Levy industries has the following items listed on its most recent trial balance:

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Using Financial Accounting Information

T H E A L T E R N A T I V E T O D E B I T S A N D C R E D I T S

Gary A. Porter DRAKE UNIVERSITY

Curtis L. Norton ARIZONA STATE UNIVERSITY

10e

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Using Financial Accounting Information: The Alternative to Debits and Credits, 10th edition

Gary A. Porter, Curtis L. Norton

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Library of Congress Control Number: 2016954444 Student Edition ISBN: 978-1-337-27633-7 Loose-Leaf Edition ISBN: 978-1-337-27639-9

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To those who really ‘‘count’’ Melissa

Kathy, Amy, Andrew

In memory of Sophie

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Brief Contents

Contents v

Preface xi

CHAPTER 1 Accounting as a Form of Communication 2

CHAPTER 2 Financial Statements and the Annual Report 50

CHAPTER 3 Processing Accounting Information 100

CHAPTER 4 Income Measurement and Accrual Accounting 148

CHAPTER 5 Inventories and Cost of Goods Sold 208

CHAPTER 6 Cash and Internal Control 276

CHAPTER 7 Receivables and Investments 310

CHAPTER 8 Operating Assets: Property, Plant, and Equipment, and Intangibles 356

CHAPTER 9 Current Liabilities, Contingencies, and the Time Value of Money 402

CHAPTER 10 Long-Term Liabilities 454

CHAPTER 11 Stockholders’ Equity 500

CHAPTER 12 The Statement of Cash Flows 554

CHAPTER 13 Financial Statement Analysis 622

APPENDIX A International Financial Reporting Standards A-1

APPENDIX B Excerpts from Chipotle Mexican Grill, Inc. Form 10-K for the Fiscal Year Ended December 31, 2015 B-1

APPENDIX C Excerpts from Panera Bread Company Form 10-K for the Fiscal Year Ended December 29, 2015 C-1

Glossary G-1

Index I-1

iv

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Contents

CHAPTER 1 Accounting as a Form of Communication 2

Chipotle Mexican Grill, Inc.: Making Business Decisions 3

MODULE 1 The Nature of Business 4

Forms of Organization 4 Business Entities 5 Sole Proprietorships 5 Partnerships 5 Corporations 5

Nonbusiness Entities 6 Organizations and Social Responsibility 6

The Nature of Business Activity 6 Financing Activities 6 Investing Activities 7 Operating Activities 7 Summary of Business Activities 7

MODULE 2 Accounting and Financial Statements 9 Users of Accounting Information and Their Needs 9 Internal Users 9 External Users 9

Using Financial Accounting Information 10

Financial Decision Framework 10

Financial Statements: How Accountants Communicate 11

The Accounting Equation 11 The Balance Sheet 12 The Income Statement 13 The Statement of Retained Earnings 14 The Statement of Cash Flows 14 Relationships Among the Financial Statements 15 Looking at Financial Statements for a Real Company: Chipotle 15 Chipotle’s Balance Sheet 15 Chipotle’s Income Statement 18

MODULE 3 Conceptual Framework of Accounting 19

Conceptual Framework for Accounting 19 Economic Entity Concept 20 Asset Valuation: Cost or Fair Value? 20 Going Concern 20 Time Period Assumption 21

Setting Accounting Standards 21 Who Determines the Rules for Financial Statements? 21 The Audit of Financial Statements 22

Introduction to Ethics in Accounting 22

Why Should Accountants Be Concerned with Ethics? 22 Is the Information Relevant and a Faithful Representation? 22 Moral and Social Context of Ethical Behavior 23

Accountants and Ethical Judgments 23 The Changing Face of the Accounting Profession 24

CHAPTER 2 Financial Statements and the Annual Report 50

Panera Bread Company: Making Business Decisions 51

MODULE 1 Financial Reporting Objectives and Characteristics of Useful Information 52

What Makes Accounting Information Useful? Qualitative Characteristics 53

Understandability 53 Relevance 54 Faithful Representation 54 Comparability and Consistency 54 Materiality 55 Conservatism 55 An International Perspective on Qualitative Characteristics 56

MODULE 2 Classified Balance Sheets 56 Understanding the Operating Cycle 57 Current Assets 58 Noncurrent Assets 58 Investments 59 Property, Plant, and Equipment 59 Intangibles 59

Current Liabilities 59 Long-Term Liabilities 60 Stockholders’ Equity 60

Using a Classified Balance Sheet: Introduction to Ratios 62

Working Capital 62 Current Ratio 62

MODULE 3 Income Statements, Statements of Retained Earnings, and Statements of Cash Flows 64

What Appears on the Income Statement? 64 Format of the Income Statement 64 Single-Step Format for the Income Statement 64 Multiple-Step Format for the Income Statement 65

Using an Income Statement 66 The Statement of Retained Earnings 67 The Statement of Cash Flows 68

v

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MODULE 4 Reading and Using the Annual Report 70

Panera Bread’s Balance Sheet 70 Panera Bread’s Income Statement 72

Making Business Decisions: Panera Bread 73 Other Elements of an Annual Report 76 Report of Independent Accountants (Auditors’ Report) 76 The Ethical Responsibility of Management and the Auditors 76 Management Discussion and Analysis 77 Notes to Consolidated Financial Statements 78

CHAPTER 3 Processing Accounting Information 100

Vail Resorts, Inc.: Making Business Decisions 101

MODULE 1 Transactions and the Accounting Equation 102

External and Internal Events 102

The Role of Source Documents in Recording Transactions 102 Analyzing the Effects of Transactions on the Accounting Equation 103

The Cost Principle 105 Balance Sheet and Income Statement for Glengarry Health Club 105

What Is an Account? 107 Chart of Accounts 107 The General Ledger 107 Identify and Analyze 108

MODULE 2 Debits and Credits 111

Accounting Tools: The Double-Entry System 111 The T Account 111

Debits and Credits 112 Debits Aren’t Bad, and Credits Aren’t Good 113 Debits and Credits for Revenues, Expenses, and Dividends 113 Revenues 113 Expenses 113 Dividends 113

Summary of the Rules for Increasing and Decreasing Accounts 113 Normal Account Balances 113 Debits and Credits Applied to Transactions 114 Transactions for Glengarry Health Club 114

MODULE 3 Journal Entries and Trial Balances 117

The Journal: The Firm’s Chronological Record of Transactions 117 The Trial Balance 119

CHAPTER 4 Income Measurement and Accrual Accounting 148

Nordstrom, Inc.: Making Business Decisions 149

MODULE 1 Accrual Accounting Principles 150 Recognition 150 Measurement 150 Choice 1: The Attribute to Be Measured 150 Choice 2: The Unit of Measure 151

Summary of Recognition and Measurement in Financial Statements 151

The Accrual Basis of Accounting 152 Comparing the Cash and Accrual Bases of Accounting 152 What the Income Statement and the Statement of Cash Flows Reveal 154 Accrual Accounting and Time Periods 155

The Revenue Recognition Principle 155

Expense Recognition and the Matching Principle 155

MODULE 2 Adjustments 158 Types of Adjustments 158 (1) Cash Paid Before Expense Is Incurred (Deferred Expense) 159 (2) Cash Received Before Revenue Is Recognized (Deferred Revenue) 161 (3) Expense Incurred Before Cash Is Paid (Accrued Liability) 162 (4) Revenue Recognized Before Cash Is Received (Accrued Asset) 165

Accruals and Deferrals 166 Summary of Adjustments 166 Comprehensive Example of Adjustments 167 Income Statement and Balance Sheet for Duffy Transit 170 Ethical Considerations for a Company on the Accrual Basis 171

MODULE 3 The Accounting Cycle 172 The Use of a Work Sheet 173 The Closing Process 174 Interim Financial Statements 174

CHAPTER 5 Inventories and Cost of Goods Sold 208

Gap Inc.: Making Business Decisions 209

MODULE 1 Sales, Cost of Goods Sold, and Gross Profit 210

Three Types of Inventory Costs and Three Forms of Inventory 210 Three Types of Manufacturing Costs 210 Three Forms of Inventory 210

Net Sales of Merchandise 211 Sales Returns and Allowances 212 Credit Terms and Sales Discounts 212

Cost of Goods Sold 213 The Cost of Goods Sold Model 213 Inventory Systems: Perpetual and Periodic 214

vi Contents

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Beginning and Ending Inventories in a Periodic System 215 Cost of Goods Purchased 216 Purchases 216 Purchase Discounts 216 Purchase Returns and Allowances 217 Shipping Terms and Transportation Costs 217 Shipping Terms and Transfer of Title to Inventory 218

The Gross Profit Ratio 218

Making Business Decisions: Gap Inc. 219

MODULE 2 Inventory Costing Methods 222 Inventory Costs: What Should Be Included? 222

Inventory Costing Methods with a Periodic System 223

Specific Identification Method 224 Weighted Average Cost Method 225 First-In, First-Out Method (FIFO) 226 Last-In, First-Out Method (LIFO) 227

Selecting an Inventory Costing Method 227 Costing Methods and Cash Flow 227 LIFO Liquidation 228 The LIFO Conformity Rule 229 The LIFO Reserve: Estimating LIFO’s Effect on Income and on Taxes Paid for Winnebago Industries 229 Costing Methods and Inventory Profits 230 Changing Inventory Methods 231 Inventory Valuation in Other Countries 231

MODULE 3 Other Inventory Issues 232 Inventory Errors 232

Valuing Inventory at Lower of Cost or Market 235 Why Replacement Cost Is Used as a Measure of Market 235 Application of the LCM Rule 236 Lower-of-Cost-or-Market under International Standards 237

MODULE 4 Inventory Management and Cash Flow Issues 237

Making Business Decisions: Gap Inc. 238

How Inventories Affect the Cash Flows Statement 240

Appendix: MODULE 5 Inventory Costing Methods with a Perpetual System 242

FIFO Costing with a Perpetual System 242 LIFO Costing with a Perpetual System 243 Moving Average with a Perpetual System 244

CHAPTER 6 Cash and Internal Control 276

Regal Entertainment Group: Making Business Decisions 277

MODULE 1 Accounting and Controlling for Cash 278

Cash Equivalents and the Statement of Cash Flows 278

Control Over Cash 278 Cash Management 279 Reading a Bank Statement 279 The Bank Reconciliation 281 The Need for Adjustments to the Records 282 Establishing a Petty Cash Fund 283

MODULE 2 Internal Control 284 The Sarbanes-Oxley Act of 2002 284 The Control Environment 287 The Accounting System 287

Internal Control Procedures 287 Proper Authorizations 287 Segregation of Duties 287 Independent Verification 288 Safeguarding of Assets and Records 288 Independent Review and Appraisal 288 Design and Use of Business Documents 288

Limitations on Internal Control 289

Computerized Business Documents and Internal Control 289

Control Over Cash Receipts 289 Cash Received Over the Counter 289 Cash Received in the Mail 290 Cash Discrepancies 290

The Role of Computerized Business Documents in Controlling Cash Disbursements 290 Purchase Requisition 290 Purchase Order 292 Invoice 292 Receiving Report 293 Invoice Approval Form 294 Check with Remittance Advice 294

CHAPTER 7 Receivables and Investments 310

Apple Inc.: Making Business Decisions 311

MODULE 1 Accounting for Accounts Receivable 312 The Use of a Subsidiary Ledger 312 The Valuation of Accounts Receivable 313 Two Methods to Account for Bad Debts 313 Two Approaches to the Allowance Method of Accounting for Bad Debts 315 Percentage of Net Credit Sales Approach 315 Percentage of Accounts Receivable Approach 316 Aging of Accounts Receivable 317

The Accounts Receivable Turnover Ratio 319

Making Business Decisions: Apple 319

MODULE 2 Accounting for Notes Receivable 322 Important Terms Connected with Promissory Notes 323

Accelerating the Inflow of Cash from Sales 324 Credit Card Sales 325 Discounting Notes Receivable 326

Contents vii

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MODULE 3 Accounting for Investments 327 Investments in Highly Liquid Financial Instruments 327 Investments in Stocks and Bonds 329 No Significant Influence 329 Significant Influence 330 Control 330

Valuing and Reporting Investments on the Financial Statements 332

MODULE 4 How Liquid Assets Affect the Statement of Cash Flows 333

CHAPTER 8 Operating Assets: Property, Plant, and Equipment, and Intangibles 356

Nike: Making Business Decisions 357

MODULE 1 Acquisition of Operating Assets 358

Acquisition of Property, Plant, and Equipment 358 Group Purchase 359 Capitalization of Interest 359 Land Improvements 360

MODULE 2 Depreciation and Disposal of Operating Assets 361

Straight-Line Method 362 Units-of-Production Method 362 Accelerated Depreciation Methods 363 Comparison of Depreciation Methods 364 Depreciation and Income Taxes 364 Choice of Depreciation Method 364 Change in Depreciation Estimate 365

Capital versus Revenue Expenditures 366 Environmental Aspects of Operating Assets 368

Disposal of Property, Plant, and Equipment 368 Gain on Sale of Assets 369 Loss on Sale of Assets 370

IFRS and Property, Plant, and Equipment 370

MODULE 3 Intangible Assets 372 Balance Sheet Presentation 372 Acquisition Cost of Intangible Assets 372 Research and Development Costs 372

Amortization of Intangibles 373 Intangibles with Finite Life 373 Intangibles with Indefinite Life 374 Goodwill and Impairments 374

IFRS and Intangible Assets 375

MODULE 4 Cash Flow and Analysis Issues 376

Analyzing Long-Term Assets for Average Life and Asset Turnover 378

Making Business Decisions: Nike 378

CHAPTER 9 Current Liabilities, Contingencies, and the Time Value of Money 402

Starbucks Corporation: Making Business Decisions 403

MODULE 1 Current Liabilities 404 Accounts Payable 404 Notes Payable 405 Current Maturities of Long-Term Debt 407 Taxes Payable 408 Other Accrued Liabilities 408

IFRS and Current Liabilities 409

MODULE 2 Cash Flow Effects 410

MODULE 3 Contingent Liabilities 411 Contingent Liabilities That Are Recorded 412 Product Warranties and Guarantees: Common Contingent Liabilities That Are Recorded 412 Premiums or Coupons: Other Contingent Liabilities That Are Recorded 413 Some Lawsuits and Legal Claims Are Contingent Liabilities That Must Be Recorded 413

Contingent Liabilities That Are Disclosed 414 Contingent Liabilities versus Contingent Assets 414

IFRS and Contingencies 414

MODULE 4 Time Value of Money 415 Simple Interest 416 Compound Interest 416 Interest Compounding 416

Present Value and Future Value: Single Amounts 417 Future Value of a Single Amount 417 Present Value of a Single Amount 419

Present Value and Future Value of an Annuity 420 Future Value of an Annuity 420 Present Value of an Annuity 421 Solving for Unknowns 421

Appendix: Accounting Tools: Using Excel¤ for Problems Involving Interest Calculations 427

CHAPTER 10 Long-Term Liabilities 454

Coca-Cola: Making Business Decisions 455

MODULE 1 Long-Term Liabilities Including Bonds Payable 456

Bonds Payable: Characteristics 457 Collateral 458

viii Contents

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Due Date 458 Other Features 458

Issuance of Bonds 458 Factors Affecting Bond Price 458

Premium or Discount on Bonds 460

MODULE 2 Bond Amortization and Bond Retirement 463

Effective Interest Method: Impact on Expense 463

Redemption of Bonds 466 Retired Early at a Gain or a Loss 466 Financial Statement Presentation of Gain or Loss 468

MODULE 3 Liability for Leases 469 Leases 469 Lease Criteria 469 Operating Leases 469 Capital Leases 470

IFRS and Leasing 473

MODULE 4 Analysis of Long-Term Liabilities and Cash Flow Issues 473

Making Business Decisions: Pepsico 474

How Long-Term Liabilities Affect the Statement of Cash Flows 476

Appendix: MODULE 5 Deferred Tax 478

CHAPTER 11 Stockholders’ Equity 500

Southwest Airlines: Making Business Decisions 501

MODULE 1 Stockholders’ Equity, Issuance of Stock, and Treasury Stock 502

Stockholders’ Equity on the Balance Sheet 503 How Income and Dividends Affect Retained Earnings 503 Identifying Components of the Stockholders’ Equity Section of the Balance Sheet 503 Number of Shares 504 Par Value: The Firm’s ‘‘Legal Capital’’ 504 Additional Paid-In Capital 505 Retained Earnings: The Amount Not Paid as Dividends 505

IFRS and Stockholders’ Equity 505

Preferred Stock 505 Issuance of Stock 506

Stock Issued for Cash 506 Stock Issued for Noncash Consideration 507

What Is Treasury Stock? 507 Retirement of Stock 509

MODULE 2 Cash Dividends, Stock Dividends, and Stock Splits 511

Cash Dividends 511 Cash Dividends for Preferred and Common Stock 511

Stock Dividends 512 Stock Splits 514

MODULE 3 Analysis and Cash Flow Issues 516 What Is Comprehensive Income? 517

What Analyzing Stockholders’ Equity Reveals About a Firm’s Value 518

Calculating Book Value When Preferred Stock Is Present 518 Market Value per Share 519

How Changes in Stockholders’ Equity Affect the Statement of Cash Flows 519

Appendix: MODULE 4 Sole Proprietorships and Partnerships 521

Sole Proprietorships 522 Typical Transactions 522

Partnerships 523 Investments and Withdrawals 524 Distribution of Income 525

CHAPTER 12 The Statement of Cash Flows 554

Walgreens Boots Alliance: Making Business Decisions 555

MODULE 1 Purpose and Format for the Statement of Cash Flows 556

Purpose of the Statement of Cash Flows 556 Reporting Requirements for a Statement of Cash Flows 556

The Definition of Cash: Cash and Cash Equivalents 558

Classification of Cash Flows 559 Operating Activities 560 Investing Activities 560 Financing Activities 561 Summary of the Three Types of Activities 561

Noncash Investing and Financing Activities 561

Two Methods of Reporting Cash Flow from Operating Activities 563

MODULE 2 Preparing the Statement of Cash Flows Using the Direct Method 567

The Accounting Equation and the Statement of Cash Flows 567 An Approach to Preparing the Statement of Cash Flows: Direct Method 568 Step 2: Determine the Cash Flows from Operating Activities 569 Sales Revenue and Accounts Receivable 569 Interest Revenue 571 Gain on Sale of Machine 571 Cost of Goods Sold, Inventory, and Accounts Payable 571

Contents ix

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Salaries and Wages Expense and Salaries and Wages Payable 572 Depreciation Expense 572 Insurance Expense and Prepaid Insurance 572 Interest Expense 573 Income Taxes Expense and Income Taxes Payable 573 Loss on Retirement of Bonds 573 Compare Net Income with Net Cash Flow from Operating Activities 573

Step 3: Determine the Cash Flows from Investing Activities 575 Long-Term Investments 575 Land 575 Property and Equipment 575

Step 4: Determine the Cash Flows from Financing Activities 576 Notes Payable 576 Bonds Payable 576 Capital Stock 576 Retained Earnings 577

Using the Three Schedules to Prepare a Statement of Cash Flows 577

MODULE 3 Preparing the Statement of Cash Flows Using the Indirect Method 579

Net Income 579 Accounts Receivable 579 Gain on Sale of Machine 579 Inventory 580 Accounts Payable 580 Salaries and Wages Payable 580 Depreciation Expense 580 Prepaid Insurance 580 Income Taxes Payable 580 Loss on Retirement of Bonds 580 Summary of Adjustments to Net Income under the Indirect Method 580

Comparison of the Indirect and Direct Methods 581

MODULE 4 Cash Flow Analysis 582 Creditors and Cash Flow Adequacy 582

Making Business Decisions: Nordstrom 583 Stockholders and Cash Flow per Share 585

Appendix: MODULE 5 A Work Sheet Approach to Preparing the Statement of Cash Flows 586

CHAPTER 13 Financial Statement Analysis 622

Lululemon Athletica Inc.: Making Business Decisions 623

MODULE 1 Horizontal and Vertical Analysis 624 Watch for Alternative Accounting Principles 624

Take Care When Making Comparisons 624 Understand the Possible Effects of Inflation 624

Analysis of Comparative Statements: Horizontal Analysis 625 Analysis of Common-Size Statements: Vertical Analysis 629

MODULE 2 Liquidity Analysis 632 Working Capital 632 Current Ratio 633 Acid-Test Ratio 633 Cash Flow from Operations to Current Liabilities 634 Accounts Receivable Analysis 635 Inventory Analysis 636 Cash Operating Cycle 636

MODULE 3 Solvency Analysis 638 Debt-to-Equity Ratio 638 Times Interest Earned 638 Debt Service Coverage 639 Cash Flow from Operations to Capital Expenditures Ratio 640

MODULE 4 Profitability Analysis 641 Rate of Return on Assets 641 Components of Return on Assets 642 Return on Common Stockholders’ Equity 643 Return on Assets, Return on Equity, and Leverage 643 Earnings per Share 644 Price/Earnings Ratio 645 Dividend Ratios 646 Summary of Selected Financial Ratios 646

APPENDIX A International Financial Reporting Standards A-1

APPENDIX B Excerpts from Chipotle Mexican Grill, Inc. Form 10-K for the Fiscal Year Ended December 31, 2015 B-1

APPENDIX C Excerpts from Panera Bread Company Form 10-K for the Fiscal Year Ended December 29, 2015 C-1

Glossary G-1

Index I-1

x Contents

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Preface

Seeing the Forest for the Trees Accounting is more than just recording business events. It is a powerful tool for invest- ors, managers, and decision makers. It is a common and powerful tool in every business. This is even more true for the majority of business students who may never see a journal entry in their entire professional careers. Using Financial Accounting Information, 10e is written for these students—people who may not become accountants but still need to understand why accounting is important.

Connecting to the Big Picture By demonstrating that accounting is an important decision-making tool, Porter/ Norton’s Using Financial Accounting Information, 10e helps students see the big pic- ture and understand how accounting is more than recording a series of events. Students who understand why accounting is important are more motivated to learn and succeed.

This text uses a variety of methods to connect students to the big picture. First, a hallmark of this text has always been emphasizing why accounting is important through the use of financial statements and other data for real-world company examples, chapter openers, and end-of-chapter material, giving students the opportunity to use that data to apply what they’re learning.

This emphasis is continued through the text’s unique transaction model. Each transac- tion in the text and the solutions manual is notated using a two-part element that focuses on the relationships between accounts, their increases and decreases, and the resulting artic- ulation of the financial statements.