Financial Accounting

Robert S. Kemp, DBA, CPA    Professor Kemp is the Ramon W. Breeden, Sr. Research Professor at the McIntire School of Commerce, University of Virginia. He is a certified public accountant and possesses a baccalaureate, master’s, and doctorate in business administration. Professor Kemp is an accomplished scholar, conducting research and writing in the theory and practice of contemporary business. He currently is conducting research in the funding of pensions, the management of financial institutions, and corporate finance. His scholarly works include 70 completed projects, including monographs, articles, cases, research presentations, and working papers. His work is published in, among other places, The Financial Review; The Journal of Financial Research; Advances in Accounting, A Research Journal; Benefits Quarterly; The Journal of Mathematics Applied in Business and Industry; The Journal of Accountancy; The Journal of Commercial Bank Lending; The Journal of Bank Accounting and Auditing; and The Journal of Business Economics. Professor Kemp is likewise an accomplished teacher, to both University students and executives throughout the world. During his 34 years at the University of Virginia, he has taught numerous undergraduate and graduate courses. He has taught classes using lectures, case studies, discussion groups, and distance learning. His consistently high evaluations by students reflect his devotion to the classroom. This high quality is likewise seen in his teaching of business executives. He has worked with and taught for organizations such as Bank of America, the FDIC, Navigant–Tucker Alan, the Siberian Banking Institute, the Barents Group, KPMG, Gerson Lehrman, Wellington Management, the Russian Bankers Association, the Central Asian American Enterprise Fund, the American Institute of Certified Public Accountants, and the Consumer Bankers Association. Jeffrey Waybright teaches accounting at Spokane Community College, which is part of a multi-college district in eastern Washington. He has been a full-time, tenured community college instructor for more than 21 years. In addition to teaching at the community college level, he has also taught upper division courses for Linfield College. Jeffrey is a co-recipient of the Washington Society of CPA’s Outstanding Educator Award. Jeffrey received his BA in business administration (emphasis in accounting) and MBA from Eastern Washington University. Before becoming a professor, Jeffrey spent eight years as a practicing CPA in Washington State and still holds his license. During his teaching career, he has taught in many disciplines of accounting including financial, managerial, computerized, and payroll accounting as well as in the disciplines of economics, business math, and general business. Jeffrey developed online courses in accounting, teaches online and traditional courses for financial and managerial accounting, and advises students. Jeffrey is passionate about teaching students the subject of accounting. A01_

Chapter 1 Business, Accounting, and You 1

Business, Accounting, and You 1
What Is a Business, and Why Study Accounting? 2
The Definition of a Business 2
The General Concept of Value 3
Business Owners and Other Stakeholders 4
The Goal of a Business 5
How Does a Business Operate? 5
Resources Needed to Start and Operate a Business 5
Operating the Business 5
The Cost of Money 6
How Are Businesses Organized? 6
The Types of Businesses 6
The Legal Forms of Businesses 7
What Is Accounting, and What Are the Key Accounting
Principles and Concepts? 9
Generally Accepted Accounting Principles 9
International Financial Reporting Standards 10
The Business Entity Principle 10
The Reliability (Objectivity) Principle 10
The Cost Principle 10
Accounting Ethics: A Matter of Trust 10
What Is the Role of Accounting in a Business? 11
How Do You Recognize a Business Transaction? 12
Cash Accounting 12
Accrual Accounting 12
How Do You Measure a Business Transaction? 12
How Do You Record Business Transactions Using the Accounting Equation? 13
Transaction Analysis 14
Stockholders’ Equity 14
How Do You Report Business Transactions Using Financial Statements? 20
The Income Statement 20
The Statement of Retained Earnings 22
The Balance Sheet 22
The Statement of Cash Flows 22
Relationships Among the Financial Statements 23

¿Accounting, Business, and You—Putting It All Together 24
Summary 25
Accounting Practice 28
Apply Your Knowledge 49
Know Your Business 50





Chapter 2 Analyzing and Recording Business Transactions 53
Business, Accounting, and You 53
How Are Accounts Used to Keep Business Transactions Organized? 54
Organizing Accounts 54
Assets 55
Liabilities 55
Stockholders’ Equity 55
What Is Double-Entry Accounting? 56
Normal Balance 58
How Are the General Journal and General Ledger Used to Keep Track of Business Transactions? 58
Transaction Analysis 60
Applying Transaction Analysis 60
Balancing the T-Accounts 67
How Is a Trial Balance Prepared, and What Is It Used For? 69
Correcting Errors 70
Preparation of Financial Statements 71
Summary 74
Accounting Practice 75
Apply Your Knowledge 99
Know Your Business 99





Chapter 3 Adjusting and Closing Entries 102
Business, Accounting, and You 102
How Does a Company Accurately Report Its Income? 104
Revenue Recognition and Matching Principles 104
What Is the Role of Adjusting Entries, and When Are They Prepared? 105

Accruing Revenues 106
Accruing Expenses 107
Adjusting Deferred Revenues 107
Adjusting Deferred Expenses 108
How Are Financial Statements Prepared from an Adjusted Trial Balance? 113
The Adjusted Trial Balance 113
Preparing the Financial Statements 115
How Does a Company Prepare for a New Accounting Period? 117
Completing the Accounting Cycle 117
The Three Closing Entries: Revenues, Expenses, and Dividends 118
Post-Closing Trial Balance 120
Summary of the Adjusting and Closing Processes 120
Summary 123
Accounting Practice 125
Apply Your Knowledge 154
Know Your Business 154
Comprehensive Problem 157





Chapter 4 Accounting for a Merchandising Business 159
Business, Accounting, and You 159
What Are the Relationships Among Manufacturers, Wholesalers, Retailers, and Customers? 160
How Do Periodic and Perpetual Inventory Systems Differ? 161
How Do You Account for the Purchase of Inventory? 162
Cash and Credit Purchases 162
Purchase Returns and Allowances 162
Purchase Discounts 163
How Do You Account for the Sale of Inventory? 164
Cash Sales 165
Credit Sales 165
Sales Returns and Allowances 166
Sales Returns 167
Sales Allowances 167
Sales Discounts 168
How Do You Account for Freight Charges and Other Selling Expenses? 169
Costs Related to the Receipt of Goods from Suppliers 170
Costs Related to Delivering Goods to Customers 171
Other Selling Costs 173
How Do You Prepare a Merchandiser’s Financial Statements? 174
The Income Statement 174
The Statement of Retained Earnings 177
The Balance Sheet 177

Summary 180
Accounting Practice 183
Apply Your Knowledge 205
Know Your Business 205





Chapter 5 Inventory 208
Business, Accounting, and You 208
What Inventory Costing Methods Are Allowed? 209
Cost Flow Versus Physical Flow of Inventory 210
How Are the Four Inventory Costing Methods Applied? 212
Inventory Cost Flows 212
Specific-Identification Method 213
First-In, First-Out (FIFO) Method 214
Last-In, First-Out (LIFO) Method 215
Average Cost Method 216
Journalizing Inventory Transactions 217
What Effect Do the Different Costing Methods Have on Net Income? 218
What Else Determines How Inventory Is Valued? 220
How Is Inventory Reported on the Balance Sheet? 222
Inventory Shrinkage 222
How Do Inventory Errors Affect the Financial Statements? 223
Is It Possible to Estimate the Value of Inventory If the Inventory Is Accidentally Destroyed? 224
Summary 228
Accounting Practice 230
Apply Your Knowledge 252
Know Your Business 252
Comprehensive Problem 254





Chapter 6 The Challenges of Accounting: Standards, Internal Control, Audits, Fraud, and Ethics 256
Business, Accounting, and You 256
What Are the Rules that Govern Accounting? 257
Understandable 257
Relevant 258
Reliable 258
Generally Accepted Accounting Principles (GAAP) in the United States 258
Generally Accepted Accounting Principles Around the World: IFRS 259
Differences Between FASB and IFRS 259
What Is Internal Control? 261
Elements of an Internal Control System 261
What Is Fraud, and Who Commits It? 265
Management Fraud 265

Employee Embezzlement 265
The Factors Usually Present When Fraud Is Committed 266
What Is a Certified Public Accountant (CPA)? 268
Audits 268
Audit Opinions 269
What Are the Legal and Ethical Responsibilities of Accountants? 270
The Legal Responsibilities of Accountants 270
Ethical Responsibilities of Accountants 271
Summary 273
Accounting Practice 275
Apply Your Knowledge 282
Know Your Business 285





Chapter 7 Cash and Receivables 288
Business, Accounting, and You 288
What Are the Different Types of Sales? 289
Cash Sales 289
Credit Card Sales 290
Debit Card Sales 290
Credit/Debit Card Processing 290
Sales on Account 291
What Internal Control Procedures Should Be Used for Cash? 291
Internal Controls over Cash Receipts 291
Internal Control over Cash Payments 292
Purchase and Payment Process 293
The Bank Reconciliation 294
Preparing the Bank Reconciliation 294
Book Side of the Reconciliation 295
Online Banking 299
How Is Cash Reported on the Balance Sheet? 300
How Do You Account for Receivables? 300
Types of Receivables 300
Internal Control over Accounts Receivable 301
Accounting for Uncollectible Accounts Receivable 301
How Do You Account for Uncollectible Accounts? 301
The Direct Write-Off Method 301
Direct Write-Off Method: Recovery of Accounts Previously Written Off 302
The Allowance Method 303
Estimating the Amount of Uncollectible Accounts 303
Writing Off Uncollectible Accounts Under the Allowance Method 306
Allowance Method: Recovery of Accounts Previously Written Off 307
How Are Accounts Receivable Reported on the Balance Sheet? 308
How Do You Account for Notes Receivable? 309
Identifying the Maturity Date 309
Origination of Notes Receivable 310

Computing Interest on a Note 310
Accruing Interest Revenue 311
Summary 315
Accounting Practice 318
Apply Your Knowledge 344
Know Your Business 345
Appendix 7A 347
What Is a Petty Cash Fund? 347
Setting Up the Petty Cash Fund 347
Replenishing the Petty Cash Fund 348
Changing the Petty Cash Fund 349
Accounting Practice 350





Chapter 8 Long-Term and Other Assets 353
Business, Accounting, and You 353
What Are the Different Types of Long-Term Assets? 354
How Is the Cost of a Fixed Asset Calculated? 355
Land and Land Improvements 355
Buildings 356
Machinery and Equipment 356
Furniture and Fixtures 357
Lump-Sum (Basket) Purchase of Assets 357
How Are Fixed Assets Depreciated? 358
Measuring Depreciation 359
Depreciation Methods 360
Comparing Depreciation Methods 364
Partial Year Depreciation 364
Changing the Useful Life of a Depreciable Asset 365
Using Fully Depreciated Assets 366
How Are Costs of Repairing Fixed Assets Recorded? 367
Ordinary Repairs 367
Extraordinary Repairs 367
Betterments 368
What Happens When a Fixed Asset Is Disposed? 368
How Do You Account for Intangible Assets? 371
Specific Intangibles 371
Accounting for Research and Development Costs 373
How Are Natural Resources Accounted For? 373
What Are Other Assets? 374
How Are Long-Term Assets Reported on the Balance Sheet? 375
Summary 377
Accounting Practice 380
Apply Your Knowledge 400
Know Your Business 401





Chapter 9 Current Liabilities and Long-Term Debt 404
Business, Accounting, and You 404
What Are the Differences Among Known, Estimated, and Contingent Liabilities? 405
How Do You Account for Current Liabilities of a Known Amount? 406
Accounts Payable 406
Notes Payable 406
Sales Tax Payable 408
Accrued Expenses (Accrued Liabilities) 408
Unearned Revenues 408
Current Portion of Long-Term Debt 409
How Do You Account for Current Liabilities of an Uncertain Amount? 409
Estimated Warranty Liability 409
How Do You Account for a Contingent Liability? 410
How Do You Account for Long-Term Debt? 411
Notes Payable 411
Bonds Payable 413
Lease Liabilities 419
How Are Liabilities Reported on the Balance Sheet? 421
Summary 425
Accounting Practice 428
Apply Your Knowledge 448
Know Your Business 449
Appendix 9A: Payroll.com (Located online at www.pearsonhighered/kemp) 9A-1





Chapter 10 Corporations: Paid-In Capital and Retained Earnings 452
Business, Accounting, and You 452
How Are Corporations Organized? 453
What Makes Up the Stockholders’ Equity of a Corporation? 455
Stockholders’ Rights 455
Classes of Stock 455
Par Value, Stated Value, and No-Par Stock 456
How Is the Issuance of Stock Recorded? 456
Issuing Common Stock 457
Issuing Preferred Stock 458
How Are Cash Dividends Accounted For? 458
Dividend Dates 459
Declaring and Paying Dividends 459
Dividing Dividends Between Preferred and Common Shareholders 460
Dividends on Cumulative and Noncumulative Preferred Stock 461

How Are Stock Dividends and Stock Splits Accounted For? 462
Stock Dividends 462
Recording Stock Dividends 463
Stock Splits 465
Stock Dividends and Stock Splits Compared 467
How Is Treasury Stock Accounted For? 467
Treasury Stock Basics 467
Purchase of Treasury Stock 468
Sale of Treasury Stock 468
How Is Stockholders’ Equity Reported on the Balance Sheet? 471
Summary 473
Accounting Practice 475
Apply Your Knowledge 502
Know Your Business 502





Chapter 11 The Statement of Cash Flows 505
Business, Accounting, and You 505
What Is the Statement of Cash Flows? 507
How Does a Business Create a Statement of Cash Flows? 508
The Logic of How the Statement of Cash Flows Is Prepared 509
Sources and Uses of Cash: Categorizing Changes as Operating, Investing, or Financing 509
Statement of Cash Flows: Two Formats 511
How Is the Statement of Cash Flows Prepared Using the Indirect Method? 512
Cash Flows from Operating Activities 514
Cash Flows from Investing Activities 516
Cash Flows from Financing Activities 518
Net Change in Cash and Cash Balances 520
Noncash Investing and Financing Activities 520
How Is the Statement of Cash Flows Prepared Using the Direct Method? 523
Cash Flows from Operating Activities 524
Summary 530
Accounting Practice 531
Apply Your Knowledge 559
Know Your Business 560
Comprehensive Problem 562





Chapter 12 Financial Statement Analysis 565
Business, Accounting, and You 565
What Is Financial Analysis? 566
Step One: Understand a Business’s Model and Strategy 567
Step Two: Understand the Environment in Which a Business Operates 567

Step Three: Analyze the Content of the Financial Statements and Other Information, Making Adjustments If Desired 568
Step Four: Analyze the Business’s Operations 568
Step Five: Use the Financial Analysis to Make Decisions 569
What Measures Does Someone Use to Analyze the Performance of a Business? 569
The Techniques of Financial Analysis 570
Vertical Analysis 572
Horizontal Analysis 573
Trend Percentages 575
Question 1: Is the Business a Going Concern? 575
An Example: Tucker Enterprises, Inc. 576
Question 2: How Is the Business Earning a Net Income or Loss? 577
An Example: Tucker Enterprises, Inc. 579
Question 3: Where Is the Business Getting Its Money, and Can It Pay Its
Debt Obligations? 580
An Example: Tucker Enterprises, Inc. 580
Question 4: How Is the Business Investing Its Money, and Is It Using Its
Assets Efficiently? 581
An Example: Tucker Enterprises, Inc. 582
Question 5: Is the Business Generating Enough Net Income to Reward the
Stockholders for the Use of Their Money? 583
An Example: Tucker Enterprises, Inc. 584
How Do You Put Everything Together to Make Decisions? 586
Seeing the Impact of Decisions 588
What Are Red Flags in Financial Statement Analysis? 588

Summary 591
Accounting Practice 593
Apply Your Knowledge 618
Know Your Business 619





Appendix A
Columbia Sportswear Company
2012 Annual Report to Shareholders 621
Appendix B
Time Value of Money—Future and Present Value Concepts 689
Future Value 689
Future-Value Tables 690
Future Value of an Annuity 691
Present Value 692
Present-Value Tables 693
Present Value of an Annuity 693
Accounting Practice 695
Company Index 697
Glindex 705
Credits 723