Financial Accounting

Walter T. Harrison Jr. is professor emeritus of accounting at the Hankamer School of Business, Baylor University. He received his BBA from Baylor University, his MS from Oklahoma State University, and his PhD from Michigan State University. Professor Harrison, recipient of numerous teaching awards from student groups as well as from university administrators, has also taught at Cleveland State Community College, Michigan State University, the University of Texas, and Stanford University. A member of the American Accounting Association and the American Institute of Certified Public Accountants, Professor Harrison has served as chairman of the Financial Accounting Standards Committee of the American Accounting Association, on the Teaching/Curriculum Development Award Committee, on the Program Advisory Committee for Accounting Education and Teaching, and on the Notable Contributions to Accounting Literature Committee. Professor Harrison has lectured in several foreign countries and published articles in numerous journals, including Journal of Accounting Research, Journal of Accountancy, Journal of Accounting and Public Policy, Economic Consequences of Financial Accounting Standards, Accounting Horizons, Issues in Accounting Education, and Journal of Law and Commerce. He is co-author of Financial & Managerial Accounting, second edition, 2009 and Accounting, eighth edition, 2009 (with Charles T. Horngren and M. Suzanne Oliver), published by Pearson Prentice Hall. Professor Harrison has received scholarships, fellowships, and research grants or awards from PricewaterhouseCoopers, Deloitte & Touche, the Ernst & Young Foundation, and the KPMG Foundation. Charles T. Horngren (1926—2011) was the Edmund W. Littlefield professor of accounting, emeritus, at Stanford University. A graduate of Marquette University, he received his MBA from Harvard University and his PhD from the University of Chicago. He was also the recipient of honorary doctorates from Marquette University and DePaul University. A certified public accountant, Horngren served on the Accounting Principles Board for six years, the Financial Accounting Standards Board Advisory Council for five years, and the Council of the American Institute of Certified Public Accountants for three years. For six years he served as a trustee of the Financial Accounting Foundation, which oversees the Financial Accounting Standards Board and the Government Accounting Standards Board. Horngren is a member of the Accounting Hall of Fame. A member of the American Accounting Association, Horngren was its president and its director of research. He received its first annual Outstanding Accounting Educator Award. The California Certified Public Accountants Foundation gave Horngren its Faculty Excellence Award and its Distinguished Professor Award. He was the first person to have received both awards. The American Institute of Certified Public Accountants presented its first Outstanding Educator Award to Horngren. Horngren was named Accountant of the Year, in Education, by the national professional accounting fraternity, Beta Alpha Psi. Professor Horngren was also a member of the Institute of Management Accountants, from whom he received its Distinguished Service Award. He was a member of the institute’s Board of Regents, which administers the Certified Management Accountant examinations. Horngren is the author of these other accounting books published by Pearson: Cost Accounting: A Managerial Emphasis, Fifteenth Edition, 2015 (with Srikant Datar and George Foster); Introduction to Financial Accounting, Eleventh Edition, 2014 (with Gary L. Sundem, John A. Elliott, and Donna Philbrick); Introduction to Management Accounting, Sixteenth Edition, 2014 (with Gary L. Sundem, Jeff Schatzberg, and Dave Burgstahler); Financial & Managerial Accounting, Sixteenth Edition, 2014 and Horngren’s Accounting, Tenth Edition, 2014 (revised by Tracie Nobles, Brenda Mattison, and Ella Mae Matsumura). Horngren was the consulting editor for Pearson’s Charles T. Horngren Series in Accounting. C. William (Bill) Thomas is the J. E. Bush Professor of Accounting and a Master Teacher at Baylor University. A Baylor University alumnus, he received both his BBA and MBA there and went on to earn his PhD from The University of Texas at Austin. With primary interests in the areas of financial accounting and auditing, Bill Thomas has served as the J. E. Bush Professor of Accounting since 1995. He has been a member of the faculty of the Accounting and Business Law Department of the Hankamer School of Business since 1971, and served as chair of the department from 1983 until 1995. He was recognized as an Outstanding Faculty Member of Baylor University in 1984 and Distinguished Professor for the Hankamer School of Business in 2002. Dr. Thomas has received several awards for outstanding teaching, including the Outstanding Professor in the Executive MBA Programs in 2001, 2002, and 2006. In 2004, he received the designation as Master Teacher. Thomas is the author of textbooks in auditing and financial accounting, as well as many articles in auditing, financial accounting and reporting, taxation, ethics and accounting education. His scholarly work focuses on the subject of fraud prevention and detection, as well as ethical issues among accountants in public practice. His most recent publication of national prominence is “The Rise and Fall of the Enron Empire” which appeared in the April 2002 Journal of Accountancy, and which was selected by Encyclopedia Britannica for inclusion in its Annals of American History. He presently serves as both technical and accounting and auditing editor of Today’s CPA, the journal of the Texas Society of Certified Public Accountants, with a circulation of approximately 28,000. Thomas is a certified public accountant in Texas. Prior to becoming a professor, Thomas was a practicing accountant with the firms of KPMG, LLP, and BDO Seidman, LLP. He is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Texas Society of Certified Public Accountants.

Chapter 1  The Financial Statements 1
Spotlight: The Gap, Inc. 1
Explain Why Accounting Is the Language of Business 3
Who Uses Accounting Information? 4
Two Kinds of Accounting: Financial Accounting and Management Accounting 4
Organizing a Business 5
Explain and Apply Underlying Accounting Concepts, Assumptions, and Principles 6
The Entity Assumption 8
The Continuity (Going-Concern) Assumption 8
The Historical Cost Principle 8
The Stable-Monetary-Unit Assumption 9
Apply the Accounting Equation to Business Organizations 11
Assets and Liabilities 11
Owners’ Equity 12
Evaluate Business Operations Through the Financial Statements 14
The Income Statement Measures Operating Performance 14
The Statement of Retained Earnings Shows What a Company Did with Its Net Income 16
The Balance Sheet Measures Financial Position 17
The Statement of Cash Flows Measures Cash Receipts and Payments 20
Construct Financial Statements and Analyze the Relationships Among Them 21
Evaluate Business Decisions Ethically 23
End-of-Chapter Summary Problem 26

 

Chapter 2  Transaction Analysis 53
Spotlight: Whole Foods Market, Inc. 53
Explain What a Transaction Is 55

Define “Account,” and List and Differentiate Between Different Types of Accounts 55
Assets 55
Liabilities 56
Stockholders’ (Owners’) Equity 56
Show the Impact of Business Transactions on the Accounting Equation 57
Example: Freddy’s Auto Service, Inc. 57
Transactions and Financial Statements 63
Mid-Chapter Summary Problem 66
Analyze the Impact of Business Transactions on Accounts 68
The T-Account 68
Increases and Decreases in the Accounts: The Rules of Debit and Credit 68
Additional Stockholders’ Equity Accounts: Revenues and Expenses 70
Record (Journalize and Post) Transactions in the Books 71
Copying Information (Posting) from the Journal to the Ledger 72
The Flow of Accounting Data 73
Accounts after Posting to the Ledger 77
Construct and Use a Trial Balance 78
Analyzing Accounts 79
Correcting Accounting Errors 80
Chart of Accounts 80
The Normal Balance of an Account 81
Account Formats 81
Analyzing Transactions Using Only T-Accounts 82
End-of-Chapter Summary Problem 84




Chapter 3  Accrual Accounting & Income 113
Spotlight: Starbucks Corporation 113
Explain How Accrual Accounting
Differs from Cash-Basis
Accounting 115
Accrual Accounting and Cash Flows 116
The Time-Period Concept 116
Apply the Revenue and Expense Recognition Principles 116
The Revenue Principle 116
The Expense Recognition Principle 118
Ethical Issues in Accrual Accounting 119
Adjust the Accounts 119
Which Accounts Need to Be Updated (Adjusted)? 119
Categories of Adjusting Entries 120
Prepaid Expenses 120
Depreciation of Plant Assets 123
Accrued Expenses 125
Accrued Revenues 127
Unearned Revenues 128
Summary of the Adjusting Process 129
The Adjusted Trial Balance 132
Construct the Financial Statements 133
Mid-Chapter Summary Problem 135
Close the Books 141
Classifying Assets and Liabilities Based on Their Liquidity 142
Reporting Assets and Liabilities: Starbucks Corporation 143
Formats for the Financial Statements 143
Analyze and Evaluate a Company’s Debt-Paying Ability 145
Net Working Capital 145
Current Ratio 145
Debt Ratio 146
How Do Transactions Affect the Ratios? 146
End-of-Chapter Summary Problem 150




Chapter 4  Internal Control & Cash 192
Spotlight: Cooking the Books: Mid-Atlantic Manufacturing Company Takes a Hit 192
Describe Fraud and Its Impact 195
Fraud and Ethics 197
Explain the Objectives and Components of Internal Control 197
The Sarbanes-Oxley Act (SOX) 198
The Components of Internal Control 199
Internal Control Procedures 200
Information Technology 202
Safeguard Controls 203
Internal Controls for E-Commerce 203
Security Measures 203
The Limitations of Internal Control—Costs and Benefits 204
Design and Use a Bank Reconciliation 204
Signature Card 205
Deposit Ticket 205
Check 205
Bank Statement 206
Bank Reconciliation 207
Preparing the Bank Reconciliation 208
Online Banking 211
Mid-Chapter Summary Problem 213
Evaluate Internal Controls Over Cash Receipts and Cash Payments 215
Cash Receipts Over the Counter 215
Cash Receipts by Mail 215
Controls Over Payment by Check 216
Construct and Use a Cash Budget 218
Report Cash on the Balance Sheet 220
Compensating Balance Agreements 220
End-of-Chapter Summary Problem 221





Chapter 5  Short-Term Investments & Receivables 245
Spotlight: Amazing Apple! Short-term investments and accounts receivable are 37 times as large as inventories! 245

Account for Short-Term Investments 247
Reasons to Invest in Other Companies 247
Trading Securities 248
Reporting on the Balance Sheet and the Income Statement 252
Ethics and the Current Ratio 252
Mid-Chapter Summary Problem 253
Apply GAAP for Proper Revenue Recognition 254
Shipping Terms, Sales Discounts, and Sales Returns 255
Account for and Control Accounts Receivable 256
Types of Receivables 256
Internal Controls Over Cash Collections on Account 257
How Do We Manage the Risk of Not Collecting? 257
Evaluate Collectibility Using the Allowance for Uncollectible Accounts 258
Allowance Method 259
Direct Write-Off Method 265
Computing Cash Collections from Customers 265
Account for Notes Receivable 266
Accounting for Notes Receivable 267
Show How to Speed Up Cash Flow from Receivables 269
Credit Card or Bankcard Sales 269
Selling (Factoring) Receivables 270
Reporting on the Statement of Cash Flows 270
Evaluate Liquidity Using Two New Ratios 271
Quick (Acid-Test) Ratio 271
Days’ Sales in Receivables 271
End-of-Chapter Summary Problem 273





Chapter 6  Inventory & Cost of Goods Sold 300
Spotlight: Family Dollar Stores, Inc. 300
Show How to Account for Inventory 303
Sale Price vs. Cost of Inventory 304
Accounting for Inventory in the Perpetual System 306

Apply and Compare Various Inventory Cost Methods 308
What Goes into Inventory Cost? 308
Apply the Various Inventory Costing Methods 309
Compare the Effects of FIFO, LIFO, and Average Cost on Cost of Goods Sold, Gross Profit, and Ending Inventory 311
Keeping Track of Perpetual Inventories under LIFO and Weighted-Average Cost Methods 312
The Tax Advantage of LIFO 313
Mid-Chapter Summary Problem 314
Explain and Apply Underlying GAAP for Inventory 316
Disclosure Principle 316
Lower-of-Cost-or-Market Rule 316
Inventory and the Detailed Income Statement 318
Compute and Evaluate Gross Profit (Margin) Percentage and Inventory Turnover 318
Gross Profit Percentage 318
Inventory Turnover 319
Use the COGS Model to Make Management Decisions 320
Computing Budgeted Purchases 321
Estimating Inventory by the Gross Profit Method 321
Analyze Effects of Inventory Errors 322
End-of-Chapter Summary Problem 325





Chapter 7  Plant Assets, Natural Resources, & Intangibles 362
Spotlight: FedEx Corporation 362
Measure and Account for the Cost of Plant Assets 365
Land 365
Buildings, Machinery, and Equipment 365
Land Improvements and Leasehold Improvements 366
Lump-Sum (or Basket) Purchases of Assets 366
Distinguish a Capital Expenditure from an Immediate Expense 367

Measure and Record Depreciation on Plant Assets 369
How to Measure Depreciation 370
Depreciation Methods 370
Comparing Depreciation Methods 375
Mid-Chapter Summary Problem 377
Other Issues in Accounting for Plant Assets 378
Depreciation for Tax Purposes 378
Depreciation for Partial Years 380
Changing the Useful Life of a Depreciable Asset 380
Fully Depreciated Assets 382
Analyze the Effect of a Plant Asset Disposal 382
Disposing of a Fully Depreciated Asset for No Proceeds 383
Selling a Plant Asset 383
Exchanging a Plant Asset 384
T-Accounts for Analyzing Plant Asset Transactions 385
Apply GAAP for Natural Resources and Intangible Assets 387
Accounting for Natural Resources 387
Accounting for Intangible Assets 388
Accounting for Specific Intangibles 388
Accounting for Research and Development Costs 390
Explain the Effect of an Asset Impairment on the Financial Statements 390
Analyze Rate of Return on Assets 392
DuPont Analysis: A More Detailed View of ROA 393
Analyze the Cash Flow Impact of Long-Lived Asset Transactions 394
End-of-Chapter Summary Problem 397





Chapter 8  Long-Term Investments & the Time Value of Money 428
Spotlight: Intel Holds Several Different Types of Investments 428

Stock and Bond Prices 430
Reporting Investments on the Balance Sheet 430
Analyze and Report Investments in Held-to-Maturity Debt Securities 431
Analyze and Report Investments in Available-for-Sale Securities 433
Accounting Methods for Long-Term Stock Investments 433
The Fair Value Adjustment 435
Selling an Available-for-Sale Investment 436
Analyze and Report Investments in Affiliated Companies Using the Equity Method 437
Buying a Large Stake in Another Company 437
Accounting for Equity-Method Investments 438
Analyze and Report Controlling Interests in Other Corporations Using Consolidated Financial Statements 440
Why Buy Controlling Interest in Another Company? 440
Consolidation Accounting 440
The Consolidated Balance Sheet and the Related Work Sheet 441
Goodwill and Noncontrolling Interest 442
Income of a Consolidated Entity 442
Mid-Chapter Summary Problem 444
Consolidation of Foreign Subsidiaries 446
Foreign Currencies and Exchange Rates 446
The Foreign-Currency Translation Adjustment 447
Report Investing Activities on the Statement of Cash Flows 448
Explain the Impact of the Time Value of Money on Certain Types of Investments 449
Present Value 450
Present-Value Tables 451
Present Value of an Ordinary Annuity 452
Using Microsoft Excel to Calculate Present Value 454
Using the PV Model to Compute Fair Value of Available-for-Sale Investments 455
Present Value of an Investment in Bonds 456
End-of-Chapter Summary Problems 457




Chapter 9  Liabilities 482
Spotlight: Southwest Airlines: Still Flying High! 482
Account for Current and Contingent Liabilities 484
Current Liabilities of Known Amount 484
Current Liabilities That Must Be Estimated 490
Contingent Liabilities 491
Are All Liabilities Reported on the Balance Sheet? 492
Summary of Current Liabilities 493
Mid-Chapter Summary Problem 493
Account for Bonds Payable, Notes Payable, and Interest Expense 494
Bonds: An Introduction 494
Issuing Bonds Payable at Par (Face Value) 497
Issuing Bonds Payable at a Discount 499
What Is the Interest Expense on These Bonds Payable? 499
Interest Expense on Bonds Issued at a Discount 501
Partial-Period Interest Amounts 504
Issuing Bonds Payable at a Premium 504
The Straight-Line Amortization Method: A Quick and Dirty Way to Measure Interest Expense 508
Should We Retire Bonds Payable Before Their Maturity? 509
Convertible Bonds and Notes 509
Analyze and Differentiate Financing with Debt Versus Equity 510
The Leverage Ratio 512
The Times-Interest-Earned Ratio 513
Understand Other Long-Term Liabilities 513
Leases 513
Types of Leases 513
Do Lessees Prefer Operating Leases or Capital Leases? 514
Pensions and Postretirement Liabilities 515
Report Liabilities 516

Reporting on the Balance Sheet 516
Disclosing the Fair Value of Long-Term Debt 517
Reporting Financing Activities on the Statement of Cash Flows 517
End-of-Chapter Summary Problems 518





Chapter 10  Stockholders’ Equity 550
Spotlight: The Home Depot: Building Toward Success 550
Explain the Features of a Corporation 552
Organizing a Corporation 553
Stockholders’ Rights 554
Stockholders’ Equity 555
Classes of Stock 555
Account for the Issuance of Stock 557
Common Stock 557
A Stock Issuance for Other Than Cash Can Create an Ethical Challenge 560
Preferred Stock 561
Mid-Chapter Summary Problem 562
Authorized, Issued, and Outstanding Stock 564
Show how Treasury Stock Affects a Company 564
How Is Treasury Stock Recorded? 564
Retirement of Treasury Stock 566
Resale of Treasury Stock 566
Issuing Stock for Employee Compensation 566
Summary of Treasury-Stock Transactions 567
Account for Retained Earnings, Dividends, and Splits 567
Should the Company Declare and Pay Cash Dividends? 568
Cash Dividends 568
Analyzing the Stockholder’s Equity Accounts 569
Dividends on Preferred Stock 570
Stock Dividends 571
Stock Splits 572
Summary of the Effects on Assets, Liabilities, and Stockholders’ Equity 573

Use Stock Values in Decision Making 573
Market, Redemption, Liquidation, and Book Value 573
ROE: Relating Profitability to Stockholder Investment 575
Report Stockholders’ Equity Transactions in the Financial Statements 577
Statement of Cash Flows 577
Statement of Stockholders’ Equity 578
A Detailed Stockholders’ Equity Section of the Balance Sheet 579
End-of-Chapter Summary Problems 581





Chapter 11  Evaluating Performance: Earnings Quality, the Income Statement, & the Statement of Comprehensive Income 617
Spotlight: The Gap, Inc.: What a Difference a Year Makes! 617
Evaluate Quality of Earnings 619
Revenue Recognition 620
Cost of Goods Sold and Gross Profit (Gross Margin) 621
Operating and Other Expenses 622
Operating Income (Earnings) 622
Account for Foreign-Currency Gains and Losses 623
Dollars versus Foreign Currency 623
Reporting Foreign-Currency Gains and Losses on the Income Statement 624
Reporting Foreign-Currency Exchange Gains and Losses on Cash and Cash Equivalents in the Statement of Cash Flows 624
Should We Hedge Our Foreign-Currency- Transaction Risk? 625
Account for Other Items on the Income Statement 625
Interest Expense and Interest Income 625
Corporate Income Taxes 625
Which Income Number Predicts Future Profits? 627
Discontinued Operations 628
Accounting Changes 629

Compute Earnings per Share 630
Analyze the Statement of Comprehensive Income, Footnotes, and Supplemental Disclosures 631
Reporting Comprehensive Income 631
For Additional Details, Don’t Forget the Footnotes 632
Nonfinancial Reports 634
Differentiate Management’s and Auditors’ Responsibilities in Financial Reporting 634
Management’s Responsibility 634
Auditor Report 634
End-of-Chapter Summary Problems 637





Chapter 12  The Statement of Cash Flows 664
Spotlight: Google: The Ultimate Answer (and Cash) Machine 664
Identify the Purposes of the Statement of Cash Flows 666
How’s Your Cash Flow? Telltale Signs of Financial Difficulty 667
Distinguish Among Operating, Investing, and Financing Activities 668
Two Formats for Operating Activities 669
Prepare a Statement of Cash Flows by the Indirect Method 669
Cash Flows from Operating Activities 671
Cash Flows from Investing Activities 675
Cash Flows from Financing Activities 676
Noncash Investing and Financing Activities 680
Mid-Chapter Summary Problem 681
Prepare a Statement of Cash Flows by the Direct Method 684
Cash Flows from Operating Activities 685
Depreciation, Depletion, and Amortization Expense 687
Cash Flows from Investing Activities 687
Cash Flows from Financing Activities 688
Noncash Investing and Financing Activities 688
Computing Operating Cash Flows by the Direct Method 689

Computing Investing and Financing Cash Flows 693
Measuring Cash Adequacy: Free Cash Flow 694
End-of-Chapter Summary Problems 696





Chapter 13  Financial Statement Analysis 739
Spotlight: How Well Is Amazon.com Doing? 739
It Starts with the Big Picture 741
Perform Horizontal Analysis 743
Illustration: Amazon.com, Inc. 743
Trend Percentages 748
Perform Vertical Analysis 749
Illustration: Amazon.com, Inc. 749
Prepare Common-Size Financial Statements 752
Benchmarking 753
Benchmarking Against a Key Competitor 753
Analyze the Statement of Cash Flows 753
Mid-Chapter Summary Problem 756
Use Ratios to Make Business Decisions 757
Remember to Start at the Beginning: Company and Industry Information 758
Now Let’s Do the Numbers 759
Measuring Ability to Pay Current Liabilities 759
Measuring Turnover and the Cash Conversion Cycle 762
Measuring Leverage: Overall Ability to Pay Debts 765

Measuring Profitability 766
Analyzing Stock as an Investment 771
The Limitations of Ratio Analysis 773
Use Other Measures to Make Investment Decisions 773
Economic Value Added (EVA®) 773
Red Flags in Financial Statement Analysis 774
Efficient Markets 775
End-of-Chapter Summary Problems 778





Appendix A: Amazon.com 2012 Annual Report 821
Appendix B: Yum! Brands, Inc. Annual Report 2012 845
Appendix C: Typical Charts of Accounts for Different Types of Businesses 863
Appendix D: Summary of Generally Accepted Accounting Principles (GAAP) 865
Appendix E: Summary of Differences Between U.S. GAAP and IFRS Cross Referenced to Chapter 867
Company Index 871
Glindex 875