Financial Accounting in an Economic Context

Part 1: An Overview of Financial Accounting 1


1 Financial Accounting and Its Economic Context 2


Financial Reporting and Investment Decisions 3


The Demand for Financial Information: A User’s Orientation 5


The Economic Environment in Which Financial Reports Are Prepared and Used 16


Corporate Governance 18


International Perspective: Financial Statement Users Need to Be Bilingual 25


Appendix 1A Three Other Kinds of Accounting 27


Review of Learning Objectives 27


Key Terms 29


Online Research Exercise 29


Issues for Discussion 30


2 A Closer Look at the Financial Statements 32


A Story That Builds a Set of Financial Statements 33


Gone Fishin’s Financial Statements 39


The Classified Balance Sheet 41


The Income Statement 46


The Statement of Cash Flows 49


The Statement of Shareholders’ Equity 50


Financial Statements As a Package and Five Fundamental Performance Metrics 52


Using the Financial Statement Package to Compute Five Fundamental Metrics of Performance 54


Appendix 2A Organizational Form and the Equity Section 57


Review Problem 58


Review of Learning Objectives 62


Key Terms 63


Online Research Exercise 64


Brief Exercises 64


Exercises 65


Problems 68


Issues for Discussion 73


Part 2: Measurement, Mechanics, and Use of Financial Statements 77


3 The Measurement Fundamentals of Financial Accounting 78


Assumptions of Financial Accounting 79


Valuations on the Balance Sheet 83


The Principles of Financial Accounting Measurement 87


Two Exceptions to the Basic Principles: Materiality and Conservatism 93


International Perspective: Fundamental Differences between U.S. GAAP and IFRS 95


Review of Learning Objectives 96


Key Terms 98


Online Research Exercise 98


Brief Exercises 98


Exercises 99


Problems 101


Issues for Discussion 107


4 The Mechanics of Financial Accounting 111


Economic Events 112


The Fundamental Accounting Equation 113


Business Transactions, the Accounting Equation, and the Financial Statements 114


The Journal Entry 119


The Double Entry System 120


The Journal Entry Box 120


Journal Entries and the Accounting Equation: Examples 121


T-Accounts 121


Recognizing Gains and Losses 127


Periodic Adjustments 128


Reporting Difficulties Faced by Multinational Companies 139


Appendix 4A T-Account Analysis and Preparing the Statement of Cash Flows 140


Operating Items 141


Non Operating Items 144


Review Problem 147


Review of Learning Objectives 151


Key Terms 152


Online Research Exercise 153


Brief Exercises 153


Exercises 154


Problems 161


Issues for Discussion 170


5 Using Financial Statement Information 174


Control and Prediction 175


Four Elements of Successful Companies 176


Analyzing the Financial Statements 180


Additional Areas of Financial Statement Analysis 190


Assessing the Business Environment 190


Reading and Studying the Financial Statements and Footnotes 190


Assessing Earnings Quality 193


Annual Report Information, Company Value, and Projected Financial Statements 195


International Perspective: Financial Statement Analysis in an International Setting 196


Appendix 5A Shareholder Value, ROE, and Cash Flow Analyses 199


Determinants of Value Creation: Analyzing Return on Equity 200


Shareholder Value Creation and the ROE Model: Macy’s vs. Kohl’s 203


Cash Flow Analysis 205


Cash Flow Profiles 207


Review Problem 208


Review of Learning Objectives 211


Key Terms 212


Online Research Exercise 213


Brief Exercises 213


Exercises 214


Problems 221


Issues for Discussion 231


Part 3: Assets: A Closer Look 239


6 The Current Asset Classification, Cash, and Accounts Receivable 240


The Current Asset Classification 241


Cash 246


Accounts Receivable 249


Two Fundamental Issues Related to Receivables 259


International Perspective: Receivables, Foreign Currencies, and Hedging 264


ROE Exercise: Management of Working Capital and Receivables and Return on Equity 265


Review Problem 266


Review of Learning Objectives 267


Key Terms 268


Online Research Exercise 269


Brief Exercises 269


Exercises 270


Problems 272


Issues for Discussion 278


7 Merchandise Inventory 283


The Relative Size of Inventories 284


Accounting for Inventory: Four Important Issues 285


Inventory Valuation and Net Income: An Example of Counterbalancing 285


Acquiring Inventory: What Costs to Capitalize? 287


Carrying Inventory: Perpetual Method vs. Periodic Method 291


Selling Inventory: Which Cost Flow Assumption? 293


Ending Inventory: Applying the Lower-of-Cost-or-Market Rule 302


The Lower-of-Cost-or-Market Rule and Hidden Reserves 303


International Perspective: Japanese Business and Inventory Accounting 304


ROE Exercise: Management of Inventory and Return on Equity 305


Inventory Turnover 305 ROE Analysis 305


Review Problem 306


Review of Learning Objectives 309


Key Terms 310


Online Research Exercise 311


Brief Exercises 311


Exercises 311


Problems 315


Issues for Discussion 320


8 Investments in Equity Securities 324


Equity Securities Classified as Current 325


Passive Investments in Equity Securities 327


Long-Term Equity Investments 330


Appendix 8A Consolidated Financial Statements 343


ROE Exercise: Managing Investments in Equity Securities and Return on Equity 343


Review Problem I 349


Review Problem II 350


Review of Learning Objectives 351


Key Terms 352


Online Research Exercise 353


Brief Exercises 353


Exercises 354


Problems 359


Issues for Discussion 366


9 Long-Lived Assets 370


The Relative Size of Long-Lived Assets 371


Long-Lived Asset Accounting: General Issues and Financial Statement Effects 372


An Overview of Long-Lived Asset Accounting 375


Acquisition: What Costs to Capitalize? 376


Postacquisition Expenditures: Betterments or Maintenance? 378


Cost Allocation: Amortizing Capitalized Costs 380


Disposal: Retirements, Impairments, Sales, and Trade-Ins 390


Intangible Assets 393


Copyrights, Patents, and Trademarks 394


The Costs of Developing Computer Software 394


Goodwill 395


Organizational Costs 395


Research and Development Costs 395


IFRS vs. U.S. GAAP: Revaluations to Fair Market Value 397


ROE Exercise: Managing Long-Lived Assets and Return on Equity 399


Review Problem 399


Review of Learning Objectives 400


Key Terms 401


Online Research Exercise 402


Brief Exercises 402


Exercises 403


Problems 408


Issues for Discussion 412


Part 4: Liabilities and Shareholders’ Equity: A Closer Look 415


10 Introduction to Liabilities: Economic Consequences, Current Liabilities, and Contingencies 416


What Is a Liability? 417


The Relative Size of Liabilities on the Balance Sheet 417


Reporting Liabilities on the Balance Sheet: Economic Consequences 418


Current Liabilities 421


Determinable Current Liabilities 423


Contingencies and Contingent Liabilities 430


Provisions vs. Contingent Liabilities: The “Devil Is in the Details” 434


ROE Exercise: Managing Current Liabilities 436


Appendix 10A Retirement Costs: Pensions and Postretirement Healthcare and Insurance 436


Pensions 436


Defined Contribution Plan 436


Defined Benefit Plan 437


Postretirement Healthcare and Insurance Costs 439


Appendix 10B Deferred Income Taxes 441


The Concept of Deferred Income Taxes 441


Accounting Entries for Deferred Income Taxes 442


Deferred Income Taxes: Additional Issues 443


The Conservatism Ratio 444


Review Problem 446


Review of Learning Objectives 448


Key Terms 449


Online Research Exercise 449


Brief Exercises 450


Exercises 450


Problems 454


Issues for Discussion 458


11 Long-Term Liabilities: Notes, Bonds, and Leases 463


The Relative Size of Long-Term Liabilities 464


The Economic Consequences of Reporting Long-Term Liabilities 465


Basic Definitions and Different Contractual Forms 466


Effective Interest Rate 468


Accounting for Long-Term Obligations: The Effective Interest Method 470


Accounting for Long-Term Notes Payable 470


Bonds Payable 472


Financial Instruments, Fair Market Values, and Off-Balance-Sheet Risks 481


Leases 483


International Perspective: The Importance of Debt Financing in Other Countries 487


ROE Exercise: Managing Long-Term Debt 489


Appendix 11A Determination of Bond Prices 489


Appendix 11B Investing in Bonds 491


Review of Learning Objectives 495


Key Terms 496


Online Research Exercise 497


Brief Exercises 497


Exercises 498


Problems 504


Issues for Discussion 510


12 Shareholders’ Equity 515


The Relative Importance of Liabilities, Contributed Capital, and Earned Capital 516


Debt and Equity Distinguished 517


Accounting for Shareholders’ Equity 521


Accounting for Common and Preferred Stock Issuances 527


The Statement of Shareholders’ Equity 541


International Perspective: The Rise of International Equity Markets 541


ROE Exercise: Return on Equity and Value Creation 543


Review Problem 544


Review of Learning Objectives 546


Key Terms 547


Online Research Exercise 548


Brief Exercises 548


Exercises 549


Problems 554


Issues for Discussion 561


Part 5: Income and Cash Flows 567


13 The Complete Income Statement 568


The Economic Consequences Associated with Income


Measurement and Disclosure 569


The Measurement of Income: Different Measures for Different Objectives 570


A Complete Income Statement: Disclosure and Presentation 579


Intraperiod Tax Allocation 585


Earnings-Per-Share Disclosure 586


Income Statement Categories: Useful for Decisions but Subjective 588


International Perspective: Investments and Income Statement Disclosure 589


ROE Exercise: Using the Right Earnings Number 591


Review Problem 591


Review of Learning Objectives 593


Key Terms 594


Online Research Exercise 595


Brief Exercises 595


Exercises 596


Problems 602


Issues for Discussion 607


14 The Statement of Cash Flows 611


The Definition of Cash 612


A General Description of the Statement of Cash Flows 613


How the Statement of Cash Flows Can Be Used 617


The Statement of Cash Flows: Economic Consequences 620


Deriving Cash Flow from Accrual Financial Statements 621


The Complete Statement of Cash Flows 630


Analyzing the Statement of Cash Flows: An Application 633


International Perspective: The Statement of Cash Flows 635


Review Problem 636


Review of Learning Objectives 639


Key Terms 640


Online Research Exercise 640


Brief Exercises 641


Exercises 641


Problems 652


Issues for Discussion 662


Appendix A The Time Value of Money 669


Interest: The Price of Money 669


Time Value 670


Time Value Computations 670


Computing Implicit Rates of Return and Interest Rates 680


Present Value and Financial Accounting 682


Review of Learning Objectives 683


Exercises 684


Problems 687


Appendix B Quality of Earnings Cases: A Comprehensive Review 695


Case 1: Liberty Manufacturing 695


Case 2: Microline Corporation 698


Case 3: Technic Enterprises and Sonar-Sun Inc. 702


Case 4: Avery Corporation 708


Case 5: Zenith Creations 714


Case 6: Pierce and Snowden 718


Glossary 728


Subject Index 758


Company Index 769