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Financial AccountingFinancial Accounting

Financial AccountingFinancial Accounting

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UNIVERSITY OF MINNESOTA LIBRARIES PUBLISHING EDITION, 2015. THIS EDITION ADAPTED FROM A WORK ORIGINALLY PRODUCED IN 2010 BY A PUBLISHER WHO HAS REQUESTED THAT IT NOT RECEIVE

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Financial Accounting by University of Minnesota is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.

Contents

Publisher Information x

Chapter 1: Why Is Financial Accounting Important?

1.1 Making Good Financial Decisions about an Organization 2 1.2 Incorporation and the Trading of Capital Shares 7 1.3 Using Financial Accounting for Wise Decision Making 13 1.4 End-of-Chapter Exercises 18

Chapter 2: What Should Decision-makers Know So That Good Decisions Can Be Made about an Organization?

2.1 Creating a Portrait of an Organization That Can Be Used by Decision Makers 23 2.2 Dealing with Uncertainty 27 2.3 The Need for Generally Accepted Accounting Principles 30 2.4 Four Basic Terms Found in Financial Accounting 36 2.5 End-of-Chapter Exercises 42

Chapter 3: In What Form Is Financial Information Actually Delivered to Decision Makers Such as Investors and Creditors?

3.1 The Construction of an Income Statement 47 3.2 Reported Profitability and the Principle of Conservatism 53 3.3 Increasing the Net Assets of a Company 58 3.4 Reporting a Balance Sheet and a Statement of Cash Flows 63 3.5 End-of-Chapter Exercises 70

Chapter 4: How Does an Organization Accumulate and Organize the Information Necessary to Prepare Financial Statements?

4.1 The Essential Role of Transaction Analysis 79 4.2 The Effects Caused by Common Transactions 84

4.3 An Introduction to Double-Entry Bookkeeping 89 4.4 Preparing Journal Entries 94 4.5 The Connection of the Journal and the Ledger 100 4.6 End-of-Chapter Exercises 109

Chapter 5: Why Must Financial Information Be Adjusted Prior to the Production of Financial Statements?

5.1 The Need for Adjusting Entries 118 5.2 Preparing Various Adjusting Entries 122 5.3 Preparing Financial Statements Based on Adjusted Balances 127 5.4 Chapter Appendix 131 5.5 End-of-Chapter Exercises 135

Chapter 6: Why Should Decision Makers Trust Financial Statements?

6.1 The Need for the Securities and Exchange Commission 144 6.2 The Role of the Independent Auditor in Financial Reporting 148 6.3 Performing an Audit 152 6.4 The Need for Internal Control 156 6.5 The Purpose and Content of an Independent Auditor’s Report 159 6.6 End-of-Chapter Exercises 164

Chapter 7: In a Set of Financial Statements, What Information Is Conveyed about Receivables?

7.1 Accounts Receivable and Net Realizable Value 169 7.2 Accounting for Uncollectible Accounts 173 7.3 The Problem with Estimations 178 7.4 Estimating the Amount of Uncollectible Accounts 183 7.5 Remeasuring Foreign Currency Balances 189 7.6 A Company’s Vital Signs—Accounts Receivable 193 7.7 End-of-Chapter Exercises 198

Chapter 8: How Does a Company Gather Information about Its Inventory?

8.1 Determining and Reporting the Cost of Inventory 209 8.2 Perpetual and Periodic Inventory Systems 214 8.3 The Calculation of Cost of Goods Sold 219 8.4 Reporting Inventory at the Lower-of-Cost-or-Market 225 8.5 Determining Inventory on Hand 229 8.6 End-of-Chapter Exercises 234

Chapter 9: Why Does a Company Need a Cost Flow Assumption in Reporting Inventory?

9.1 The Necessity of Adopting a Cost Flow Assumption 244 9.2 The Selection of a Cost Flow Assumption for Reporting Purposes 250 9.3 Problems with Applying LIFO 255 9.4 Merging Periodic and Perpetual Inventory Systems with a Cost Flow Assumption 259 9.5 Applying LIFO and Averaging to Determine Reported Inventory Balances 264 9.6 Analyzing Reported Inventory Figures 270 9.7 End-of-Chapter Exercises 276

Chapter 10: In a Set of Financial Statements, What Information Is Conveyed about Property and Equipment?

10.1 The Reporting of Property and Equipment 287 10.2 Determining Historical Cost and Depreciation Expense 292 10.3 Recording Depreciation Expense for a Partial Year 297 10.4 Alternative Depreciation Patterns and the Recording of a Wasting Asset 301 10.5 Recording Asset Exchanges and Expenditures That Affect Older Assets 308 10.6 Reporting Land Improvements and Impairments in the Value of Property and Equipment

314

10.7 End-of-Chapter Exercises 321

Chapter 11: In a Set of Financial Statements, What Information Is Conveyed about Intangible Assets?

11.1 Identifying and Accounting for Intangible Assets 331 11.2 The Balance Sheet Reporting of Intangible Assets 336 11.3 Recognizing Intangible Assets Owned by a Subsidiary 340 11.4 Accounting for Research and Development 345 11.5 Acquiring an Asset with Future Cash Payments 349 11.6 End-of-Chapter Exercises 357

Chapter 12: In a Set of Financial Statements, What Information Is Conveyed about Equity Investments?

12.1 Accounting for Investments in Trading Securities 367 12.2 Accounting for Investments in Securities That Are Available for Sale 372 12.3 Accounting for Investments by Means of the Equity Method 377 12.4 The Reporting of Consolidated Financial Statements 383 12.5 End-of-Chapter Exercises 390

Chapter 13: In a Set of Financial Statements, What Information Is Conveyed about Current and Contingent Liabilities?

13.1 Basic Reporting of Liabilities 403 13.2 Reporting Current Liabilities Such as Gift Cards 408 13.3 Accounting for Contingencies 412 13.4 Accounting for Product Warranties 418 13.5 End-of-Chapter Exercises 425

Chapter 14: In a Set of Financial Statements, What Information Is Conveyed about Noncurrent Liabilities Such as Bonds?

14.1 Debt Financing 438 14.2 The Issuance of Notes and Bonds 442 14.3 Accounting for Zero-Coupon Bonds 448 14.4 Pricing and Reporting Term Bonds 454 14.5 Issuing and Accounting for Serial Bonds 459 14.6 Bonds with Other Than Annual Interest Payments 465 14.7 End-of-Chapter Exercises 470

Chapter 15: In Financial Statements, What Information Is Conveyed about Other Noncurrent Liabilities?

15.1 Accounting for Leases 480 15.2 Operating Leases versus Capital Leases 485 15.3 Recognition of Deferred Income Taxes 491 15.4 Reporting Postretirement Benefits 496 15.5 End-of-Chapter Exercises 502

Chapter 16: In a Set of Financial Statements, What Information Is Conveyed about Shareholders’ Equity?

16.1 Selecting a Legal Form for a Business 515 16.2 The Issuance of Common Stock 519 16.3 Issuing and Accounting for Preferred Stock and Treasury Stock 525 16.4 The Issuance of Cash and Stock Dividends 531 16.5 The Computation of Earnings per Share 537 16.6 End-of-Chapter Exercises 542

Chapter 17: In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows?

17.1 The Structure of a Statement of Cash Flows 556 17.2 Cash Flows from Operating Activities: The Direct Method 562

17.3 Cash Flows from Operating Activities: The Indirect Method 569 17.4 Cash Flows from Investing and Financing Activities 575 17.5 Appendix 583 17.6 End-of-Chapter Exercises 593

Appendix: Present Value Tables 607

Please share your supplementary material! 610

Publisher Information

Financial Accounting is adapted from a work produced and distributed

under a Creative Commons license (CC BY-NC-SA) in 2012 by a

publisher who has requested that they and the original author not receive

attribution. This adapted edition is produced by the University of

Minnesota Libraries Publishing through the eLearning Support Initiative.

This adaptation has reformatted the original text, and replaced some images and figures to make the resulting

whole more shareable. This adaptation has not significantly altered or updated the original 2012 text. This work

is made available under the terms of a Creative Commons Attribution-NonCommercial-ShareAlike license.

x

Chapter 1: Why Is Financial Accounting Important?

Video ClipVideo Clip

(click to see video)

Unnamed Author introduces the course objectives and Chapter 1 “Why Is Financial Accounting Important?”.

1

1.1 Making Good Financial Decisions about an Organization

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

1. Define “financial accounting.”

2. Understand the connection between financial accounting and the communication of information.

3. Explain the importance of learning to understand financial accounting.

4. List decisions that an individual might make about an organization.

5. Differentiate between financial accounting and managerial accounting.

6. Provide reasons for individuals to be interested in the financial accounting information supplied by their employers.

Question: This textbook professes to be an introduction to financial accounting. A logical place to begin such an

exploration is to ask the obvious question: What is financial accounting?

Answer: In simplest terms, financial accounting is the communication of information about a business or other

type of organization (such as a charity or government) so that individuals can assess its financial health and

prospects. Probably no single word is more relevant to financial accounting than “information.” Whether it is

gathering financial information about a specific organization, putting that information into a structure designed

to enhance communication, or working to understand the information being conveyed, financial accounting is

intertwined with information.

In today’s world, information is king. Financial accounting provides the rules and structure for the conveyance of

financial information about businesses (and other organizations). At any point in time, some businesses are poised

to prosper while others teeter on the verge of failure. Many people are seriously interested in evaluating the degree

2

of success achieved by a particular organization as well as its prospects for the future. They seek information.

Financial accounting provides data that these individuals need and want.

organization → reports information based on the principles of financial accounting → individual assesses

financial health

Question: Every semester, most college students are enrolled in several courses as well as participate in numerous

outside activities. All of these compete for the hours in each person’s day. Why should a student invest valuable

time to learn the principles of financial accounting? Why should anyone be concerned with the information

communicated about an organization? More concisely, what makes financial accounting important?

Answer: Many possible benefits can be gained from acquiring a strong knowledge of financial accounting and

the means by which information is communicated about an organization. In this book, justification for the serious

study that is required to master the subject matter is simple and straightforward: obtaining a working knowledge

of financial accounting and its underlying principles enables a person to understand the information conveyed

about an organization so that better decisions can be made.

Around the world, millions of individuals make critical judgments each day about the businesses and other

organizations they encounter. Developing the ability to analyze financial information and then using that

knowledge to arrive at sound decisions can be critically important. Whether an organization is as gigantic as Wal-

Mart or as tiny as a local convenience store, a person could have many, varied reasons for making an assessment.

As just a single example, a recent college graduate looking at full-time employment opportunities might want to

determine the probability that Company A will have a brighter economic future than Company B. Although such

decisions can never be correct 100 percent of the time, knowledge of financial accounting and the information

being communicated greatly increases the likelihood of success. As Kofi Annan, former secretary-general of the

United Nations, has said, “Knowledge is power. Information is liberating1.”

Thus, the ultimate purpose of this book is to provide students with a rich understanding of the rules and nuances

of financial accounting so they can evaluate available information and then make good choices about those

organizations. In the world of business, most successful individuals have developed this talent and are able to use

it to achieve their investing and career objectives.

Question: Knowledge of financial accounting assists individuals in making informed decisions about businesses

and other organizations. What kinds of evaluations are typically made? For example, assume that a former

student—one who recently graduated from college—has been assigned the task of analyzing financial data

provided by Company C. What real-life decisions could a person be facing where an understanding of financial

accounting is beneficial?

Answer: The number of possible judgments that an individual might need to make about a business or other

1.1 MAKING GOOD FINANCIAL DECISIONS ABOUT AN ORGANIZATION • 3

organization is close to unlimited. However, many decisions deal with current financial health and the prospects

for future success. In making assessments of available data, a working knowledge of financial accounting is

invaluable. The more in-depth the understanding is of those principles, the more likely the person will be able to

use the available information to arrive at the best possible choice. Common examples include the following:

• The college graduate might be employed by a bank to work in its corporate lending department. Company

C is a local business that has applied to the bank for a large loan. The graduate has been asked by bank

management to prepare an assessment of Company C to determine if it is likely to be financially healthy in

the future so that it will be able to repay the money when due. A correct decision to lend the money

eventually earns the bank profit because Company C (the debtor) will be required to pay an extra amount

(known as interest) on the money borrowed. Conversely, an incorrect analysis of the information could lead

to a substantial loss if the loan is granted and Company C is unable to fulfill its obligation. Bank officials

must weigh the potential for profit against the risk of loss. That is a daily challenge in virtually all

businesses. The former student’s career with the bank might depend on the ability to analyze financial

accounting data and then make appropriate choices about the actions to be taken. Should a loan be made to

this company?

• The college graduate might hold a job as a credit analyst for a manufacturing company that sells its

products to retail stores. Company C is a relatively new retailer that wants to buy goods (inventory) for its

stores on credit from this manufacturer. The former student must judge whether it is wise to permit

Company C to buy goods now but wait until later to remit the money. If payments are received on a timely

basis, the manufacturer will have found a new outlet for its merchandise. Profits will likely increase.

Unfortunately, another possibility also exists. Company C could make expensive purchases but then be

unable to make payment, creating significant losses for the manufacturer. Should credit be extended to this

company?

• The college graduate might be employed by an investment firm that provides financial advice to its clients.

The firm is presently considering whether to recommend acquisition of the ownership shares of Company C

as a good investment strategy. The former student has been assigned to gather and evaluate relevant

financial information as a basis for this decision. If Company C is poised to become stronger and more

profitable, its ownership shares will likely rise in value over time, earning money for the firm’s clients.

Conversely, if the prospects for Company C appear to be less bright, the value of these shares might be

expected to drop (possibly precipitously) so that the investment firm should avoid suggesting the purchase

of an ownership interest in Company C. Should shares of this company be recommended for acquisition?

Success in life—especially in business—frequently results from making appropriate decisions. Many economic

choices, such as those described above, depend on the ability to understand and make use of the financial

information that is produced and presented about an organization in accordance with the rules and principles

underlying financial accounting.

Exercise

Link to multiple-choice question for practice purposes: http://www.quia.com/quiz/2092614.html

4 • FINANCIAL ACCOUNTING

Question: A great number of possible decisions could be addressed in connection with an organization. Is an

understanding of financial accounting relevant to all business decisions? What about the following?

• Should a business buy a building to serve as its new headquarters or rent a facility instead?

• What price should a data processing company charge customers for its services?

• Should advertisements to alert the public about a new product be carried on the Internet or on television?

Answer: Organizational decisions such as these are extremely important for success. However, these examples are

not made about the reporting organization. Rather, they are made within the organization in connection with some

element of its operations.

The general term “accounting” refers to the communication of financial information for decision-making

purposes. Accounting is then further subdivided into (a) financial accounting and (b) managerial accountingThe

communication of financial information within an organization so internal decisions can be made in an appropriate

manner2.. Financial accounting is the subject explored in this textbook. It focuses on conveying relevant data

(primarily to external parties) so that decisions can be made about an organization (such as Motorola or Starbucks)

as a whole. Thus, questions such as the following all fall within the discussion of financial accounting:

• Do we loan money to Company C?

• Do we sell on credit to Company C?

• Do we recommend that our clients buy the ownership shares of Company C?

They relate to evaluating the financial health and prospects of Company C as a whole.

Managerial accounting is the subject of other books and other courses. This second branch of accounting refers to

the communication of information within an organization so that internal decisions (such as whether to buy or rent

a building) can be made in an appropriate manner. Individuals studying an organization as a whole have different

goals than do internal parties making operational decisions. Thus, many unique characteristics have developed

in connection with each of these two branches of accounting. Financial accounting and managerial accounting

have evolved independently over the decades to address the specific needs of the users being served and the

decisions being made. This textbook is designed to explain those attributes that are fundamental to attaining a

usable understanding of financial accounting.

It is not that one of these areas of accounting is better, more useful, or more important than the other. Financial

accounting and managerial accounting have simply been created to achieve different objectives. They both do

their jobs well; they just do not have the same jobs.

Exercise

Link to multiple-choice question for practice purposes: http://www.quia.com/quiz/2092571.html

1.1 MAKING GOOD FINANCIAL DECISIONS ABOUT AN ORGANIZATION • 5

Question: Financial accounting refers to the conveyance of information about an organization as a whole and is

most frequently directed to assisting outside decision makers. Is there any reason for a person who is employed

by a company to care about the financial accounting data reported about that organization? Why should an

employee in the marketing or personnel department of Company C be interested in the financial information that

it distributes?

Answer: As indicated, financial accounting is designed to portray the overall financial condition and prospects

of an organization. Every employee should be quite interested in assessing that information to judge future

employment prospects. A company that is doing well will possibly award larger pay raises or perhaps significant

end-of-year cash bonuses. A financially healthy organization can afford to hire new employees, buy additional

equipment, or pursue major new initiatives. Conversely, when a company is struggling and prospects are dim,

employees might anticipate layoffs, pay cuts, or reductions in resources.

Thus, although financial accounting information is often directed to outside decision makers, employees should

be vitally interested in the financial health of their own organization. No one wants to be clueless as to whether

their employer is headed for prosperity or bankruptcy. In reality, employees are often the most avid readers of the

financial accounting information distributed by their employers because the results can have such an immediate

and direct impact on their jobs and, hence, their lives.

Key Takeaway

Financial accounting encompasses the rules and procedures to convey financial information about an organization. Individuals who attain a proper level of knowledge of financial accounting can utilize this information to make decisions based on the organization’s perceived financial health and outlook. Such decisions might include assessing employment potential, lending money, granting credit, and buying or selling ownership shares. However, financial accounting does not address issues that are purely of an internal nature, such as whether an organization should buy or lease equipment or the level of pay raises. Information to guide such internal decisions is generated according to managerial accounting rules and procedures that are introduced in other books and courses. Despite not being directed toward the inner workings of an organization, employees are interested in financial accounting because it helps them assess the future financial prospects of their employer.

1See http://www.deepsky.com/~madmagic/kofi.html.

2Tax accounting serves as another distinct branch of accounting. It is less focused on decision making and

more on providing the information needed to comply with all government rules and regulations. Even in tax

accounting, though, decision making is important as companies seek to take all possible legal actions to minimize

tax payments.

6 • FINANCIAL ACCOUNTING

1.2 Incorporation and the Trading of Capital Shares

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

1. Define “incorporation.”

2. Explain the popularity of investing in the capital stock of a corporation.

3. Discuss the necessity and purpose of a board of directors.

4. List the potential benefits gained from acquiring capital stock.

Question: Above, in discussing the possible decisions that could be made about an organization, ownership shares

were mentioned. Occasionally, on television, in newspapers, or on the Internet, mention is made that the shares

of one company or another have gone up or down in price during that day because of trading on one of the stock

markets. Why does a person or an organization acquire ownership shares of a business such as Capital One or

Intel?

Answer: In the United States, as well as in many other countries, owners of a business or other type of organization

can apply to the state government to have it identified as an entity legally separate from its owners. This process

is referred to as incorporation. Therefore, a corporation is an organization that has been formally recognized by

the government as a legal entity. A business that has not been incorporated is legally either a sole proprietorship

(one owner) or a partnership (more than one owner).

As will be discussed in detail in Chapter 16 “In a Set of Financial Statements, What Information Is Conveyed

about Shareholders’ Equity?”, several advantages can be gained from incorporation. For one, a corporation has

the

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