,000 Instructions Answer the following questions, assuming the year begins January 1. (a) If the amount in Supplies Expense is the January 31 adjusting entry, and $850 of supplies was pur- chased in January, what was the balance in Supplies on January 1? (b) If the amount in Insurance Expense is the January 31 adjusting entry, and the original insurance premium was for one year, what was the total premium and when was the policy purchased? (c) If $2,500 of salaries was paid in January, what was the balance in Salaries and Wages Payable at December 31, 2013? (d) If $1,600 was received in January for services performed in January, what was the balance in Unearned Service Revenue at December 31, 2013? 5 E3-8 (Adjusting Entries) Andy Roddick is the new owner of Ace Computer Services. At the end of August 2014, his first month of ownership, Roddick is trying to prepare monthly financial statements. Below is some information related to unrecorded expenses that the business incurred during August. 1. At August 31, Roddick owed his employees $1,900 in wages that will be paid on September 1. 2. At the end of the month, he had not yet received the month’s utility bill. Based on past experience, he estimated the bill would be approximately $600. 3. On August 1, Roddick borrowed $30,000 from a local bank on a 15-year mortgage. The annual interest rate is 8%. 4. A telephone bill in the amount of $117 covering August charges is unpaid at August 31. Instructions Prepare the adjusting journal entries as of August 31, 2014, suggested by the information above. 138 Chapter 3 The Accounting Information System 5 E3-9 (Adjusting Entries) Selected accounts of Urdu Company are shown below. Supplies Accounts Receivable Beg. Bal. 800 10⁄31 470 10⁄17 2,400 10⁄31 1,650 Salaries and Wages Expense Salaries and Wages Payable 10⁄15 800 10⁄31 600 10⁄31 600 Unearned Service Revenue Supplies Expense 10⁄31 400 10⁄20 650 10⁄31 470 Service Revenue 10⁄17 2,400 10⁄31 1,650 10⁄31 400 Instructions From an analysis of the T-accounts, reconstruct (a) the October transaction entries, and (b) the adjusting journal entries that were made on October 31, 2014. Prepare explanations for each journal entry. 5 E3-10 (Adjusting Entries) Greco Resort opened for business on June 1 with eight air-conditioned units. Its trial balance on August 31 is as follows. GRECO RESORT TRIAL BALANCE AUGUST 31, 2014 Debit Credit Cash $ 19,600 Prepaid Insurance 4,500 Supplies 2,600 Land 20,000 Buildings 120,000 Equipment 16,000 Accounts Payable $ 4,500 Unearned Rent Revenue 4,600 Mortgage Payable 60,000 Common Stock 91,000 Retained Earnings 9,000 Dividends 5,000 Rent Revenue 76,200 Salaries and Wages Expense 44,800 Utilities Expenses 9,200 Maintenance and Repairs Expense 3,600 $245,300 $245,300 Other data: 1. The balance in prepaid insurance is a one-year premium paid on June 1, 2014. 2. An inventory count on August 31 shows $450 of supplies on hand. 3. Annual depreciation rates are buildings (4%) and equipment (10%). Salvage value is estimated to be 10% of cost. 4. Unearned Rent Revenue of $3,800 was earned prior to August 31.

5. Salaries of $375 were unpaid at August 31. 6. Rentals of $800 were due from tenants at August 31. 7. The mortgage interest rate is 8% per year. Exercises 139 Instructions (a) Journalize the adjusting entries on August 31 for the 3-month period June 1–August 31. (Omit explanations.) (b) Prepare an adjusted trial balance on August 31. 6 E3-11 (Prepare Financial Statements) The adjusted trial balance of Anderson Cooper Co. as of December 31, 2014, contains the following. ANDERSON COOPER CO. ADJUSTED TRIAL BALANCE DECEMBER 31, 2014 Account Titles Dr. Cr. Cash $19,472 Accounts Receivable 6,920 Prepaid Rent 2,280 Equipment 18,050 Accumulated Depreciation—Equipment $ 4,895 Notes Payable 5,700 Accounts Payable 5,472 Common Stock 20,000 Retained Earnings 11,310 Dividends 3,000 Service Revenue 11,590 Salaries and Wages Expense 6,840 Rent Expense 2,260 Depreciation Expense 145 Interest Expense 83 Interest Payable 83 $59,050 $59,050 Instructions (a) Prepare an income statement. (b) Prepare a statement of retained earnings. (c) Prepare a classified balance sheet. 6 E3-12 (Prepare Financial Statements) Santo Design Agency was founded by Thomas Grant in January 2008. Presented below is the adjusted trial balance as of December 31, 2014. SANTO DESIGN AGENCY ADJUSTED TRIAL BALANCE DECEMBER 31, 2014 Dr. Cr. Cash $ 11,000 Accounts Receivable 21,500 Supplies 5,000 Prepaid Insurance 2,500 Equipment 60,000 Accumulated Depreciation—Equipment $ 35,000 Accounts Payable 5,000 Interest Payable 150 Notes Payable 5,000 Unearned Service Revenue 5,600 Salaries and Wages Payable 1,300 Common Stock 10,000 Retained Earnings 3,500 Service Revenue 61,500 Salaries and Wages Expense 11,300 Insurance Expense 850 Interest Expense 500 Depreciation Expense 7,000 Supplies Expense 3,400 Rent Expense 4,000 $127,050 $127,050 140 Chapter 3 The Accounting Information System Instructions (a) Prepare an income statement and a statement of retained earnings for the year ending December 31, 2014, and an unclassified balance sheet at December 31. (b) Answer the following questions. (1) If the note has been outstanding 6 months, what is the annual interest rate on that note? (2) If the company paid $17,500 in salaries in 2014, what was the balance in Salaries and Wages Payable on December 31, 2013? 7 8 E3-13 (Closing Entries) The adjusted trial balance of Lopez Company shows the following data pertain- ing to sales at the end of its fiscal year, October 31, 2014: Sales Revenue $800,000, Delivery Expense $12,000, Sales Returns and Allowances $24,000, and Sales Discounts $15,000. Instructions (a) Prepare the revenues section of the income statement. (b) Prepare separate closing entries for (1) sales and (2) the contra accounts to sales. 7 8 E3-14 (Closing Entries) Presented below is information related to Gonzales Corporation for the month of January 2014. Cost of goods sold $208,000 Salaries and wages expense $ 61,000 Delivery expense 7,000 Sales discounts 8,000 Insurance expense 12,000 Sales returns and allowances 13,000 Rent expense 20,000 Sales revenue 350,000 Instructions Prepare the necessary closing entries. 8 E3-15 (Missing Amounts) Presented below is financial information for two different companies. Alatorre Company Eduardo Company Sales revenue $90,000 (d) Sales returns and allowances (a) $ 5,000 Net sales 81,000 95,000 Cost of goods sold 56,000 (e) Gross profi t (b) 38,000 Operating expenses 15,000 23,000 Net income (c) 15,000 Instructions Compute the missing amounts. 7 E3-16 (Closing Entries for a Corporation) Presented below are selected account balances for Homer Winslow Co. as of December 31, 2014. Inventory 12/31/14 $ 60,000 Cost of Goods Sold $225,700 Common Stock 75,000 Selling Expenses 16,000 Retained Earnings 45,000 Administrative Expenses 38,000 Dividends 18,000 Income Tax Expense 30,000 Sales Returns and Allowances 12,000 Sales Discounts 15,000 Sales Revenue 410,000 Instructions Prepare closing entries for Homer Winslow Co. on December 31, 2014. (Omit explanations.) 4 E3-17 (Transactions of a Corporation, Including Investment and Dividend) Scratch Miniature Golf and

Driving Range Inc. was opened on March 1 by Scott Verplank. The following selected events and transac- tions occurred during March. Mar. 1 Invested $50,000 cash in the business in exchange for common stock. 3 Purchased Michelle Wie’s Golf Land for $38,000 cash. The price consists of land $10,000, building $22,000, and equipment $6,000. (Make one compound entry.) 5 Advertised the opening of the driving range and miniature golf course, paying advertising expenses of $1,600. 6 Paid cash $1,480 for a one-year insurance policy. 10 Purchased golf equipment for $2,500 from Singh Company, payable in 30 days. Exercises 141 Mar. 18 Received golf fees of $1,200 in cash. 25 Declared and paid a $500 cash dividend. 30 Paid wages of $900. 30 Paid Singh Company in full. 31 Received $750 of fees in cash. Scratch uses the following accounts: Cash, Prepaid Insurance, Land, Buildings, Equipment, Accounts Pay- able, Common Stock, Dividends, Service Revenue, Advertising Expense, and Salaries and Wages Expense. Instructions Journalize the March transactions. (Provide explanations for the journal entries.) 9 * E3-18 (Cash to Accrual Basis) Jill Accardo, M.D., maintains the accounting records of Accardo Clinic on a cash basis. During 2014, Dr. Accardo collected $142,600 from her patients and paid $55,470 in expenses. At January 1, 2014, and December 31, 2014, she had accounts receivable, unearned service revenue, accrued expenses, and prepaid expenses as follows. (All long-lived assets are rented.) January 1, 2014 December 31, 2014 Accounts receivable $9,250 $15,927 Unearned service revenue 2,840 4,111 Accrued expenses 3,435 2,108 Prepaid expenses 1,917 3,232 Instructions Prepare a schedule that converts Dr. Accardo’s “excess of cash collected over cash disbursed” for the year 2014 to net income on an accrual basis for the year 2014. 9 * E3-19 (Cash and Accrual Basis) Wayne Rogers Corp. maintains its financial records on the cash basis of accounting. Interested in securing a long-term loan from its regular bank, Wayne Rogers Corp. requests you as its independent CPA to convert its cash-basis income statement data to the accrual basis. You are provided with the following summarized data covering 2013, 2014, and 2015. 2013 2014 2015 Cash receipts from sales: On 2013 sales $295,000 $160,000 $ 30,000 On 2014 sales –0– 355,000 90,000 On 2015 sales 408,000 Cash payments for expenses: On 2013 expenses 185,000 67,000 25,000 On 2014 expenses 40,000a 160,000 55,000 On 2015 expenses 45,000b 218,000 aPrepayments of 2014 expenses. bPrepayments of 2015 expenses. Instructions (a) Using the data above, prepare abbreviated income statements for the years 2013 and 2014 on the cash basis. (b) Using the data above, prepare abbreviated income statements for the years 2013 and 2014 on the accrual basis. 5 10 * E3-20 (Adjusting and Reversing Entries) When the accounts of Daniel Barenboim Inc. are examined, the adjusting data listed below are uncovered on December 31, the end of an annual fiscal period. 1. The prepaid insurance account shows a debit of $5,280, representing the cost of a 2-year fire insur- ance policy dated August 1 of the current year. 2. On November 1, Rent Revenue was credited for $1,800, representing revenue from a subrental for a 3-month period beginning on that date. 3. Purchase of advertising materials for $800 during the year was recorded in the Advertising Expense account. On December 31, advertising materials of $290 are on hand. 4. Interest of $770 has accrued on notes payable. Instructions Prepare the following in general journal form. (a) The adjusting entry for each item. (b) The reversing entry for each item where appropriate. 142 Chapter 3 The Accounting Information System 11 * E3-21 (Worksheet) Presented below are selected accounts for Alvarez Company as reported in the work- sheet at the end of May 2014. AAllvvaarreezz CCoommppaannyy..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G 1 2 ALVAREZ CO. 3 Worksheet 4 For The Month Ended May 31, 2014 5 Adjusted Income Balance 6 Trial Balance Statement Sheet

7 Account Titles Dr. Cr. Dr. Cr. Dr. Cr. 8 Cash 9,000 9 Inventory 80,000 10 Sales Revenue 450,000 11 Sales Returns and Allowances 10,000 12 Sales Discounts 5,000 13 Cost of Goods Sold 250,000 Instructions Complete the worksheet by extending amounts reported in the adjusted trial balance to the appropriate columns in the worksheet. Do not total individual columns. 11 * E3-22 (Worksheet and Balance Sheet Presentation) The adjusted trial balance for Ed Bradley Co. is pre- sented in the following worksheet for the month ended April 30, 2014. EEdd BBrraaddlleeyy CCoo..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G 1 2 ED BRADLEY CO. 3 Worksheet (PARTIAL) 4 For The Month Ended April 30, 2014 5 Adjusted Income Balance 6 Trial Balance Statement Sheet 7 Account Titles Dr. Cr. Dr. Cr. Dr. Cr. 8 Cash $18,972 9 Accounts Receivable 6,920 10 Prepaid Rent 2,280 11 Equipment 18,050 12 Accumulated Deprecia!on—Equipment $4,895 13 Notes Payable 5,700 14 Accounts Payable 4,472 15 Common Stock 34,960 16 Retained Earnings—April 1, 2014 1,000 17 Dividends 6,650 18 Service Revenue 12,590 19 Salaries and Wages Expense 6,840 20 Rent Expense 3,760 21 Deprecia!on Expense 145 22 Interest Expense 83 23 Interest Payable 83 Instructions Complete the worksheet and prepare a classified balance sheet. Problems 143 11 * E3-23 (Partial Worksheet Preparation) Jurassic Park Co. prepares monthly financial statements from a worksheet. Selected portions of the January worksheet showed the following data. JJuurraassssiicc PPaarrkk CCoo..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G 1 2 JURASSIC PARK CO. 3 Worksheet (PARTIAL) 4 For The Month Ended Jan. 31, 2014 5 Adjusted 6 Trial Balance Adjustments Trial Balance 7 Account Titles Dr. Cr. Dr. Cr. Dr. Cr. 8 Supplies 3,256 (a) 1,500 1,756 9 Accumulated Deprecia!on—Equipment 6,682 (b) 257 6,939 10 Interest Payable 100 (c) 50 150 11 Supplies Expense (a) 1,500 1,500 12 Deprecia!on Expense (b) 257 257 13 Interest Expense (c) 50 50 During February, no events occurred that affected these accounts. But at the end of February, the following information was available. (a) Supplies on hand $715 (b) Monthly depreciation $257 (c) Accrued interest $ 50 Instructions Reproduce the data that would appear in the February worksheet, and indicate the amounts that would be shown in the January income statement. EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 4 6 P3-1 (Transactions, Financial Statements—Service Company) Listed below are the transactions of 7 Yasunari Kawabata, D.D.S., for the month of September. Sept. 1 Kawabata begins practice as a dentist and invests $20,000 cash. 2 Purchases dental equipment on account from Green Jacket Co. for $17,280. 4 Pays rent for office space, $680 for the month. 4 Employs a receptionist, Michael Bradley. 5 Purchases dental supplies for cash, $942. 8 Receives cash of $1,690 from patients for services performed. 10 Pays miscellaneous office expenses, $430. 14 Bills patients $5,820 for services performed. 18 Pays Green Jacket Co. on account, $3,600. 19 Withdraws $3,000 cash from the business for personal use. 20 Receives $980 from patients on account. 25 Bills patients $2,110 for services performed. 30 Pays the following expenses in cash: Salaries and wages $1,800; miscellaneous office expenses $85. 30 Dental supplies used during September, $330. 144 Chapter 3 The Accounting Information System Instructions (a) Enter the transactions shown above in appropriate general ledger accounts (use T-accounts). Use the following ledger accounts: Cash, Accounts Receivable, Supplies, Equipment, Accumulated Depreciation—Equipment, Accounts Payable, Owner’s Capital, Service Revenue, Rent Expense, Office Expense, Salaries and Wages Expense, Supplies Expense, Depreciation Expense, and Income Summary. Allow 10 lines for the Cash and Income Summary accounts, and 5 lines for each of the other accounts needed. Record depreciation using a 5-year life on the equipment, the straight-line

method, and no salvage value. Do not use a drawing account. (b) Prepare a trial balance. (c) Prepare an income statement, a statement of owner’s equity, and an unclassified balance sheet. (d) Close the ledger. (e) Prepare a post-closing trial balance. 5 6 P3-2 (Adjusting Entries and Financial Statements) Mason Advertising Agency was founded in January 2010. Presented below are adjusted and unadjusted trial balances as of December 31, 2014. MASON ADVERTISING AGENCY TRIAL BALANCE DECEMBER 31, 2014 Unadjusted Adjusted Dr. Cr. Dr. Cr. Cash $ 11,000 $ 11,000 Accounts Receivable 20,000 23,500 Supplies 8,400 3,000 Prepaid Insurance 3,350 2,500 Equipment 60,000 60,000 Accumulated Depreciation—Equipment $ 28,000 $ 33,000 Accounts Payable 5,000 5,000 Interest Payable –0– 150 Notes Payable 5,000 5,000 Unearned Service Revenue 7,000 5,600 Salaries and Wages Payable –0– 1,300 Common Stock 10,000 10,000 Retained Earnings 3,500 3,500 Service Revenue 58,600 63,500 Salaries and Wages Expense 10,000 11,300 Insurance Expense 850 Interest Expense 350 500 Depreciation Expense 5,000 Supplies Expense 5,400 Rent Expense 4,000 4,000 $117,100 $117,100 $127,050 $127,050 Instructions (a) Journalize the annual adjusting entries that were made. (Omit explanations.) (b) Prepare an income statement and a statement of retained earnings for the year ending December 31, 2014, and an unclassified balance sheet at December 31. (c) Answer the following questions. (1) If the note has been outstanding 3 months, what is the annual interest rate on that note? (2) If the company paid $12,500 in salaries and wages in 2014, what was the balance in Salaries and Wages Payable on December 31, 2013? 5 P3-3 (Adjusting Entries) A review of the ledger of Baylor Company at December 31, 2014, produces the following data pertaining to the preparation of annual adjusting entries. 1. Salaries and Wages Payable $0. There are eight employees. Salaries and wages are paid every Friday for the current week. Five employees receive $700 each per week, and three employees earn $600 each per week. December 31 is a Tuesday. Employees do not work weekends. All employees worked the last 2 days of December. Problems 145 2. Unearned Rent Revenue $429,000. The company began subleasing office space in its new building on November 1. Each tenant is required to make a $5,000 security deposit that is not refundable until occupancy is terminated. At December 31, the company had the following rental contracts that are paid in full for the entire term of the lease. Date Term (in months) Monthly Rent Number of Leases Nov. 1 6 $6,000 5 Dec. 1 6 $8,500 4 3. Prepaid Advertising $13,200. This balance consists of payments on two advertising contracts. The contracts provide for monthly advertising in two trade magazines. The terms of the contracts are as shown below. Contract Date Amount Number of Magazine Issues A650 May 1 $6,000 12 B974 Oct. 1 7,200 24 The first advertisement runs in the month in which the contract is signed. 4. Notes Payable $60,000. This balance consists of a note for one year at an annual interest rate of 12%, dated June 1. Instructions Prepare the adjusting entries at December 31, 2014. (Show all computations). 4 5 P3-4 (Financial Statements, Adjusting and Closing Entries) The trial balance of Bellemy Fashion Center 6 7 contained the following accounts at November 30, the end of the company’s fiscal year. 8 BELLEMY FASHION CENTER TRIAL BALANCE NOVEMBER 30, 2014 Debit Credit Cash $ 28,700 Accounts Receivable 33,700 Inventory 45,000 Supplies 5,500 Equipment 133,000 Accumulated Depreciation—Equipment $ 24,000 Notes Payable 51,000 Accounts Payable 48,500 Common Stock 90,000 Retained Earnings 8,000 Sales Revenue 757,200 Sales Returns and Allowances 4,200 Cost of Goods Sold 495,400 Salaries and Wages Expense 140,000 Advertising Expense 26,400 Utilities Expenses 14,000 Maintenance and Repairs Expense 12,100 Delivery Expense 16,700 Rent Expense 24,000 $978,700 $978,700 Adjustment data: 1. Supplies on hand totaled $1,500. 2. Depreciation is $15,000 on the equipment. 3. Interest of $11,000 is accrued on notes payable at November 30.