Accounting Principles: A Business Perspective First Global Text Edition, Volume 1 Financial Accounting Roger H. Hermanson,PhD, CPA Regents Professor Emeritus of Accounting Ernst & Young-J. W. Holloway Memorial Professor Emeritus Georgia State University James Don Edwards PhD, D.H.C, CPA J.M. Tull Professor Emeritus of Accounting Terry College of Business University of Georgia Michael W. Maher PhD, CPA Graduate School of Management University of California at Davis Special con to managerial chapters: Kathleen M. Donelan-Knox Department of Accountancy University of Notre Dame Funding for the First Global Text Edition was provided by the Endeavor Corporation, Houston, Texas, USA The Global Text Project is funded by the Jacobs Foundation, Zurich, Switzerland This book is licensed under a Creative Commons Attribution 3.0 License Acknowledgments for the Global Text First Edition: Revision Editor: Donald J. McCubbrey, PhD Clinical Professor, Daniels College of Business University of Denver Life member, American Institute of Certified Public Accountants Revision Assistants Emily Anderson Kyle Block Assistant Editor Jackie Sharman Associate Editor Marisa Drexel Conversion Specialist Varun Sharma This book is licensed under a Creative Commons Attribution 3.0 License Table of Contents Accounting principles:A business perspective................................................................................................. 8 The accounting environment.......................................................................................................................... 18 Accounting defined......................................................................................................................................... 19 Financial accounting versus managerial accounting.....................................................................................23 Development of financial accounting standards............................................................................................ 25 Ethical behavior of accountants..................................................................................................................... 26 1. Accounting and its use in business decisions.......................................................................30 Forms of business organizations.................................................................................................................... 31 Types of activities performed by business organizations..............................................................................32 Financial statements of business organizations............................................................................................ 33 The financial accounting process................................................................................................................... 37 Analyzing and using the financial results—the equity ratio..........................................................................46 2. Recording business transactions...........................................................................................65 The account and rules of debit and credit...................................................................................................... 66 The accounting cycle....................................................................................................................................... 72 The journal...................................................................................................................................................... 73 The ledger........................................................................................................................................................ 76 The accounting process in operation.............................................................................................................. 76 3. Adjustments for financial reporting....................................................................................116 Cash versus accrual basis accounting............................................................................................................ 117 Classes and types of adjusting entries.......................................................................................................... 120 Adjustments for deferred items.................................................................................................................... 122 Adjustments for accrued items..................................................................................................................... 129 4. Completing the accounting cycle.........................................................................................150 The accounting cycle summarized................................................................................................................ 151 The work sheet............................................................................................................................................... 151 Preparing financial statements from the work sheet....................................................................................157 Journalizing adjusting entries...................................................................................................................... 158 The closing process....................................................................................................................................... 159 Accounting systems: From manual to computerized...................................................................................164 A classified balance sheet.............................................................................................................................. 169 Analyzing and using the financial results — the current ratio.....................................................................175 5. Accounting theory................................................................................................................198 Traditional accounting theory...................................................................................................................... 199 Other basic concepts..................................................................................................................................... 201 The measurement process in accounting..................................................................................................... 202 The major principles.................................................................................................................................... 203 Modifying conventions (or constraints)...................................................................................................... 209 The financial accounting standards board's conceptual framework project...............................................212 Objectives of financial reporting................................................................................................................... 212 Qualitative characteristics............................................................................................................................ 214 Recognition and measurement in financial statements...............................................................................218 6. Merchandising transactions................................................................................................236 Introduction to inventories and the classified income statement...............................................................236 Two income statements compared— Service company and merchandising company...............................237 Sales revenues............................................................................................................................................... 238 Cost of goods sold......................................................................................................................................... 244 Classified income statement......................................................................................................................... 252 Analyzing and using the financial results—Gross margin percentage........................................................256 7. Measuring and reporting inventories..................................................................................279 Accounting Principles: A Business Perspective 4 A Global Text Inventories and cost of goods sold............................................................................................................... 280 Determining inventory cost.......................................................................................................................... 282 Departures from cost basis of inventory measurement...............................................................................303 Analyzing and using financial results—inventory turnover ratio................................................................308 8. Control of cash.....................................................................................................................332 Internal control............................................................................................................................................. 333 Controlling cash............................................................................................................................................ 340 The bank checking account.......................................................................................................................... 343 Bank reconciliation....................................................................................................................................... 347 Petty cash funds............................................................................................................................................ 352 Analyzing and using the financial results—The quick ratio.........................................................................355 9. Receivables and payables.....................................................................................................371 Accounts receivable...................................................................................................................................... 372 Current liabilities.......................................................................................................................................... 381 Notes receivable and notes payable............................................................................................................. 387 Short-term financing through notes payable............................................................................................... 391 Analyzing and using the financial results—Accounts receivable turnover and number of days' sales in accounts receivable............................................................................................................................................ 394 10. Property, plant, and equipment........................................................................................410 Nature of plant assets.................................................................................................................................... 411 Initial recording of plant assets.................................................................................................................... 412 Depreciation of plant assets.......................................................................................................................... 416 Subsequent expenditures (capital and revenue) on assets..........................................................................428 Subsidiary records used to control plant assets...........................................................................................431 Analyzing and using the financial results—Rate of return on operating assets..........................................433 11. Plant asset disposals, natural resources, and intangible assets........................................449 Disposal of plant assets................................................................................................................................ 450 Intangible assets............................................................................................................................................ 461 Analyzing and using the financial results—Total assets turnover...............................................................468 12. Stockholders' equity: Classes of capital stock...................................................................486 The corporation............................................................................................................................................ 487 Documents, books, and records relating to capital stock.............................................................................491 Par value and no-par capital stock............................................................................................................... 492 Other values commonly associated with capital stock................................................................................493 Capital stock authorized and outstanding...................................................................................................493 Classes of capital stock................................................................................................................................. 494 Types of preferred stock............................................................................................................................... 495 Balance sheet presentation of stock............................................................................................................. 497 Stock issuances for cash............................................................................................................................... 498 Capital stock issued for property or services............................................................................................... 500 Balance sheet presentation of paid-in capital in excess of par (or stated) value—Common or preferred. 500 Analyzing and using the financial results—Return on average common stockholders' equity..................503 13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock............521 Paid-in (or contributed) capital.................................................................................................................... 522 Retained earnings......................................................................................................................................... 523 Paid-in capital and retained earnings on the balance sheet........................................................................523 Retained earnings appropriations................................................................................................................ 530 Statement of retained earnings.................................................................................................................... 532 Statement of stockholders' equity................................................................................................................ 532 Treasury stock............................................................................................................................................... 533 Net income inclusions and exclusions......................................................................................................... 536 Analyzing and using the financial results—Earnings per share and price-earnings ratio..........................540 5 This book is licensed under a Creative Commons Attribution 3.0 License 14. Stock investments..............................................................................................................559 Cost and equity methods.............................................................................................................................. 560 Consolidated balance sheet at time of acquisition.......................................................................................568 Accounting for income, losses, and dividends of a subsidiary.....................................................................572 Consolidated financial statements at a date after acquisition.....................................................................572 Uses and limitations of consolidated statements.........................................................................................576 Analyzing and using the financial results—Dividend yield on common stock and payout ratios...............577 15. Long-term financing: Bonds..............................................................................................593 Bonds payable............................................................................................................................................... 594 Bond prices and interest rates..................................................................................................................... 600 Analyzing and using the financial results—Times interest earned ratio......................................................611 16. Analysis using the statement of cash flows.......................................................................630 Purposes of the statement of cash flows....................................................................................................... 631 Uses of the statement of cash flows.............................................................................................................. 631 Information in the statement of cash flows.................................................................................................632 Cash flows from operating activities............................................................................................................ 634 Steps in preparing statement of cash flows..................................................................................................636 Analysis of the statement of cash flows........................................................................................................ 641 Analyzing and using the financial results—Cash flow per share of common stock, cash flow margin, and cash flow liquidity ratios............................................................................................................................................ 647 Appendix: Use of a working paper to prepare a statement of cash flows....................................................649 17. Analysis and interpretation of financial statements.........................................................675 Objectives of financial statement analysis................................................................................................... 676 Sources of information................................................................................................................................. 678 Horizontal analysis and vertical analysis: An illustration...........................................................................679 Trend percentages........................................................................................................................................ 682 Ratio analysis................................................................................................................................................ 683 18. Managerial accounting concepts/job costing...................................................................728 Compare managerial accounting with financial accounting........................................................................729 Merchandiser and manufacturer accounting: Differences in cost concepts...............................................730 Financial reporting by manufacturing companies.......................................................................................733 The general cost accumulation model.......................................................................................................... 736 Job costing.................................................................................................................................................... 738 Predetermined overhead rates..................................................................................................................... 743 19. Process: Cost systems.........................................................................................................765 Nature of a process cost system.................................................................................................................... 765 Process costing illustration........................................................................................................................... 766 Process costing in service organizations....................................................................................................... 775 Spoilage......................................................................................................................................................... 775 20. Using accounting for quality and cost management........................................................795 Importance of good accounting information...............................................................................................795 Quality and customer satisfaction measures............................................................................................... 802 Just-in-time method.................................................................................................................................... 805 Activity-based costing and management..................................................................................................... 808 Methods used for activity-based costing....................................................................................................... 811 Impact of new production environment on cost drivers..............................................................................815 Activity-based costing in marketing............................................................................................................. 816 Strategic use of activity-based management................................................................................................ 816 Behavioral and implementation issues......................................................................................................... 817 Opportunities to improve activity-based costing in practice.......................................................................817 21. Cost-volume-profit analysis...............................................................................................831 Accounting Principles: A Business Perspective 6 A Global Text Cost behavior patterns................................................................................................................................. 832 Methods for analyzing costs......................................................................................................................... 835 Cost-volume-profit (CVP) analysis............................................................................................................... 837 Finding the break-even point....................................................................................................................... 838 Cost-volume-profit analysis illustrated........................................................................................................ 841 Assumptions made in cost-volume-profit analysis.....................................................................................843 Using computer spreadsheets for CVP analysis..........................................................................................844 Effect of automation on cost-volume-profit analysis..................................................................................845 22. Short-term decision making: Differential analysis..........................................................859 Contribution margin income statements..................................................................................................... 859 Differential analysis...................................................................................................................................... 861 Applications of differential analysis............................................................................................................. 863 Applying differential analysis to quality...................................................................................................... 867 23. Budgeting for planning and control..................................................................................881 The budget—For planning and control........................................................................................................ 882 The master budget illustrated...................................................................................................................... 887 Budgeting in merchandising companies...................................................................................................... 899 Budgeting in service companies.................................................................................................................. 900 Additional concepts related to budgeting....................................................................................................900 24. Control through standard costs.........................................................................................916 Uses of standard costs................................................................................................................................... 916 Advantages and disadvantages of using standard costs..............................................................................918 Computing variances.................................................................................................................................... 920 Goods completed and sold........................................................................................................................... 930 Investigating variances from standard........................................................................................................ 930 Disposing of variances from standard.......................................................................................................... 931 Nonfinancial performance measures........................................................................................................... 932 Activity-based costing, standards, and variances........................................................................................933 25. Responsibility accounting: Segmental analysis................................................................945 Responsibility accounting............................................................................................................................ 945 Responsibility reports................................................................................................................................... 947 Responsibility centers.................................................................................................................................. 949 Transfer prices.............................................................................................................................................. 952 Use of segmental analysis............................................................................................................................. 952 Concepts used in segmental analysis........................................................................................................... 953 Investment center analysis........................................................................................................................... 956 Economic value added and residual income...............................................................................................960 Segmental reporting in external financial statements.................................................................................961 26. Capital budgeting:Long-range planning...........................................................................978 Capital budgeting defined............................................................................................................................ 978 Profitability index......................................................................................................................................... 987 Investments in working capital.................................................................................................................... 990 The postaudit................................................................................................................................................ 991 Investing in high technology projects.......................................................................................................... 992 Capital budgeting in not-for-profit organizations.......................................................................................992 Epilogue........................................................................................................................................................ 992 7 This book is licensed under a Creative Commons Attribution 3.0 License Accounting principles:A business perspective Eighth edition Roger H. Hermanson, PhD, CPA (Georgia State University, USA) James D. Edwards, PhD, D.H.C., CPA (The University of Georgia, USA) Michael W. Maher, PhD, CPA (University of Notre Dame, USA) About the authors Professor Roger H. Hermanson, PhD, CPA Regents Professor Emeritus of Accounting and Ernst & Young-J. W. Holloway Memorial Professor Emeritus at Georgia State University. He received his doctorate at Michigan State University in 1963 and is a CPA in Georgia. Professor Hermanson taught and later served as chairperson of the Division of Accounting at the University of Maryland. He has authored or coauthored approximately one-hundred articles for professional and scholarly journals and has coauthored numerous editions of several textbooks, including Accounting Principles, Financial Accounting, Survey of Financial and Managerial Accounting, Auditing Theory and Practice, Principles of Financial and Managerial Accounting, and Computerized Accounting with Peachtree Complete III. He also has served on the editorial boards of the Journal of Accounting Education, New Accountant, Accounting Horizons, and Management Accounting. Professor Hermanson has served as co-editor of the Trends in Accounting Education column for Management Accounting. He has held the office of vice president of the American Accounting Association and served on its Executive Committee. He was also a member of the Institute of Management Accountants, the American Institute of Certified Public Accountants, and the Financial Executives Institute. Professor Hermanson has been awarded two excellence in teaching awards, a doctoral fellow's award, and a Distinguished Alumni Professor award; and he was selected as the Outstanding Faculty Member for 1985 by the Federation of Schools of Accountancy. He has served as a consultant to many companies and organizations. In 1990, Professor Hermanson was named Accounting Educator of the Year by the Georgia Society of CPAs. His wife's name is Dianne, and he has two children, Dana and Susan, both of whom are accounting professors. Professor James D. Edwards, PhD, DHC, CPA J. M. Tull Professor Emeritus of Accounting in the Terry College of Business at the University of Georgia. He is a graduate of Louisiana State University and has been inducted into the Louisiana State University Alumni Federation's Hall of Distinction. He received his MBA from the University of Denver and his PhD from the University of Texas and is a CPA in Texas and Georgia. He has served as a professor and chairman of the Department of Accounting and Financial Administration at Michigan State University, a professor and dean of the Graduate School of Business Administration at the University of Minnesota, and a Visiting Scholar at Oxford University in Oxford, England. Professor Edwards is a past president of the American Accounting Association and a past national vice president and executive committee member of the Institute of Management Accountants. He has served on the board of directors of the American Institute of Certified Public Accountants and as chairman of the Georgia State Board of Accountancy. He was an original trustee of the Financial Accounting Foundation, the parent organization of the FASB, and a member of the Public Review Board of Arthur Andersen & Co. He has published in The Accounting Review, The Journal of Accountancy, The Journal of Accounting Research, Management Accounting, and The Harvard Business History Review. He is also the author of History Accounting Principles: A Business Perspective 8 A Global Text Accounting principles:A business perspective of Public Accounting in the United States. He has served on various American Institute of Certified Public Accountants committees and boards, including the Objectives of Financial Statements Committee, Standards of Professional Conduct Committee, and the CPA Board of Examiners. He was the managing editor of the centennial issue of The Journal of Accountancy. In 1974, Beta Alpha Psi, the National Accounting Fraternity, selected Professor Edwards for its first annual Outstanding Accountant of the Year award. This selection is made from industry, government, and educational leaders. In 1975, he was selected by the American Accounting Association as its Outstanding Educator. He has served the AICPA as president of the Benevolent Fund, chairman of the Awards Committee, member of the Professional Ethics Committee and Program for World Congress of Accountants. He was on the Education Standards Committee of the International Federation of Accountants and the Committee on Planning for the Institute of Management Accountants. He was the director of the Seminar for Management Accountants-Financial Reporting for the American Accounting Association. He is also a member of the Financial Executives Institute. He received the 1993 AICPA Gold Medal Award, the highest award given by the Institute. A Doctor Honoris Causa (Honorary Doctorate) from the University of Paris was awarded to him in 1994. He is the first accountant to receive this distinction in France. The Academy of Accounting Historians awarded him the 1994 Hourglass Award which is the highest international honor in the field of Accounting History. He was inducted into the Ohio State University Accounting Hall of Fame in 2001. His wife's name is Clara, and he has one son, Jim. Professor Michael W. Maher, PhD, CPA Professor of management at the University of California at Davis. He is a graduate of Gonzaga University (BBA) and the University of Washington (MBA, PhD). Before going to the University of California at Davis, he taught at the University of Michigan and the University of Chicago. He also worked on the audit staff at Arthur Andersen & Co. and was a self-employed financial consultant for small businesses while attending graduate school. Professor Maher is the coauthor of two leading textbooks, Cost Accounting and Managerial Accounting. He has coauthored several additional books and monographs, including Internal Controls in US Corporations (Financial Executives Research Foundation, 1980); and Management Incentive Compensation Plans (National Association of Accountants, 1986). His articles have appeared in Management Accounting, The Journal of Accountancy, The Accounting Review, The Journal of Accounting Research, Financial Executive, and The Wall Street Journal, among others. For his research on internal controls, Professor Maher was awarded the American Accounting Association Competitive Manuscript Award and the AICPA Notable Contribution in Literature Award. He has also been awarded the American Tax Association Manuscript Award. From the students at the Graduate School of Management, University of California, Davis, he has received the Annual Outstanding Teacher Award three times and twice received a special award for outstanding service. In 1989, Gonzaga University honored Maher with its Outstanding Alumni Merit Award. Preface Philosophy and purpose Imagine that you have graduated from college without taking an accounting course. You are employed by a company as a sales person, and you eventually become the sales manager of a territory. While attending a sales managers' meeting, financial results are reviewed by the Vice President of Sales and terms such as gross margin 9 This book is licensed under a Creative Commons Attribution 3.0 License percentage, cash flows from operating activities, and LIFO inventory methods are being discussed. The Vice President eventually asks you to discuss these topics as they relate to your territory. You try to do so, but it is obvious to everyone in the meeting that you do not know what you are talking about. Accounting principles courses teach you the "language of business" so you understand terms and concepts used in business decisions. If you understand how accounting information is prepared, you will be in an even stronger position when faced with a management decision based on accounting information. The importance of transactions analysis and proper recording of transactions has clearly been demonstrated in some of the recent business failures that have been reported in the press. If the financial statements of an enterprise are to properly represent the results of operations and the financial condition of the company, the transactions must be analyzed and recorded in the accounts following generally accepted accounting principles. The debits and credits are important not only to accounting majors but also to those entering or engaged in a business career to become managers because the ultimate effects of these journal entries are reflected in the financial statements. If expenses are reported as assets, liabilities and their related expenses are omitted from the financial statements, or reported revenues are recorded prematurely or do not really exist, the financial statements are misleading. The financial statements are only useful and meaningful if they are fair and clearly represent the business events of the company. We wrote this text to give you an understanding of how to use accounting information to analyze business performance and make business decisions. The text takes a business perspective. We use the annual reports of real companies to illustrate many of the accounting concepts. You are familiar with many of the companies we use, such as The Limited, The Home Depot, and Coca-Cola Company. Gaining an understanding of accounting terminology and concepts, however, is not enough to ensure your success. You also need to be able to find information on the Internet, analyze various business situations, work effectively as a member of a team, and communicate your ideas clearly. This text was developed to help you develop these skills. Curriculum concerns Significant changes have been recommended for accounting education. Some parties have expressed concern that recent accounting graduates do not possess the necessary set of skills to succeed in an accounting career. The typical accounting graduate seems unable to successfully deal with complex and unstructured "real world" accounting problems and generally lacks communication and interpersonal skills. One recommendation is the greater use of active learning techniques in a re-energized classroom environment. The traditional lecture and structured problem solving method approach would be supplemented or replaced with a more informal classroom setting dealing with cases, simulations, and group projects. Both inside and outside the classroom, there would be two-way communication between (1) professor and student and (2) student and student. Study groups would be formed so that students could tutor other students. The purposes of these recommendations include enhancing students' critical thinking skills, written and oral communication skills, and interpersonal skills. One of the most important benefits you can obtain from a college education is that you "learn how to learn". The concept that you gain all of your learning in school and then spend the rest of your life applying that knowledge is not valid. Change is occurring at an increasingly rapid pace. You will probably hold many different jobs during your career, and you will probably work for many different companies. Much of the information you learn in college will Accounting Principles: A Business Perspective 10 A Global Text Accounting principles:A business perspective be obsolete in just a few years. Therefore, you will be expected to engage in life-long learning. Memorizing is much less important than learning how to think critically. With this changing environment in mind, we have developed a text that will lend itself to developing the skills that will lead to success in your future career in business. The section at the end of each chapter titled, "Beyond the numbers—Critical thinking", provides the opportunity for you to address unstructured case situations, the analysis of real companies' financial situations, ethics cases, and team projects. Each chapter also includes one or two Internet projects in the section titled "Using the Internet—A view of the real world". For many of these items, you will use written and oral communication skills in presenting your results. Objectives and overall approach of the eighth edition The Accounting Education Change Commission (AECC) made specific recommendations regarding teaching materials and methods used in the first-year accounting course. As a result, significant changes have taken place in that course at many universities. The AECC states: The first course in accounting can significantly benefit those who enter business, government, and other organizations, where decision-makers use accounting information. These individuals will be better prepared for their responsibilities if they understand the role of accounting information in decision-making by managers, investors, government regulators, and others. All organizations have accountability responsibilities to their constituents, and accounting, properly used, is a powerful tool in creating information to improve the decisions that affect those constituents. 1 One of the purposes of the first course should be to recruit accounting majors. To help accomplish this, the text has a section preceding each chapter entitled, "Careers in accounting". We retained a solid coverage of accounting that serves business students well regardless of the majors they select. Those who choose not to major in accounting, which is a majority of those taking this course, will become better users of accounting information because they will know something about the preparation of that information. Approach and organization Business emphasis Without actual business experience, business students sometimes lack a frame of reference in attempting to apply accounting concepts to business transactions. We seek to involve the business student more in real world business applications as we introduce and explain the subject matter. • "An accounting perspective: Business insight" boxes throughout the text provide examples of how companies featured in text examples use accounting information every day, or they provide other useful information. • "Accounting perspective: Uses of technology" boxes throughout the text demonstrate how technology has affected the way accounting information is prepared, manipulated, and accessed. • Some chapters contain "A broader perspective". These situations, taken from annual reports of real companies and from articles in current business periodicals such as Accounting Today, and Management 1 Accounting Education Change Commission, Position Statement No. Two, “The First Course in Account” (Torrance, CA, June 1992), pp. 1-2. 11 This book is licensed under a Creative Commons Attribution 3.0 License Accounting, relate to subject matter discussed in that chapter or present other useful information. These real world examples demonstrate the business relevance of accounting. • Real world questions and real world business decision cases are included in almost every chapter. • The annual report appendix included with this text contains significant portions of the annual report of The Limited, Inc. Many of the real world questions and business decision cases are based on this annual report. • Numerous illustrations adapted from Accounting Trends & Techniques show the frequency of use in business of various accounting techniques. Placed throughout the text, these illustrations give students real world data to consider while learning about different accounting techniques. • Throughout the text we have included numerous references to the annual reports of many companies. • Chapters 1-16 contain a section entitled, "Analyzing and using the financial results". This section discusses and illustrates a ratio or other analysis technique that pertains to the content of the chapter. For instance, this section in Chapter 4 discusses the current ratio as it relates to a classified balance sheet. • Some of the chapters contain end-of-chapter questions, exercises, or business decision cases that require the student to refer to the Annual report appendix and answer certain questions. As stated earlier, this appendix is included with the text and contains the significant portions of the annual report of The Limited, Inc. • Each chapter contains a section entitled, "Beyond the numbers—Critical thinking". This section contains business decision cases, annual report analysis problems, writing assignments based on the Ethical perspective and Broader perspective boxes, group projects, and Internet projects. Pedagogy Students often come into accounting principles courses feeling anxious about learning the subject matter. Recognizing this apprehension, we studied ways to make learning easier and came up with some helpful ideas on how to make this edition work even better for students. • Improvements in the text's content reflect feedback from adopters, suggestions by reviewers, and a serious study of the learning process itself by the authors and editors. New subject matter is introduced only after the stage has been set by transitional paragraphs between topic headings. These paragraphs provide students with the reasons for proceeding to the new material and explain the progression of topics within the chapter. • The Introduction contains a section entitled "How to study the chapters in this text", which should be very helpful to students. • Each chapter has an "Understanding the learning objectives" section. These "summaries" enable the student to determine how well the learning objectives were accomplished. We were the first authors (1974) to ever include Learning objectives in an accounting text. These objectives have been included at the beginning of the chapter, as marginal notes within the chapter, at the end of the chapter, and in supplements such as the Test bank, Instructors' resource guide, Computerized test bank, and Study guide. The objectives are also indicated for each exercise and problem. • Demonstration problems and solutions are included for each chapter, and a different one appears for each chapter in the Study guide. These demonstration problems help students to assess their own progress by showing them how problems that focus on the topic(s) covered in the chapter are worked before students do assigned homework problems. Accounting Principles: A Business Perspective 12 A Global Text Accounting principles:A business perspective • Key terms are printed for emphasis. End-of-chapter glossaries contain the definition. • Each chapter includes a "Self-test" consisting of true-false and multiple-choice questions. The answers and explanations appear at the end of the chapter. These self-tests are designed to determine whether the student has learned the essential information in each chapter. • In the margin beside each exercise and problem, we have included a description of the requirements and the related Learning objective(s). These descriptions let students know what they are expected to do in the problem. • Throughout the text we use examples taken from everyday life to relate an accounting concept being introduced or discussed to students' experiences. Ethics There is no better time to emphasize high ethical standards to students. This text includes many items throughout the text entitled, "An ethical perspective". These items present situations in which students are likely to find themselves throughout their careers. They range from resisting pressure by a superior or a client to do the wrong thing to deciding between alternative corporate behaviors that have environmental and profit consequences. End-of-chapter materials Describing teaching methods, the AECC stated, "Teachers...should place a priority on their interaction with students and on interaction among students. Students' involvement should be promoted by methods such as cases, simulations, and group projects..." 2 A section entitled "Beyond the numbers—Critical thinking" at the end of every chapter is designed to implement these recommendations. Business decision cases require critical thinking in complex situations often based on real companies. The Annual report analysis section requires analyzing annual reports and interpreting the results in writing. The Ethics cases require students to respond in writing to situations they are likely to encounter in their careers. These cases do not necessarily have one right answer. The Group projects for each chapter teach students how to work effectively in teams, a skill that was stressed by the AECC and is becoming increasingly necessary for success in business. The Internet projects teach students how to retrieve useful information from the Internet. A team approach can also be introduced in the classroom using the regular exercises and problems in the text. Teams can be assigned the task of presenting their solutions to exercises or problems to the rest of the class. Using this team approach in class can help re-energize the classroom by creating an active, informal environment in which students learn from each other. (Two additional group projects are described in the Instructor's resource guide. These projects are designed to be used throughout the semester or quarter.) We have included a vast amount of other resource materials for each chapter within the text from which the instructor may draw: (1) one of the largest selections of end-of-chapter questions, exercises, and problems available; (2) several comprehensive review problems that allow students to review all major concepts covered to that point; and (3) from one to three business decision cases per chapter. Other key features regarding end-ofchapter material follow. • A uniform chart of accounts appears in a separate file you can download. This uniform chart of accounts is used consistently throughout the first 11 chapters. We believe students will benefit from using the same chart of accounts for all homework problems in those chapters. 2 Ibid, p.2. 13 This book is licensed under a Creative Commons Attribution 3.0 License • A comprehensive review problem at the end of Chapter 4 serves as a mini practice set to test all material covered to that point. Another comprehensive problem at the end of Chapter 19 reviews the material covered in Chapters 18 and 19. Two comprehensive budgeting problems are also included as business decision cases at the end of Chapter 23. • Some of the end-of-chapter problem materials (questions, exercises, problems, business decision cases, other "Beyond the numbers" items, and comprehensive review problems) have been updated. Each exercise and problem is identified with the learning objective(s) to which it relates. • All end-of-chapter exercises and problems have been traced back to the chapters to ensure that nothing is asked of a student that does not appear in the book. This feature was a strength of previous editions, ensuring that instructors could confidently assign problems without having to check for applicability. Also, we took notes while teaching from the text and clarified problem and exercise instructions that seemed confusing to our students. Acknowledgments The development of all eight editions of Accounting: A Business Perspective was an evolving and challenging process. Significant changes have taken place in the first course in accounting in schools across the country, and the authors and publisher worked hard throughout the development of this text to stay on top of those changes. We are grateful to the following individuals for their valuable contributions and suggestions which we have incorporated in the various editions of this text. The affiliations shown for all individuals are as of the time of their contributions. Survey Participants Diane Adcox (University of North Florida-Jacksonville, USA) Sue Atkinson (Tarleton State University, USA) Ed Bader (Holy Family College, USA) Keith Baker (Oglethorpe University, USA) C. Richard Baker (Fordham University, USA) Audrie Beck (The American University, USA) Joe Bentley (Bunker Hill Community College, USA) Lucille Berry (Webster University, USA) Robert Bricker (Case Western Reserve, USA) William Brosi (Delhi College, USA) Doug Brown (Eastern Montana College, USA) Stuart Brown (Bristol Community College, USA) Janice Buddinseck (Wagner College, USA) Kurt Buerger (Anglo State University, USA) Robert Cantwell (University of Phoenix-Utah, USA) Bruce Cassel (Dutchess Community College, USA) Stan Chu (Borough of Manhattan Community College, USA) Bruce Collier (University of Texas-El Paso, USA) Rosalind Cranor (Virginia Polytech Institute, USA) James Crockett (University of Southern Mississippi, USA) Accounting Principles: A Business Perspective 14 A Global Text Accounting principles:A business perspective Lee Daugherty (Lorain County Community College, USA) Mary Davis (University of Maryland, USA) Frances Engel (Niagra University, USA) J. Michael Erwin (University of Tennessee, USA) Ali Fekrat (Georgetown University, USA) Bill Felty (Lindenwood College, USA) Clyde J. Galbraith (West Chester University, USA) Susan D. Garr (Wayne State University, USA) John Gercio (Loyola College, USA) Martin Ginsberg (Rockland Community College, USA) Earl Godfrey (Gardner-Webb College, USA) Thomas Grant (Kutztown University, USA) Paul W. Greenough (Assumption College, USA) Roy Gross (Dutchess Community College, USA) Vincent D. R. Guide (Clemson University, USA) Pat Haggerty (Lansing Community College, USA) Paul Hajja (Rivier College, USA) Joh Haney (Lansing Community College, USA) Thomas D. Harris (Indiana State University, USA) Dennis Hart (Manchester Community College, USA) Brenda Hartman (Tomball College, USA) Mary Hatch (Thomas College, USA) Margaret Hicks (Howard University, USA) Patricia H. Holmes (Des Moines Area Community College, USA) Anita Hope (Tarrant County Junior College, USA) Andrew Jackson (Central State University, USA) Donald W. Johnson, Sr. (Siena College, USA) Glenn L. Johnson (Washington State University, USA) Richard W. Jones (Lamar University, USA) Ed Kerr (Bunker Hill Community College, USA) David Kleinerman (Roosevelt University, USA) Jane Konditi (Northwood University, USA) Nathan J. Kranowski (Radford University, USA) Michael Kulper (Santa Barbara Community College, USA) Michael R. Lane (Nassau Community College, USA) Judy Laux (Colorado College, USA) Linda Lessing (SUNY-Farmingdale, USA) Bruce McClane (Hartnell College, USA) Melvin T. McClure (University of Maine, USA) T. J. McCoy (Middlesex Community College, USA) 15 This book is licensed under a Creative Commons Attribution 3.0 License J. Harrison McCraw (West Georgia College, USA) James E. McKinney (Valdosta State, USA) B. J. Michalek (La Roche College, USA) Andrew Miller (Hudson Valley Community College, USA) Cheryl E. Mitchum (Virginia State University, USA) Susan Moncada (Indiana State University, USA) Susan Mulhern (Rivier College, USA) Lee H. Nicholas (University of Southern Iowa, USA) Kristine N. Palmer (Longwood College, USA) Lynn M. Paluska (Nassau Community College, USA) Seong Park (University of Tennessee-Chattanooga, USA) Vikki Passikoff (Dutchess Community College, USA) Barb Pauer (W. Wisconsin Tech Institute, USA) Doug Pfister (Lansing Community College, USA) Sharyll A. Plato (University of Central Oklahoma, USA) Patricia P. Polk (University of Southern Mississippi, USA) Harry Purcell (Ulster Community College, USA) T. J. Regan (Middlesex County College, USA) Ruthie G. Reynolds (Howard University, USA) E. Barry Rice (Loyola College in Maryland, USA) Cheryl Rumler (Monroe County Community College, USA) Francis Sake (Mercer County Community College, USA) Jackie Sanders (Mercer County Community College, USA) Alex J. Sannella (Rutgers University, USA) Thomas Sears (Hartwich College, USA) John Sedensky (Newbury College, USA) Sarah H. Smith (Cedarville College, USA) John Snyder (Mohawk Valley Community College, USA) Leonard E. Stokes (Siena College, USA) Janice Stoudemire (Midlands Technical College-Airport Campus, USA) Marty Stub (DeVry Institute-Chicago, USA) Barbara Sturdevant (Delhi College, USA) William N. Sullivan (Assumption College, USA) Norman A. Sunderman (Angelo State University, USA) Janice M. Swanson (Southern Oregon State College, USA) Norman Swanson (Greenville College, USA) Audrey G. Taylor (Wayne State University, USA) Kayla Tessler (Oklahoma City Community College, USA) Julia Tiernan (Merrimack College, USA) John Vaccaro (Bunker Hill Community College, USA) Accounting Principles: A Business Perspective 16 A Global Text Accounting principles:A business perspective Al Veragraziano (Santa Barbara Community College, USA) David Wagaman (Kutztown University, USA) Karen Walton (John Carroll University, USA) Linda Wanacott (Portland Community College, USA) Jim Weglin (North Seattle Community College, USA) David P. Weiner (University of San Francisco, USA) L.K. Williams (Morehead State University, USA) Marge Zolldi (Husson College, USA) Reviewers Lucille Berry (Webster University, USA) Elizabeth L. Boudreau (Newbury College, USA) Wayne G. Bremser (Villanova University, USA) Fred Dial (Stephen F. Austin State University, USA) Larry Falcetto (Emporia State University, USA) Katherine Beal Frazier (North Carolina State University, USA) Al L. Hartgraves (Emory University, USA) Martin G. Jagels (University of South Carolina, USA) Emel Kahya (Rutgers University, USA) Emogene W. King (Tyler Junior College, USA) Jane Konditi (Northwood University, USA) Charles Konkol (University of Wisconsin-Milwaukee, USA) William Lawler (Tomball College, USA) Keith R. Leeseberg (Manatee Junior College-Bradenton, USA) Susan Moncada (Indiana State University, USA) Lee H. Nicholas (University of Northern Iowa, USA) Douglas R. Pfister (Lansing Community College, USA) Patricia P. Polk (University of Southern Mississippi, USA) Richard Rand (Tennessee Technical University, USA) Ruthie G. Reynolds (Howard University, USA) Marilyn Rholl (Lane Community College, USA) E. Berry Rice (Loyola College in Maryland, USA) William Richardson (University of Phoenix, USA) Douglas Sharp (Wichita State University, USA) Janet Stoudemire (Midlands Technical College-Airport Campus, USA) Marilyn Young (Tulsa Junior College-Southeast, USA) Annotations authors Diane Adcox (University of North Florida-Jacksonville, USA) C. Sue Cook (Tulsa Junior College, USA) Alan B. Cryzewski (Indiana State University, USA) 17 This book is licensed under a Creative Commons Attribution 3.0 License Patricia H. Holmes (Des Moines Area Community College, USA) Donald W. Johnson, Sr. (Siena College, USA) Linda Lessing (SUNY at Farmingdale, USA) Cheryl E. Mitchem (Coordinator) (Virginia State University, USA) Lee H. Nicholas (University of Northern Iowa, USA) Lynn Mazzola Paluska (Nassau Community College, USA) Benjamin Shlaes (Des Moines Area Community College, USA) Margaret Skinner (SUNY at New Paltz, USA) Leonard F. Stokes III (Siena College, USA) Kathy J. Tam (Tulsa Junior College, USA) Other Contributors Donald R. Herrmann (Baylor University, USA) Keith F. Sellers (Fort Lewis College, USA) Wayne B. Thomas (University of Oklahoma, USA) T. Sterling Wetzel (Oklahoma State University-Stillwater, USA) Former co-author R. F. Salmonson (Deceased) (Michigan State University, USA) The accounting environment Learning objectives After studying this introduction, you should be able to: • Define accounting. • Describe the functions performed by accountants. • Describe employment opportunities in accounting. • Differentiate between financial and managerial accounting. • Identify several organizations that have a role in the development of financial accounting standards. You have embarked on the challenging and rewarding study of accounting—an old and time-honored discipline. History indicates that all developed societies require certain accounting records. Record-keeping in an accounting sense is thought to have begun about 4000 BCE The record-keeping, control, and verification problems of the ancient world had many characteristics similar to those we encounter today. For example, ancient governments also kept records of receipts and disbursements and used procedures to check on the honesty and reliability of employees. A study of the evolution of accounting suggests that accounting processes have developed primarily in response to business needs. Also, economic progress has affected the development of accounting processes. History shows that the higher the level of civilization, the more elaborate the accounting methods. The emergence of double-entry bookkeeping was a crucial event in accounting history. In 1494, a Franciscan monk, Luca Pacioli, described the double-entry Method of Venice system in his text called Summa de Arithmetica, Geometric, Proportion et Proportionate (Everything about arithmetic, geometry, and proportion). Many consider Pacioli's Summa to be a reworked version of a manuscript that circulated among teachers and pupils of the Venetian school of commerce and arithmetic. Accounting Principles: A Business Perspective 18 A Global Text Accounting principles:A business perspective Since Pacioli's days, the roles of accountants and professional accounting organizations have expanded in business and society. As professionals, accountants have a responsibility for placing public service above their commitment to personal economic gain. Complementing their obligation to society, accountants have analytical and evaluative skills needed in the solution of ever-growing world problems. The special abilities of accountants, their independence, and their high ethical standards permit them to make significant and unique contributions to business and areas of public interest. You probably will find that of all the business knowledge you have acquired or will learn, the study of accounting will be the most useful. Your financial and economic decisions as a student and consumer involve accounting information. When you file income tax returns, accounting information helps determine your taxes payable. Understanding the discipline of accounting also can influence many of your future professional decisions. You cannot escape the effects of accounting information on your personal and professional life. Every profit-seeking business organization that has economic resources, such as money, machinery, and buildings, uses accounting information. For this reason, accounting is called the language of business. Accounting also serves as the language providing financial information about not-for-profit organizations such as governments, churches, charities, fraternities, and hospitals. However, this text concentrates on accounting for business firms. The accounting system of a profit-seeking business is an information system designed to provide relevant financial information on the resources of a business and the effects of their use. Information is relevant if it has some impact on a decision that must be made. Companies present this relevant information in their financial statements. In preparing these statements, accountants consider the users of the information, such as owners and creditors, and decisions they make that require financial information. As a background for studying accounting, this Introduction defines accounting and lists the functions accountants perform. In addition to surveying employment opportunities in accounting, it differentiates between financial and managerial accounting. Because accounting information must conform to certain standards, we discuss several prominent organizations contributing to these standards. As you continue your study of accounting in this text, accounting—the language of business—will become your language also. You will realize that you are constantly exposed to accounting information in your everyday life. Accounting defined The American Accounting Association—one of the accounting organizations discussed later in this Introduction —defines accounting as "the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by the users of the information". 3 This information is primarily financial—stated in money terms. Accounting, then, is a measurement and communication process used to report on the activities of profit-seeking business organizations and not-for-profit organizations. As a measurement and communication process for business, accounting supplies information that permits informed judgments and decisions by users of the data. The accounting process provides financial data for a broad range of individuals whose objectives in studying the data vary widely. Bank officials, for example, may study a company's financial statements to evaluate the company's ability to repay a loan. Prospective investors may compare accounting data from several companies to decide which 3 American Accounting Association, A Statement of Basic Accounting Theory (Evanston, III., 1966), p. 1. 19 This book is licensed under a Creative Commons Attribution 3.0 License company represents the best investment. Accounting also supplies management with significant financial data useful for decision making. Reliable information is necessary before decision makers can make a sound decision involving the allocation of scarce resources. Accounting information is valuable because decision makers can use it to evaluate the financial consequences of various alternatives. Accountants eliminate the need for a crystal ball to estimate the future. They can reduce uncertainty by using professional judgment to quantify the future financial impact of taking action or delaying action. Although accounting information plays a significant role in reducing uncertainty within the organization, it also provides financial data for persons outside the company. This information tells how management has discharged its responsibility for protecting and managing the company's resources. Stockholders have the right to know how a company is managing its investments. In fulfilling this obligation, accountants prepare financial statements such as an income statement, a statement of retained earnings, a balance sheet, and a statement of cash flows. In addition, they prepare tax returns for federal and state governments, as well as fulfill other governmental filing requirements. Accounting is often confused with bookkeeping. Bookkeeping is a mechanical process that records the routine economic activities of a business. Accounting includes bookkeeping but goes well beyond it in scope. Accountants analyze and interpret financial information, prepare financial statements, conduct audits, design accounting systems, prepare special business and financial studies, prepare forecasts and budgets, and provide tax services. Specifically the accounting process consists of the following groups of functions (see Exhibit 1 below): • Accountants observe many events (or activities) and identify and measure in financial terms (dollars) those events considered evidence of economic activity. (Often, these three functions are collectively referred to as analyze.) The purchase and sale of goods and services are economic events. • Next, the economic events are recorded, classified into meaningful groups, and summarized. • Accountants report on economic events (or business activity) by preparing financial statements and special reports. Often accountants interpret these statements and reports for various groups such as management, investors, and creditors. Interpretation may involve determining how the business is performing compared to prior years and other similar businesses. Employment opportunities in accounting During the last half-century, accounting has gained the same professional status as the medical and legal professions. Today, the accountants in the United States number well over a million. In addition, several million people hold accounting-related positions. Typically, accountants provide services in various branches of accounting. These include public accounting, management (industrial) accounting, governmental or other not-for-profit accounting, and higher education. The demand for accountants will likely increase dramatically in the future. This increase is greater than for any other profession. You may want to consider accounting as a career. Public accounting firms offer professional accounting and related services for a fee to companies, other organizations, and individuals. An accountant may become a Certified Public Accountant (CPA) by passing an examination prepared and graded by the American Institute of Certified Public Accountants (AICPA). The exam is administered by computer. In addition to passing the exam, CPA candidates must meet other requirements, which include obtaining a state license. These requirements vary by state. A number of states require a CPA candidate to have completed specific accounting courses and earned a certain number of college credits (five years of study in Accounting Principles: A Business Perspective 20 A Global Text Accounting principles:A business perspective many states); worked a certain number of years in public accounting, industry, or government; and lived in that state a certain length of time before taking the CPA examination. As of the year 2000, five years of course work were required to become a member of the AICPA. After a candidate passes the CPA examination, some states (called one-tier states) insist that the candidate meet all requirements before the state grants the CPA certificate and license to practice. Other states (called two-tier states) issue the CPA certificate immediately after the candidate passes the exam. However, these states issue the license to practice only after all other requirements have been met. CPAs who want to renew their licenses to practice must stay current through continuing professional education programs and must prove that they have done so. No one can claim to be a CPA and offer the services normally provided by a CPA unless that person holds an active license to practice. Exhibit 1: Functions performed by accountants. The public accounting profession in the United States consists of the Big-Four international CPA firms, several national firms, many regional firms, and numerous local firms. The Big-Four firms include Deloitte & Touche, Ernst & Young, KPMG, and Pricewaterhouse Coopers. At all levels, these public accounting firms provide auditing, tax, and, for nonaudit clients, management advisory (or consulting) services. Auditing A business seeking a loan or attempting to have its securities traded on a stock exchange usually must provide financial statements to support its request. Users of a company's financial statements are more confident that the company is presenting its statements fairly when a CPA has audited the statements. For this reason, companies hire CPA firms to conduct examinations (independent audits) of their accounting and related records. Independent auditors of the CPA firm check some of the company's records by contacting external 21 This book is licensed under a Creative Commons Attribution 3.0 License sources. For example, the accountant may contact a bank to verify the cash balances of the client. After completing a company audit, independent auditors give an independent auditor's opinion or report. (For an example of an auditor's opinion, see The Limited, Inc. annual report in the Annual report appendix at the end of the text.) This report states whether the company's financial statements fairly (equitably) report the economic performance and financial condition of the business. As you will learn in the next section, auditors within a business also conduct audits, which are not independent audits. Currently auditing standards are established by the Public Company Accounting Oversight Board. In 2002 The Sarbanes-Oxley Act was passed. The Act was passed as one result of the large losses to the employees and investors from accounting fraud situations involving companies such as Enron and WorldCom. The Act created the Public Company Accounting Oversight Board. The Board consists of five members appointed and overseen by the Securities and Exchange Commission. The Board oversees and investigates the audits and auditors of public companies and can sanction both firms and individuals for violations of laws, regulations, and rules. The Chief Executive Officer and Chief Financial Officer of a public company must now certify the company's financial statements. Corporate audit committees, rather than the corporate management, are now responsible for hiring, compensating, and overseeing the external auditors. Tax services CPAs often provide expert advice on tax planning and preparing federal, state, and local tax returns. The objective in preparing tax returns is to use legal means to minimize the taxes paid. Almost every major business decision has a tax impact. Tax planning helps clients know the tax effects of each financial decision. Management advisory (or consulting) services Before Sarbanes-Oxley management advisory services were the fastest growing service area for most large and many smaller CPA firms. Management frequently identifies projects for which it decides to retain the services of a CPA. However, the Sarbanes-Oxley Act specifically prohibits providing certain types of consulting services to a publicly-held company by its external auditor. These services include bookkeeping, information systems design and implementation, appraisals or valuation services, actuarial services, internal audits, management and human resources services, broker/dealer and investment services, and legal or expert services related to audit services. Accounting firms can perform many of these services for publicly held companies they do not audit. Other services not specifically banned are allowed if pre-approved by the company's audit committee. In contrast to public accountants, who provide accounting services for many clients, management accountants provide accounting services for a single business. In a company with several management accountants, the person in charge of the accounting activity is often the controller or chief financial officer. Management accountants may or may not be CPAs. If management accountants pass an examination prepared and graded by the Institute of Certified Management Accountants (ICMA) and meet certain other requirements, they become Certified Management Accountants (CMAs). The ICMA is an affiliate of the Institute of Management Accountants, an organization primarily consisting of management accountants employed in private industry. A career in management accounting can be very challenging and rewarding. Many management accountants specialize in one particular area of accounting. For example, some may specialize in measuring and controlling costs, others in budgeting (the development of plans for future operations), and still others in financial accounting and reporting. Many management accountants become specialists in the design and installation of computerized accounting systems. Other management accountants are internal auditors who conduct internal audits. They Accounting Principles: A Business Perspective 22 A Global Text Accounting principles:A business perspective ensure that the company's divisions and departments follow the policies and procedures of management. This last group of management accountants may earn the designation of Certified Internal Auditor (CIA). The Institute of Internal Auditors (IIA) grants the CIA certificate to accountants after they have successfully completed the IIA examination and met certain other requirements. Many accountants, including CPAs, work in governmental and other not-for-profit accounting. They have essentially the same educational background and training as accountants in public accounting and management accounting. Governmental agencies at the federal, state, and local levels employ governmental accountants. Often the duties of these accountants relate to tax revenues and expenditures. For example, Internal Revenue Service employees use their accounting backgrounds in reviewing tax returns and investigating tax fraud. Government agencies that regulate business activity, such as a state public service commission that regulates public utilities (e.g. telephone company, electric company), usually employ governmental accountants. These agencies often employ governmental accountants who can review and evaluate the utilities' financial statements and rate increase requests. Also, FBI agents trained as accountants find their accounting backgrounds useful in investigating criminals involved in illegal business activities, such as drugs or gambling. Not-for-profit organizations, such as churches, charities, fraternities, and universities, need accountants to record and account for funds received and disbursed. Even though these agencies do not have a profit motive, they should operate efficiently and use resources effectively. Approximately 10,000 accountants are employed in higher education. The activities of these academic accountants include teaching accounting courses, conducting scholarly and applied research and publishing the results, and performing service for the institution and the community. Faculty positions exist in two-year colleges, four-year colleges, and universities with graduate programs. A significant shortage of accounting faculty has developed due to the retirement beginning in the late 1990s of many faculty members. Starting salaries will continue to rise significantly because of the shortage. You may want to talk with some of your professors about the advantages and disadvantages of pursuing an accounting career in higher education. A section preceding each chapter, entitled "Careers in accounting", describes various accounting careers. You might find one that you would like to pursue. Financial accounting versus managerial accounting An accounting information system provides data to help decision makers both outside and inside the business. Decision makers outside the business are affected in some way by the performance of the business. Decision makers inside the business are responsible for the performance of the business. For this reason, accounting is divided into two categories: financial accounting for those outside and managerial accounting for those inside. Financial accounting information appears in financial statements that are intended primarily for external use (although management also uses them for certain internal decisions). Stockholders and creditors are two of the outside parties who need financial accounting information. These outside parties decide on matters pertaining to the entire company, such as whether to increase or decrease their investment in a company or to extend credit to a company. Consequently, financial accounting information relates to the company as a whole, while managerial accounting focuses on the parts or segments of the company. 23 This book is licensed under a Creative Commons Attribution 3.0 License Management accountants in a company prepare the financial statements. Thus, management accountants must be knowledgeable concerning financial accounting and reporting. The financial statements are the representations of management, not the CPA firm that performs the audit. The external users of accounting information fall into six groups; each has different interests in the company and wants answers to unique questions. The groups and some of their possible questions are: • Owners and prospective owners. Has the company earned satisfactory income on its total investment? Should an investment be made in this company? Should the present investment be increased, decreased, or retained at the same level? Can the company install costly pollution control equipment and still be profitable? • Creditors and lenders. Should a loan be granted to the company? Will the company be able to pay its debts as they become due? • Employees and their unions. Does the company have the ability to pay increased wages? Is the company financially able to provide long-term employment for its workforce? • Customers. Does the company offer useful products at fair prices? Will the company survive long enough to honor its product warranties? • Governmental units. Is the company, such as a local public utility, charging a fair rate for its services? • General public. Is the company providing useful products and gainful employment for citizens without causing serious environmental problems? General-purpose financial statements provide much of the information needed by external users of financial accounting. These financial statements are formal reports providing information on a company's financial position, cash inflows and outflows, and the results of operations. Many companies publish these statements in annual reports. (See The Limited, Inc., annual report in the Annual report appendix.) The annual report also contains the independent auditor's opinion as to the fairness of the financial statements, as well as information about the company's activities, products, and plans. Financial accounting information is historical in nature, reporting on what has happened in the past. To facilitate comparisons between companies, this information must conform to certain accounting standards or principles called generally accepted accounting principles (GAAP). These generally accepted accounting principles for businesses or governmental organizations have developed through accounting practice or been established by an authoritative organization. We describe several of these authoritative organizations in the next major section of this Introduction. Managerial accounting information is for internal use and provides special information for the managers of a company. The information managers use may range from broad, long-range planning data to detailed explanations of why actual costs varied from cost estimates. Managerial accounting information should: • Relate to the part of the company for which the manager is responsible. For example, a production manager wants information on costs of production but not of advertising. • Involve planning for the future. For instance, a budget would show financial plans for the coming year. • Meet two tests: the accounting information must be useful (relevant) and must not cost more to gather and process than it is worth. Managerial accounting generates information that managers can use to make sound decisions. The four major types of internal management decisions are: Accounting Principles: A Business Perspective 24 A Global Text Accounting principles:A business perspective • Financial decisions—deciding what amounts of capital (funds) are needed to run the business and whether to secure these funds from owners (stockholders) or creditors. In this sense, capital means money used by the company to purchase resources such as machinery and buildings and to pay expenses of conducting the business. • Resource allocation decisions—deciding how the total capital of a company is to be invested, such as the amount to be invested in machinery. • Production decisions—deciding what products are to be produced, by what means, and when. • Marketing decisions—setting selling prices and advertising budgets; determining the location of a company's markets and how to reach them. Development of financial accounting standards Several organizations are influential in the establishment of generally accepted accounting principles (GAAP) for businesses or governmental organizations. These are the American Institute of Certified Public Accountants, the Financial Accounting Standards Board, the Governmental Accounting Standards Board, the Securities and Exchange Commission, the American Accounting Association, the Financial Executives Institute, and the Institute of Management Accountants. Each organization has contributed in a different way to the development of GAAP. The American Institute of Certified Public Accountants (AICPA) is a professional organization of CPAs. Many of these CPAs are in public accounting practice. Until recent years, the AICPA was the dominant organization in the development of accounting standards. In a 20-year period ending in 1959, the AICPA Committee on Accounting Procedure issued 51 Accounting Research Bulletins recommending certain principles or practices. From 1959 through 1973, the committee's successor, the Accounting Principles Board (APB), issued 31 numbered Opinions that CPAs generally are required to follow. Through its monthly magazine, the Journal of Accountancy, its research division, and its other divisions and committees, the AICPA continues to influence the development of accounting standards and practices. Two of its committees—the Accounting Standards Committee and the Auditing Standards Committee—are particularly influential in providing input to the Financial Accounting Standards Board (the current rule-making body) and to the Securities and Exchange Commission and other regulatory agencies. In 1973, an independent, seven-member, full-time Financial Accounting Standards Board (FASB) replaced the Accounting Principles Board. The FASB has issued numerous Statements of Financial Accounting Standards. The old Accounting Research Bulletins and Accounting Principles Board Opinions are still effective unless specifically superseded by a Financial Accounting Standards Board Statement. The FASB is the private sector organization now responsible for the development of new financial accounting standards. The Emerging Issues Task Force of the FASB interprets official pronouncements for general application by accounting practitioners. The conclusions of this task force must also be followed in filings with the Securities and Exchange Commission. In 1984, the Governmental Accounting Standards Board (GASB) was established with a full-time chairperson and four part-time members. The GASB issues statements on accounting and financial reporting in the governmental area. This organization is the private sector organization now responsible for the development of new governmental accounting concepts and standards. The GASB also has the authority to issue interpretations of these standards. 25 This book is licensed under a Creative Commons Attribution 3.0 License Created under the Securities and Exchange Act of 1934, the Securities and Exchange Commission (SEC) is a government agency that administers important acts dealing with the interstate sale of securities (stocks and bonds). The SEC has the authority to prescribe accounting and reporting practices for companies under its jurisdiction. This includes virtually every major US business corporation. Instead of exercising this power, the SEC has adopted a policy of working closely with the accounting profession, especially the FASB, in the development of accounting standards. The SEC indicates to the FASB the accounting topics it believes the FASB should address. Consisting largely of accounting educators, the American Accounting Association (AAA) has sought to encourage research and study at a theoretical level into the concepts, standards, and principles of accounting. One of its quarterly magazines, The Accounting Review, carries many articles reporting on scholarly accounting research. Another quarterly journal, Accounting Horizons, reports on more practical matters directly related to accounting practice. A third journal, Issues in Accounting Education, contains articles relating to accounting education matters. Students may join the AAA as associate members by contacting the American Accounting Association, 5717 Bessie Drive, Sarasota, Florida 34233. The Financial Executives Institute is an organization established in 1931 whose members are primarily financial policy-making executives. Many of its members are chief financial officers (CFOs) of very large corporations. The role of the CFO has evolved in recent years from number cruncher to strategic planner. These CFOs played a major role in restructuring American businesses in the early 1990s. Slightly more than 14,000 financial officers, representing approximately 7,000 companies in the United States and Canada, are members of the FEI. Through its Committee on Corporate Reporting (CCR) and other means, the FEI is very effective in representing the views of the private financial sector to the FASB and to the Securities and Exchange Commission and other regulatory agencies. The Institute of Management Accountants (formerly the National Association of Accountants) is an organization with approximately 70,000 members, consisting of management accountants in private industry, CPAs, and academics. The primary focus of the organization is on the use of management accounting information for internal decision making. However, management accountants prepare the financial statements for external users. Thus, through its Management Accounting Practices (MAP) Committee and other means, the IMA provides input on financial accounting standards to the Financial Accounting Standards Board and to the Securities and Exchange Commission and other regulatory agencies. Many other organizations such as the Financial Analysts Federation (composed of investment advisers and investors), the Securities Industry Associates (composed of investment bankers), and CPA firms have committees or task forces that respond to Exposure Drafts of proposed FASB Statements. Their reactions are in the form of written statements sent to the FASB and testimony given at FASB hearings. Many individuals also make their reactions known to the FASB. Ethical behavior of accountants Several accounting organizations have codes of ethics governing the behavior of their members. For instance, both the American Institute of Certified Public Accountants and the Institute of Management Accountants have formulated such codes. Many business firms have also developed codes of ethics for their employees to follow. Ethical behavior involves more than merely making sure you are not violating a code of ethics. Most of us sense what is right and wrong. Yet get-rich-quick opportunities can tempt many of us. Almost any day, newspaper Accounting Principles: A Business Perspective 26 A Global Text Accounting principles:A business perspective headlines reveal public officials and business leaders who did not do the right thing. Greed won out over their sense of right and wrong. These individuals followed slogans such as: "Get yours while the getting is good"; "Do unto others before they do unto you"; and "You have done wrong only if you get caught". More appropriate slogans might be: "If it seems too good to be true, it usually is"; "There are no free lunches"; and the golden rule, "Do unto others as you would have them do unto you". An accountant's most valuable asset is an honest reputation. Those who take the high road of ethical behavior receive praise and honor; they are sought out for their advice and services. They also like themselves and what they represent. Occasionally, accountants do take the low road and suffer the consequences. They sometimes find their names mentioned in The Wall Street Journal and news programs in an unfavorable light, and former friends and colleagues look down on them. Some of these individuals are removed from the profession. Fortunately, the accounting profession has many leaders who have taken the high road, gained the respect of friends and colleagues, and become role models for all of us to follow. Many chapters in the text include an ethics case entitled, "An ethical perspective". We know you will benefit from thinking about the situational ethics in these cases. Often you will not have much difficulty in determining "right and wrong". Instead of making the cases "close calls", we have attempted to include situations business students might actually encounter in their careers. Critical thinking and communication skills Accountants in practice and business executives have generally been dissatisfied with accounting graduates' ability to think critically and to communicate their ideas effectively. The Accounting Education Change Commission has recommended that changes be made in the education of accountants to remove these complaints. To address these concerns, we have included a section at the end of each chapter entitled, "Beyond the numbers —Critical thinking". In that section, you are required to work relatively unstructured business decision cases, analyze real-world annual report data, write about situations involving ethics, and participate in group projects. Most of the other end-of-chapter materials also involve analysis and written communication of ideas. In some of the cases, analyses, ethics situations, and group projects, you are asked to write a memorandum regarding the situation. In writing such a memorandum, identify your role (auditor, consultant), the audience (management, stockholders, and creditors), and the task (the specific assignment). Present your ideas clearly and concisely. The purpose of the group projects is to assist you in learning to listen to and work with others. These skills are important in succeeding in the business world. Team players listen to the views of others and work cohesively with them to achieve group goals. Internet skills The Internet is a fact of life. It is important for accountants and students to be able to use the Internet to find relevant information. Thus, each chapter contains approximately two Internet projects related to accounting. Your instructor might assign some of these, or you could pursue them on your own. How to study the chapters in this text In studying each chapter: • Begin by reading the learning objectives at the beginning of each chapter. • Read "Understanding the learning objectives" at the end of the chapter for a preview of the chapter content. 27 This book is licensed under a Creative Commons Attribution 3.0 License • Read the chapter content. Each exercise at the end of the chapters identifies the learning objective(s) to which it pertains. If you learn best by reading about a concept and then working a short exercise that illustrates that concept, work the exercises as you read the chapter. • Reread "Understanding the learning objectives" to determine if you have achieved each objective. • Study the Key terms to see if you understand each term. If you do not understand a certain term, refer to the page indicated to read about the term in its original context. • Take the Self-test and then check your answers with those at the end of the chapter. • Work the Demonstration problem to further reinforce your understanding of the chapter content. Then, compare your solution to the correct solution that follows immediately. • Look over the questions at the end of the chapter and think out an answer to each one. If you cannot answer a particular question, refer back into the chapter for the needed information. • Work at least some of the exercises at the end of the chapter. • Work the Problems assigned by your instructor, using the forms available. They can be downloaded from the publisher's website (www.freeloadpress.com). • Study the items in the "Beyond the numbers—Critical thinking" section and the "Using the Internet—A view of the real world" section at the end of each chapter to relate what you have learned to real-world situations. • Work the Study guide for the chapter. The Study guide is a supplement that contains (for each chapter) Learning objectives; Demonstration problem and solution (different from the one in the text); Matching, Completion, True-false, and Multiple-choice questions; and Solutions to all questions and exercises in the study guide. The Study guide can be downloaded from the publisher's website (www.freeloadpress.com). If you perform each of these steps for each chapter, you should do well in the course. Remember that a knowledge of accounting will serve you well regardless of the career you pursue. International accounting standards In recent years, there has been a movement to develop a single set of global accounting standards for use around the world. Proponents of this movement say that it will boost cross-border investment, deepen international capital markets and save multinational companies, who must currently report under multiple systems, a lot of time and money. The International Accounting Standards Committee (IASC) Foundation was established as an independent, not-for profit, private sector organisation to work towards this goal. It seeks to develop a globally accepted set of financial reporting standards (IFRSs) under the direction of its standards-setting body, the International Accounting Standards Board (IASB). The AICPA (as well as the other entities mentioned above) supports this effort and, as of early 2010, states on its website that: “The growing acceptance of International Financial Reporting Standards (IFRS) as a basis for U.S. financial reporting represents a fundamental change for the U.S. accounting profession. Today approximately 113 countries require or allow the use of IFRS for the preparation of financial statements by publicly held companies. In the United St...
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