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ISBN-10: ISBN-13:

2012

1121539998 9781121539990

Contents

i. Preface 1 ii. Index and Source of Cases 4

Financial Accounting 9 1. Introduction 11 2. The Nature and Purpose of Accounting 12 3. Basic Accounting Concepts: The Balance Sheet 36 4. Basic Accounting Concepts: The Income Statement 60 5. Accounting Records and Systems 90 6. Revenue and Monetary Assets 118 7. Cost of Sales and Inventories 151 8. Long-Lived Nonmonetary Assets and Their Amortization 182 9. Sources of Capital: Debt 230

10. Sources of Capital: Owners’ Equity 266 11. Other Items That Affect Net Income and Owners’ Equity 293 12. The Statement of Cash Flows 325 13. Acquisitions and Consolidated Statements 355 14. Financial Statement Analysis 379 15. Understanding Financial Statements 414

iii

Contents

Management Accounting 449 16. Introduction 451 17. The Nature of Management Accounting 452 18. The Behavior of Costs 470 19. Full Costs and Their Uses 504 20. Additional Aspects of Product Costing Systems 533 21. Standard Costs, Variable Costing Systems, Quality Costs, and Joint Costs 585 22. Production Cost Variance Analyses 620 23. Other Variance Analyses 642 24. Control: The Management Control Environment 664 25. Control: The Management Control Process 696 26. Strategic Planning and Budgeting 725 27. Reporting and Evaluation 787 28. Short-Run Alternative Choice Decisions 821 29. Longer-Run Decisions: Capital Budgeting 854 30. Management Accounting System Design 882 A. Appendixes 907 B. Author Index 909 C. Subject Index 911

iii

Credits

i. Preface: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 1 ii. Index and Source of Cases: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 4

Financial Accounting 9 1. Introduction: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 11 2. The Nature and Purpose of Accounting: Chapter 1 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 12 3. Basic Accounting Concepts: The Balance Sheet: Chapter 2 from Accounting: Text and Cases, 13th Edition by

Anthony, Hawkins, Merchant, 2011 36 4. Basic Accounting Concepts: The Income Statement: Chapter 3 from Accounting: Text and Cases, 13th Edition by

Anthony, Hawkins, Merchant, 2011 60 5. Accounting Records and Systems: Chapter 4 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 90 6. Revenue and Monetary Assets: Chapter 5 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 118 7. Cost of Sales and Inventories: Chapter 6 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 151 8. Long-Lived Nonmonetary Assets and Their Amortization: Chapter 7 from Accounting: Text and Cases, 13th

Edition by Anthony, Hawkins, Merchant, 2011 182 9. Sources of Capital: Debt: Chapter 8 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 230 10. Sources of Capital: Owners’ Equity: Chapter 9 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 266 11. Other Items That Affect Net Income and Owners’ Equity: Chapter 10 from Accounting: Text and Cases, 13th

Edition by Anthony, Hawkins, Merchant, 2011 293 12. The Statement of Cash Flows: Chapter 11 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 325 13. Acquisitions and Consolidated Statements: Chapter 12 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 355 14. Financial Statement Analysis: Chapter 13 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 379 15. Understanding Financial Statements: Chapter 14 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 414

iv

Credits

Management Accounting 449 16. Introduction: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 451 17. The Nature of Management Accounting: Chapter 15 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 452 18. The Behavior of Costs: Chapter 16 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 470 19. Full Costs and Their Uses: Chapter 17 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 504 20. Additional Aspects of Product Costing Systems: Chapter 18 from Accounting: Text and Cases, 13th Edition by

Anthony, Hawkins, Merchant, 2011 533 21. Standard Costs, Variable Costing Systems, Quality Costs, and Joint Costs: Chapter 19 from Accounting: Text

and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 585 22. Production Cost Variance Analyses: Chapter 20 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 620 23. Other Variance Analyses: Chapter 21 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 642 24. Control: The Management Control Environment: Chapter 22 from Accounting: Text and Cases, 13th Edition by

Anthony, Hawkins, Merchant, 2011 664 25. Control: The Management Control Process: Chapter 23 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 696 26. Strategic Planning and Budgeting: Chapter 24 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins,

Merchant, 2011 725 27. Reporting and Evaluation: Chapter 25 from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant,

2011 787 28. Short-Run Alternative Choice Decisions: Chapter 26 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 821 29. Longer-Run Decisions: Capital Budgeting: Chapter 27 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 854 30. Management Accounting System Design: Chapter 28 from Accounting: Text and Cases, 13th Edition by Anthony,

Hawkins, Merchant, 2011 882 A. Appendixes: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 907 B. Author Index: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 909 C. Subject Index: Chapter from Accounting: Text and Cases, 13th Edition by Anthony, Hawkins, Merchant, 2011 911

iv

Preface An accounting text can be written with an emphasis on either of two viewpoints: (1) what the user of accounting information needs to know about accounting or (2) what the pre- parer of accounting reports needs to know about accounting. This book focuses on the user of accounting information. Because such a person needs to know enough about the prepa- ration of accounting reports to use them intelligently, this text includes the technical material needed for this purpose. The book is aimed primarily, however, at the person who wants to be a knowledgeable user of accounting information. This focus is reinforced in the book’s case studies, which help the student learn that accounting is not a cut-and-dried subject with all of its “answers” clearly indicated by the application of rules.

The focus of the book makes it particularly appropriate for required core courses in accounting, in which many of the students are not planning to take further elective ac- counting courses. We believe that if a core course stresses the more analytical uses of accounting information by managers and outside analysts rather than the procedural details that the practicing accountant needs to know, then those students who do not take further accounting courses will be left with a positive view of the importance of accounting rather than with the negative “bean counter” stereotype. We also feel that a user orientation in the core course actually is likely to generate a greater number of ac- counting majors from the class than if the course is oriented more toward the person who has already decided to major in accounting. Similarly, in our experience the re- quired accounting module in a management development program will generate little participant interest unless the module is oriented toward the nonaccountant user of ac- counting information. In sum, we think the book conveys the fact that accounting is interesting and fun, not dull and tedious.

Specifically, this book is used in at least the following four ways:

1. As an introductory course where most (if not all) of the students have no prior train- ing in accounting. In many schools this introduction comprises two separate courses, one dealing with financial accounting and the other with management accounting. Many schools use this book for both such courses, whereas some use it only for financial accounting (Chapter 1 and Chapters 2–14) or for management accounting (Chapter 1 and Chapters 15–28). It is used in such introductory courses both at the upper undergraduate level and in graduate programs. In addition to its widespread use in schools of business and management, it also is used in introductory accounting courses in some law schools, education schools, and schools of public health.

2. As an elective course that builds on a required introductory course in accounting— particularly where the introductory course had more of a procedural orientation and the elective is intended to be more conceptual, analytical, and user-oriented.

3. As the accounting module in a management development program where the par- ticipants represent a variety of functional and technical backgrounds.

4. As a nontechnical accounting reference book for nonaccountants in business and other organizations.

Many instructors assign or recommend the programmed text Essentials of Accounting,1

either as preliminary to study of the subject (it is often sent in advance to participants in

viii

1 Robert N. Anthony and Leslie K. Breitner, Essentials of Accounting, 10th ed. (Upper Saddle River, NJ: Prentice Hall, 2009). This material is also available in the form of computer software titled Teach Yourself Essentials of Accounting.

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MBA and management development programs) or as a review device. It is a self-study in- troductory treatment of financial accounting, geared to Part 1 of this text.

THE CASES As in previous editions, the cases have been selected because of their interest and edu- cational value as a basis for class discussion. They are not necessarily intended to illustrate either correct or incorrect handling of management problems. Skill in the management use of accounting information can be acquired, we believe, only through experience. Thinking about a case and discussing it in informal discussion groups and in the classroom require the student to do something—to analyze a problem, to weigh various factors involved in it, to make some calculations, to take a position, and so on. In class the student is required to explain her or his point of view, to defend it, to un- derstand and appraise the arguments of colleagues, and to decide what arguments are the strongest. Practice in doing these things helps to increase skill and understanding; in fact, many educators believe that the really important parts of a subject can be learned only by experience of some sort, as opposed to merely hearing or reading about them. Thus, although the case material constitutes less than half the pages in this book, the discussion of these cases is by far the more important part of the educational process. Of course, such discussions contribute to the students’ communication skills as well as to their understanding of accounting.

This edition has a total of 109 cases, 12 of which are new. It is often difficult to judge when to replace an older time-tested case (a “classic” or an “old chestnut”) with which instructors are comfortable with a case of more recent vintage. Each type of case has its advantages. In making changes, we endeavored to strike a balance. We retained some of the best, and most frequently used, older cases while replacing others with some new cases. We hope that these newer cases will become the next generation of classics.

Occasionally, a student or instructor questions our use of small business settings for many of the cases. Such cases often avoid certain complexities at a point when the stu- dent is not yet prepared to deal with them. We also would note that studies have reported that small businesses (those employing fewer than 500 people) represent over 99 per- cent of all U.S. businesses, provide about 50 percent of all private-sector jobs, generate almost 40 percent of the GNP, and contribute two out of three newly created jobs. We therefore feel that exposure to small business cases is beneficial to students, some of whom will one day own a small business while many others will eventually work in such firms or work with them as auditors or consultants. A number of the cases included in the book are copyrighted by the President and Fellows of Harvard College. They are included by express permission. These cases, along with all of the other cases in the book, have been developed solely for class discussion and do not necessarily illustrate effective or ineffective management.

CHANGES IN THE THIRTEENTH EDITION Part 1 reflects Financial Accounting Standards Board pronouncements through early 2010 and the important changes in financial accounting that are expected to occur during the following years. A number of new cases have been added, covering the politics and economics of standard setting, acquisition accounting, contingent liabilities, financial reporting fraud, fair value accounting, lease, revenue recognition, and several other con- temporary accounting controversies and developments. A significant new addition is the inclusion of more International Financial Reporting Standards materials.

Preface ix

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The basic structure of Part 2 remains intact. A discussion of time-driven activity- based costing was added, along with supporting examples and case materials. Other charges provide updated statistics, improved clarity of discussion, and new problems and cases.

ACKNOWLEDGMENTS We are grateful to the many instructors and students who have made suggestions for im- proving this book. Included among those people are our colleagues at the Harvard Busi- ness School and the Marshall School of Business, University of Southern California, as well as the following: Russ Olive, Massachusetts Institute of Technology; Pamela Stuerke, Case Western Reserve University; Marvin Carlson, Southern Methodist University; Alan Lord, Bowling Green State University; and Marc Manalastas, Mary Victoria D.Arce, and Jon Stuart Lim-Vaña,Ateneo de Manila University, the Philippines. We extend our thanks to the reviewers who commented on the twelfth edition, as well as previous editions: Timothy Moffit, Kalamazoo College; Michael Erler and Richard Rogers, Indiana University; Laurie Pant, Suffolk University; Claude Lanfranconi, Richard Ivey School of Business; Thomas Kam and Warren Wee, Hawaii Pacific Uni- versity; Len Weld, Troy State University; Mehmet Kocaculah, University of Southern Indiana; Byron K. Henry, Howard University; Jeffery Kahn, Woodbury University; Pamela Rouse, Butler University; Linda Brown, Saint Ambrose University; Ann L. Watkins, High Point University; Saad Laraqui, Embry-Riddle Aeronautical University; Noel Addy, Mississippi State University; Philip Darcy, Regis University; Frances Lynn Telavera, National University; Patricia Cummins, Troy State University; Reba Cunningham, University of Dallas; Krishagopal Menon, Boston University; Leonardo Rodriguez, Florida International University; Robert Medden, St. Francis Xavier Univer- sity; William S. Hopwood, Florida Atlantic University; Andrew Felo, Pennsylvania State University; David Hurtt and Jack Ruhl, Western Michigan University; Stan Davis, Wake Forest University; Tom Hrubec, Franklin University; Warren Wee, Hawaii Pacific University.

We also would like to thank Beth Woods, Lisa Enfinger, Helen Roybark, and Alice Sineath for their help in accuracy checking the text and Thomas Hrubec of Franklin University for creating PowerPoint® presentations to accompany the text.

Robert N. Anthony David F. Hawkins

Kenneth A. Merchant

x Preface

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xxiii

Index and Source of Cases The 109 cases included in this book are listed below in alphabetical order, together with their authors’ names and the institution with which each author was affiliated at the time the case was written. Cases with no name shown were written by, or under the supervision of, one of the authors of this book. The copyright on all cases is indicated on the first page of each case. No case may be reproduced in any form or by any means without the permission of its copyright holder. Information on requesting permission to reproduce Harvard Business School cases is included on the copyright page of this book. We regret that we are unable to provide permis- sion information for cases not copyrighted by Harvard.

Title Author Accounting at MacCloud Winery Profs. David F. Hawkins, Robert S. Kaplan, and

Gregory S. Miller, Harvard Business School Accounting Fraud at WorldCom Profs. Robert S. Kaplan, Harvard Business School and

David Kiron, Global Research Group. Amerbran Company (A) Prof. James S. Reese, University of Michigan Amerbran Company (B) Prof. James S. Reese, University of Michigan Armco Inc.: Midwestern Steel Division Axeon N.V. Profs. Kenneth A. Merchant, London School of

Economics and Wim A. Van der Stede, University of Southern California

Baldwin Bicycle Company Baron Coburg Prof. W. T. Andrews, Guilford College Behavioral Implications of Airline Depreciation Accounting Policy Choices Bennett Body Company Profs. C. A. Bliss and R. N. Anthony, Harvard

Business School Berkshire Industries PLC Profs. Kenneth A. Merchant, London School of

Economics and Wim A. Van der Stede, University of Southern California

Bill French R. C. Hill and Prof. N. E. Harlan, Harvard Business School

Black Meter Company Body Glove Borealis Profs. Bjorn Jorgensen and Robert S. Kaplan,

Harvard Business School Brisson Company Browning Manufacturing Company Butter Lumber Company

California Creamery, Inc. Profs. Kenneth A. Merchant, London School of Economics and Wim A. Van der Stede, University of Southern California

Campar Industries, Inc. Carter Corporation Copies Express Cotter Company, Inc. Prof. R. F. Vancil, Harvard Business School

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xxiv Index and Source of Cases

Darius Company Delaney Motors Profs. A. Reinstein, University of Detroit and

R. N. Anthony, Harvard Business School Dispensers of California, Inc.

Enager Industries, Inc. Prof. James S. Reece, University of Michigan

Formosa Plastics Group Forner Carpet Company Prof. James S. Reece, University of Michigan Freedom Technology Company

Genmo Corporation Grennell Farm J. Brown and Prof. John K. Shank, Harvard

Business School

Hardin Tool Company Harwood Medical Instruments PLC Hospital Supply, Inc. Prof. Michael W. Maher, University of California, Davis Huron Automotive Company Prof. James S. Reece, University of Michigan

Identify the Industries Jeremy Cott and Profs. Sharon M. McKinnon, Northeastern University, and William J. Bruns Jr., Harvard Business School

Import Distributors, Inc. Prof. James S. Reece, University of Michigan Industrial Electronics, Inc. Innovative Engineering Company Prof. James S. Reece, University of Michigan

Joan Holtz (A) Joan Holtz (B) Joan Holtz (C) Profs. C. B. Nickerson and R. N. Anthony, Harvard

Business School Joan Holtz (D)

Kim Fuller Kim Park Profs. David Hawkins, Gregory S. Miller, and

V. G. Narayaman, Harvard Business School

Landau Company Prof. James S. Reece, University of Michigan Las Ferreterías de México, S.A. de C.V. Profs. Kenneth A. Merchant, London School

of Economics and Wim A. Van der Stede, University of Southern California

Leasing Computers at Persistent Learning Prof. Devin Shanthikumar, Harvard Business School Lewis Corporation Lipman Bottle Company Prof. M. J. Sandretto, Harvard Business School Lone Pine Cafe (A) Lone Pine Cafe (B) Lupton Company Prof. James S. Reece, University of Michigan Lynch’s Chicken Ranch, Inc. Profs. Kenneth A. Merchant and Lesley Porter,

University of Southern California

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Index and Source of Cases xxv

Maynard Company (A) Maynard Company (B) Maxim Integrated Products Medieval Adventures Company Medi-Exam Health Services, Inc. Prof. James S. Reece, University of Michigan Midwest Office Products Prof. Robert S. Kaplan, Harvard Business School Morgan Manufacturing Prof. Julie H. Hertenstein, Northeastern University Music Mart, Inc.

National Association of Accountants Norman Corporation (A) Norman Corporation (B)

Olympic Car Wash Profs. Kenneth A. Merchant, University of Southern California and Wim A. Van der Stede, London School of Economics

Patagonia, Inc. Paul Murray PC Depot Phuket Beach Hotel: Valuing Mutually Profs. Su Han Chan and Ko Wang and Mary Wong,

Exclusive Capital Projects University of Hong Kong Piedmont University Pinetree Motel Profs. James S. Reece, University of Michigan The Politics and Economics of Accounting Karthik Ramanna, Harvard Business School

for Goodwill at Cisco Systems Polymedica Corporation (A) Profs. David F. Hawkins, Harvard Business School, and

Jacob Cohen, INSEAD Precision Worldwide, Inc. Prof. William J. Bruns Jr., Harvard Business School Prestige Telephone Company Prof. William J. Bruns Jr., Harvard Business School Private Fitness LLC Productos Finas Proxim, Inc. Prof. Mark Bradshaw, Harvard Business School Puente Hills Toyota Profs. Kenneth A. Merchant, University of Southern

California, Wim A. Van der Stede, London School of Economics, and Prof. Pieter Jansen, University of Groningen

Quick Lunch Profs. Robert O. Schlaifer and Robert N. Anthony, Harvard Business School

Ribbons an’ Bows, Inc. Rock Creek Golf Club Prof. James S. Reece, University of Michigan

Safety Monitoring Devices, Inc. Prof. Wim A.Van der Stede, London School of Economics Save-Mart Shelter Partnership, Inc. Shuman Automobiles, Inc. A. M. McCosh and Profs. David Hawkins, J. R. Yeager,

and James S. Reece, Harvard Business School

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xxvi Index and Source of Cases

Silic: Choosing Cost or Fair Value Prof. David Hawkins, Harvard Business School, on Adoption of IFRS Vincent Dessain, and Anthony Barron, Harvard

Business School Europe Research Center Silver Appliance Company Prof. James S. Reece, University of Michigan Sinclair Company Sippican Corporation (A) Prof. Robert S. Kaplan, Harvard Business School Sippican Corporation (B) Prof. Robert S. Kaplan, Harvard Business School Springfield National Bank Prof. Ray G. Stephens, The Ohio State University Stafford Press Stern Corporation (A) Prof. James S. Reece, University of Michigan Stern Corporation (B) Prof. James S. Reece, University of Michigan SunAir Boat Builders, Inc. Profs. M. E. Bennett and James S. Reece, Harvard

Business School Supplement to Identify the Industries Prof. Charles M. Williams, Harvard Business School

Tru-Fit Parts, Inc. Prof. James S. Reece, University of Michigan Tokyo AFM Prof. Francois Brochet, Harvard Business School

UPC, Inc.

Waikerie Co-operative Producers, Ltd. Waltham Oil and Lube Center, Inc. Wareham SC Systems, Inc. Woodside Products Prof. James S. Reece, University of Michigan

Xytech, Inc.

Zumwald AG Profs. Kenneth A. Merchant, London School of Economics and Wim A. Van der Stede, University of Southern California

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9

Financial Accounting

1 Part

Financial Accounting

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Chapter1 The Nature and Purpose of Accounting

Chapter

Most of the world’s work is done through organizations—groups of people who work together to accomplish one or more objectives. In doing its work, an organization uses resources—labor, materials, various services, buildings, and equipment.These resources need to be financed, or paid for. To work effectively, the people in an organization need information about the amounts of these resources, the means of financing them, and the results achieved through using them. Parties outside the organization need similar infor- mation to make judgments about the organization. Accounting is a system that provides such information.

Organizations can be classified broadly as either for-profit or nonprofit. As these names suggest, a dominant purpose of organizations in the former category is to earn a profit, whereas organizations in the latter category have other objectives, such as governing, providing social services, and providing education. Accounting is basically similar in both types of organizations.

The Need for Information

In its details, information differs greatly among organizations of various types. But viewed broadly, the information needs of most organizations are similar. We shall out- line and illustrate these general information needs by referring to Varsity Motors, Inc., an automobile dealership.

Varsity Motors seeks to earn a profit by selling new and used automobiles and parts and accessories, and by providing repair service. It is an organization of 52 people headed by Pat Voss, its president. It owns a building that contains the showroom, ser- vice shop, a storeroom for parts and accessories, and office space. It also owns a num- ber of new and used automobiles, which it offers for sale; an inventory of spare parts, accessories, and supplies; and cash in the bank. These are examples of the resources the company needs to conduct its business.

Illustration 1–1 depicts the different types of information that might be useful to people interested in Varsity Motors. As shown in the illustration, information can be either quantitative or nonquantitative. Quantitative information is information that is expressed in numbers. Examples of nonquantitative information are visual impressions,

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Information

Nonquantitative information Quantitative information

Consists of

Accounting information

Nonaccounting information

Consists of

Operating information

Tax accounting

Financial accounting

Management accounting

Consists of

ILLUSTRATION 1–1 Types of Information

Chapter 1 The Nature and Purpose of Accounting 3

conversations, television programs, and newspaper stories. Accounting is primarily concerned with quantitative information.

Accounting is one of several types of quantitative information. Accounting infor- mation is distinguished from the other types in that it usually is expressed in monetary terms. Data on employees’ ages and years of experience are quantitative, but they are not usually considered to be accounting information. The line here is not sharply drawn, however; nonmonetary information is often included in the notes to accounting reports when it will help the reader understand the report. For example, an accounting sales re- port for Varsity Motors would show not only the monetary amount of sales revenue, but also the number of automobiles sold, which is nonmonetary information.

What information is needed about the amounts and financing of the resources used in Varsity Motors and the results achieved by the use of these resources? This infor- mation can be classified into four categories: (1) operating information, (2) financial accounting information, (3) management accounting information, and (4) tax account- ing information. Each is shown in the bottom section of Illustration 1–1.

A considerable amount of operating information is required to conduct an organiza- tion’s day-to-day activities. For example, Varsity Motors’ employees must be paid ex- actly the amounts owed them, and the government requires that records be maintained for each employee showing amounts earned and paid, as well as various deductions. The sales force needs to know what automobiles are available for sale and each one’s cost and selling price. When an automobile is sold, a record must be made of that fact. The person in the stockroom needs to know what parts and accessories are on hand; and if the inventory of a certain part becomes depleted, this fact needs to be known so that an additional quantity can be ordered. Amounts owed by the company’s customers need to be known; and if a customer does not pay a bill on time, this fact needs to be known so that appropriate action can be taken. The company needs to know the amounts it owes to others, when these amounts should be paid, and how much money it has in the bank.

Operating Information

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Operating information constitutes by far the largest quantity of accounting infor- mation. As suggested by the arrows at the bottom of Illustration 1–1, operating infor- mation provides much of the basic data for management accounting, financial accounting, and tax accounting.

Financial accounting information is intended both for managers and also for the use of parties external to the organization, including shareholders (and trustees in nonprofit organizations), banks and other creditors, government agencies, investment advisers, and the general public. Shareholders who have furnished capital to Varsity Motors want information on how well the company is doing. If they should decide to sell their shares, they need information that helps them judge how much their investment is worth. Prospective buyers of these shares need similar information. If the company wants to borrow money, the lender wants information that will show that the company is sound and that there is a high probability that the loan will be repaid.

Only in rare instances can outside parties insist that an organization furnish informa- tion tailor-made to their specifications. In most cases, they must accept the information that the organization chooses to supply. They could not conceivably understand this in- formation without knowing the ground rules that governed its preparation. Moreover, they cannot be expected to learn a new set of ground rules for each organization of in- terest to them, nor can they compare information about two organizations unless both sets of information are prepared according to common ground rules. These ground rules are the subject matter of financial accounting (also called financial reporting).

Varsity Motors’ president, vice president of sales, service manager, and other man- agers do not have the time to examine the details of the operating information. Instead, they rely on summaries of this information. They use these summaries, together with other information, to carry out their management responsibilities. The accounting in- formation specifically prepared to aid managers is called management accounting information. This information is used in three management functions: (1) planning, (2) implementation, and (3) control.

Planning Performed by managers at all levels, in all organizations, planning is the process of de- ciding what actions should be taken in the future. A plan may be made for any segment of the organization or for the entire organization. When Varsity Motors’ service man- ager decides the order in which automobiles will be repaired and which mechanic will work on each of them, the service manager is engaged in planning in the same sense as, but on a smaller scale than, the president when the latter decides to build a new showroom and service facility.

An important form of planning is budgeting. Budgeting is the process of planning the overall activities of the organization for a specified period of time, usually a year. A primary objective of budgeting is to coordinate the separate plans made for various seg- ments of the organization to ensure that these plans harmonize with one another. For example, Varsity’s sales plans and service department capacity plans must be consistent. Also, budgeting helps managers determine whether the coming year’s activities are likely to produce satisfactory results and, if not, what should be done. Even tiny organi- zations find budgeting useful; many persons prepare a budget for their household.

Planning involves making decisions. Decisions are arrived at by (1) recognizing that a problem or an opportunity exists, (2) specifying and ranking the criteria to be used to determine the best solution, (3) identifying alternative ways of addressing the problem or opportunity, (4) analyzing the consequences of each alternative, and (5) comparing

4 Part 1 Financial Accounting

Financial Accounting Information

Management Accounting Information

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Planning Implementation Control

Feedback

Appropriate action

Plan revision

ILLUSTRATION 1–2 Relationship of Management Functions

these consequences to each other and the decision criteria in order to decide which alternative is best. Accounting information is useful especially in the analysis step of the decision-making process.

Implementation Making plans does not itself ensure that managers will implement the plans. In the case of the annual budget, each manager must take actions to provide the human and other re- sources that will be needed to achieve the planned results. Each manager also must make more detailed implementation plans than are encompassed in the budget; specific actions to be taken on a week-to-week and even day-to-day basis must be planned in advance.

The implementation of these very specific plans requires supervision on the part of the manager. Although much of this activity is routine, the manager also must react to events that were not anticipated when the budget was prepared. Indeed, a key manager- ial responsibility is to change previous plans appropriately to adjust for new conditions. If an unexpected situation impacts more than one part of the organization, the managers affected must coordinate their responses, just as their original plans were coordinated.

Control In Varsity Motors most automobile sales are made by salespersons and most service work is done by mechanics. It is not the responsibility of Pat Voss and the other managers to do this work themselves. Rather, it is their responsibility to see that it is done, and done prop- erly, by the employees of the organization. The process they use to ensure that employees perform properly is called control. Accounting information is used in the control process as a means of communication, motivation, attention getting, and appraisal.

As a means of communication, accounting reports (especially budgets) can assist in informing employees about management’s plans and in general about the types of ac- tion management wishes the organization to take. As a means of motivation, account- ing reports can induce members of the organization to act in a way that is consistent with the organization’s overall goals and objectives. As a means of attention getting, accounting information signals that problems may exist that require investigation and possibly action; this process is called feedback. As a means of appraisal, accounting helps show how well managers of the organization have performed, particularly with respect to the budgeted performance of the departments for which they are responsible. This provides a basis for a salary increase, promotion, corrective action of various kinds, or (in extreme cases) dismissal.

The relationship among the management functions of planning, implementation, and control is shown in Illustration 1–2. Chapter 15 will further introduce management accounting and contrast it with financial reporting.

Varsity Motors must file tax returns with the taxing authorities. As we will see later, in the United States for all companies and increasingly around the world for stock- exchange-listed companies, tax accounting rules can differ from financial accounting rules. Varsity Motors therefore must keep separate tax accounting records for tax pur- poses in those areas where it has elected to use different accounting rules for tax accounting and financial accounting.

Chapter 1 The Nature and Purpose of Accounting 5

Tax Accounting Information

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Accounting is related to all of the activities described above, and in all of them the em- phasis is on using accounting information in the process of making decisions. Both managers within an organization and interested outside parties use accounting infor- mation in making decisions that affect the organization. Thus, of the several available definitions of accounting, the one developed by an American Accounting Association committee is perhaps the best because of its focus on accounting as an aid to decision making. This committee defined accounting as the process of identifying, measuring, and communicating economic information to permit informed judgments and deci- sions by users of the information.

The Profession of Accounting

In most organizations the accounting group is the largest staff unit, that is, the largest group other than the “line” activities of production and marketing. The accounting group consists essentially of two types of people: (1) bookkeepers and other data-entry employees who maintain the detailed operating records and (2) staff accountants who decide how items should be reported, prepare the reports, interpret these reports, prepare special analyses, design and operate the systems through which information flows, and ensure that the information is accurate.

All publicly owned companies and many other organizations have their accounting reports audited by an independent public accounting firm. These firms also perform other services for clients. Some of these firms are very large with tens of thousands of employees and hundreds of offices around the world, with annual revenues totaling bil- lions of dollars. They are far larger than any law firm, medical group practice, or other professional firm. At the other extreme, thousands of independent public accountants practice as individuals.

Most independent public accountants are licensed by their state and are designated as Certified Public Accountants (CPAs). The professional organization of CPAs is the American Institute of Certified Public Accountants (AICPA). Many accountants em- ployed by industry belong to the Institute of Management Accountants (IMA). The IMA administers the Certified Management Accountant (CMA) program. Some accountants in industry also are Certified Internal Auditors (CIA). Many college and university ac- counting faculty members belong to the American Accounting Association (AAA).

CPAs that audit public companies are subject to the oversight of the Securities and Ex- change Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB).The SEC was created by the SecuritiesAct of 1934. Its mission is to protect in- vestors; maintain fair, orderly, and efficient securities markets; and facilitate capital for- mation. PCAOB is a five-person board appointed by the SEC to oversee the auditors of public companies in order to protect the interests of investor and further the public inter- est in the preparation of informative, fair, and independent audit reports. PCAOB has the power to set auditing standards and discipline auditors who fail to follow their standards.

Although accounting is a staff function performed by accounting professionals within an organization, the ultimate responsibility for the generation of accounting information—whether financial or managerial—rests with management. Manage- ment’s responsibility for accounting is the reason that one of the top officers of many businesses is the controller. Within the division of top management’s duties, the controller is the person responsible for satisfying other managers’ needs for manage- ment accounting information and for complying with the requirements of financial re- porting and tax accounting. To these ends the controller’s office employs accounting

6 Part 1 Financial Accounting

Definition of Accounting

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professionals in management, financial, and tax accounting. These accountants design, install, and operate the information systems required to generate financial and manage- rial reports and tax returns.

Our Approach to Accounting

Accounting can be approached from either of two directions: from the viewpoint of the accountant or from the viewpoint of the user of accounting information. The former approach emphasizes the concepts and techniques that are involved in collecting, summarizing, and reporting accounting information; the latter emphasizes what the user needs to know about accounting. We focus on the latter approach. The difference between these two approaches is only one of emphasis. Accountants need to know how informa- tion is to be used because they should collect and report information in a form that is most helpful to those who use it. Users need to know what the accountant does; otherwise, they are unlikely to understand the real meaning of the information that is provided.

The approach to accounting taken here is something like that used by an airplane pilot in learning to use flight instruments. The pilot needs to know the meaning of the message conveyed by each of the instruments—for example, that a needle on a certain gauge going above a given point probably means that a certain component is not func- tioning properly. The word probably is used because, for one reason or another, an in- strument may not always give the reading that it is supposed to give. As the user of the instrument, the pilot must realize this and also must understand something of the like- lihood of, and the reason for, these abnormalities. On the other hand, the pilot does not need to know how to design, construct, calibrate, or repair airplane instruments. Specialists are available for these important functions.

Similarly, those who use accounting information must understand what a given ac- counting figure probably means, what its limitations are, and the circumstances in which it may mean something different from the apparent “signal” that it gives. They do not, however, need to know how to design, construct, operate, or check on the accuracy of an accounting system. They can rely on accountants for these important functions.

Readers of this book have already been exposed to a great deal of accounting informa- tion. Cash register or credit card receipts, checks written or (preferably) received, bank statements, merchants’ and utilities’ bills—all these are parts of accounting systems. Newspapers report about the profit (or losses) of a company or an industry, about div- idends, or about money being spent to build new buildings; this information comes from accounting systems. Even before beginning a formal study of the subject, there- fore, the reader has accumulated a number of ideas about accounting.

The trouble is that some of these ideas probably are incorrect. For example, it seems intuitively reasonable that accounting should report what a business is “worth.” But ac- counting does not, in fact, do this, nor does it even attempt to do so. As another example, there is a general notion that the word asset refers to valuable things, good things to have. But the skills and abilities of an organization’s employees are not assets in the account- ing sense, even though they may be a key determinant of the organization’s success.

Thus, as with many other subjects, students of accounting must be wary of precon- ceptions. They will discover that accounting as it really is may be different in impor- tant respects from what they had surmised it to be. They will find that there are sound reasons for these differences, and it is important that they understand these reasons. To achieve such an understanding, users need to know enough about accounting concepts

Chapter 1 The Nature and Purpose of Accounting 7

Preconceptions about Accounting

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and techniques to understand the nature and limitations of the accounting information. They do not, however, need the detailed knowledge that the accountant must have.

We described above four types of accounting information: operating information, financial accounting information, management accounting information, and tax ac- counting information. Since our viewpoint is that of the current and potential users (as opposed to preparers) of accounting information, we shall not describe operating and tax accounting information in any great detail. The book is therefore divided into two approximately equal parts, the first on financial accounting and the second on manage- ment accounting.

The discussion of financial accounting comes first because the structure of financial accounting underlies all accounting. This structure consists of a few basic principles and concepts, a set of relationships among the elements comprising the accounting system, a terminology, and a number of rules and guidelines for the application of the principles and concepts to specific situations. We shall describe the financial account- ing structure in a general way in Chapters 2, 3, and 4; and we shall then go over the same ground again in more detail in Chapters 5 through 14.

The second half of the book discusses the nature and use of management account- ing information. The management of an organization can establish whatever ground rules it wishes for the accounting information collected for its own use. Thus, although the principles of financial accounting are applicable to all organizations, the rules of management accounting are tailor-made to meet the needs of the management of a spe- cific organization.

Nevertheless, a similarity exists in both financial accounting practices and manage- ment accounting practices in most organizations. There are obvious economies in using financial accounting information wherever possible for management accounting pur- poses rather than devising two completely different systems for the two purposes.

The Financial Accounting Framework

Suppose you were asked to keep track of what was going on in an organization in order to provide useful information for management. One way of carrying out this assign- ment would be to write down a narrative of important events in a log similar to that kept by the captain of a ship.

After some experience with your log, you would gradually develop a set of rules to guide your efforts. For example, since it would be impossible to write down every ac- tion of every person in the organization, you would develop rules to guide you in choos- ing between those events that were important enough to record and those that should be omitted. You also would find that your log would be more valuable if you standardized certain terms. People who studied it would then have a clearer understanding of what you meant. Furthermore, if you standardized terms and their definitions, you could turn the job of keeping the log over to someone else and have some assurance that this person’s report of events would convey the same information that you would have con- veyed had you been keeping the log yourself.

In devising these rules of keeping a log, you would necessarily be somewhat arbi- trary. There might be several ways of describing a certain event, all equally good. But in order to have a common basis of understanding, you would select just one of these for use in your recordkeeping system.

8 Part 1 Financial Accounting

Plan of the Book

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All these considerations were actually involved in the development of the accounting process. Accounting has evolved over a period of many centuries, and during this time certain terminology, rules, and conventions have come to be accepted as useful. If you are to understand accounting reports—the end products of an accounting system—you must be familiar with the rules and conventions lying behind these reports.

Accounting is aptly called the language of business. The task of learning accounting, very similar to the task of learning a new language, is complicated by the fact that many words used in accounting mean almost but not quite the same thing as the iden- tical words mean in everyday nonaccounting usage. Accounting is not exactly a foreign language; the problem of learning it is more like that of an American learning to speak English as it is spoken in Great Britain. For example, the grain that Americans call wheat is called corn by the British; and the British use the word maize for what Amer- icans call corn. Unless they are careful, Americans will fail to recognize that some words are used in Great Britain in a different sense from that used in America.

Similarly, some words are used in a different sense in accounting from their collo- quial meanings. For example, accountants often use the term net worth to describe an amount that appears on accounting reports. The commonsense interpretation is that this amount refers to what something is worth, what its value is. However, such an in- terpretation is incorrect, and misunderstandings can arise if the user of an accounting statement does not understand what accountants mean by net worth. (The correct meaning, somewhat technical in nature, will be given in Chapter 2.)

Accounting also resembles a language in that some of its rules are definite, whereas others are not. There are differences of opinion among accountants about how a given event should be reported, just as grammarians differ on many matters of sentence struc- ture, punctuation, and word choice. Nevertheless, just as many practices are clearly poor English, many practices are definitely poor accounting. In the following chapters we describe the elements of good accounting and indicate areas in which there are differ- ences of opinion about what constitutes good practice.

Finally, languages evolve in response to the changing needs of society, and so does accounting. The rules described here are currently in use, but some of them will probably be modified to meet the changing needs of organizations and their constituencies.

The communication and understanding of accounting information may be further com- plicated by the use of different financial statement presentation formats. As far as finan- cial reporting data are concerned, the statement user problems caused by presentational difference has been mitigated by the development and adoption of eXtensible Business Reporting Language (XBRL). XBRL is a digital business language designed to help companies communicate financial statement data internally and externally. XBRL codes every element of a set of financial statements using a simple, universal, plain- language tag. The tag allows companies to consistently communicate financial state- ment data originally prepared in many different forms, and it allows statement users to extract information rapidly and reliably. XBRL does not adjust data for differences in accounting principles. Its principal purpose is to adjust presentational differences. The SEC permits companies to file financial statements using XBRL.

The rules and basic concepts of accounting are commonly referred to as principles. The word principle is here used in the sense of a general law or rule that is to be used as a

Chapter 1 The Nature and Purpose of Accounting 9

Nature of Principles

Accounting as a Language

Different Formats

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guide to action. This means that accounting principles do not prescribe exactly how each event occurring in an organization should be recorded. Consequently, there are many matters in accounting practice that differ from one organization to another. Most of these differences are inevitable because a single detailed set of rules could not conceiv- ably apply to every organization. In part, the differences reflect that, within “generally accepted accounting principles,” management has some latitude in which to express its own ideas about the best way of recording and reporting a specific event.

Readers should realize, therefore, that they cannot know the precise meaning of a number of the items in an accounting report unless they know which of several equally acceptable possibilities has been selected by the person who prepared the report. The meaning intended in a specific situation requires knowledge of the context.

Accounting principles are established by humans. Unlike the principles of physics, chemistry, and the other natural sciences, accounting principles were not deduced from basic axioms, nor can they be verified by observation and experiment. Instead, they have evolved. This evolutionary process is going on constantly; accounting principles are not eternal truths.

The general acceptance of an accounting principle usually depends on how well it meets three criteria: relevance, objectivity, and feasibility. A principle has relevance to the extent that it results in information that is meaningful and useful to those who need to know something about a certain organization. A principle has objectivity to the extent that the resulting information is not influenced by the personal bias or judgment of those who furnish it. Objectivity connotes reliability, trustworthiness. It also con- notes verifiability, which means that there is some way of finding out whether the in- formation is correct. A principle has feasibility to the extent that it can be implemented without undue complexity or cost.

These criteria often conflict with one another. In some cases the most relevant solu- tion may be the least objective and the least feasible. Often, in this situation a less rel- evant but more objective and more feasible solution may be selected.

The development of a new product may have a significant effect on a company’s real value— “miracle” drugs and personal computer chips being spectacular examples. Information about the value of new products is most useful to the investor; it is indeed relevant. But the best esti- mate of the value of a new product is likely to be that made by management, and this is a highly subjective estimate. Accounting therefore does not attempt to record such values. Accounting sacrifices relevance in the interests of objectivity.

The measure of the value of the owners’ interest or equity in a biotechnology firm such as Genentech, Inc., obtained from the stock market quotations (i.e., multiplying the price per share of stock times the number of shares outstanding) is a much more accurate reflec- tion of the true value than the amount listed as owners’ equity that appears in the corpora- tion’s financial statements. The marketplace gave this value as $26.4 billion; the accounting records gave it as $6.8 billion. The difference does not indicate an error in the accounting records. It merely illustrates the fact that accounting does not attempt to report firm mar- ket values.

In developing new principles, the essential problem is to strike the right balance be- tween relevance on the one hand and objectivity and feasibility on the other. Failure to appreciate this problem often leads to unwarranted criticism of accounting principles. It is easy to criticize accounting on the grounds that accounting information is not as relevant as it might be; but the critic often overlooks the fact that proposals to increase

10 Part 1 Financial Accounting

Example

Criteria

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relevance almost always involve a sacrifice of objectivity and feasibility. On balance, such a sacrifice may not be worthwhile.

The foundation of accounting consists of a set of generally accepted accounting principles, or GAAP for short. Currently, these principles are established by the Financial Accounting Standards Board (FASB). Current information about the FASB’s activities can be obtained by accessing the FASB’s website (http://www.fasb.org). The FASB consists of seven members with diverse accounting backgrounds who work full time on developing new or modified principles. The board is supported by a profes- sional staff that does research and prepares a discussion memorandum on each prob- lem that the board addresses. The board acts only after interested parties have been given an opportunity to suggest solutions to problems and to comment on proposed pronouncements. The FASB is a nongovernmental organization.1

It is important to note that the acronym “GAAP” when used in practice (and this text) refers to accounting standards applicable in the United States, where the accept- ability of the FASB pronouncements rests on their general acceptability. In most other countries, the authority of accounting standards is based on laws enacted by the national governing bodies.

Each of the Standards of the FASB deals with a specific topic.2 Collectively, they do not cover all the important topics in accounting. If an authoritative pronouncement has not been made on a given topic, accountants can treat that topic in the way they believe most fairly presents the situation.

Companies are not legally required to adhere to GAAP as established by the FASB. As a practical matter, however, there are strong pressures for them to do so. The accoun- ting reports of most companies are audited by certified public accountants who are members of the American Institute of Certified Public Accountants (AICPA). Although the AICPA (http://www.aicpa.org) does not require its members to force companies to adhere to FASB standards, it does require that if the CPA finds that the company has not followed FASB standards, the difference must be called to public attention. Since companies usually do not like to go counter to the FASB—even though they may feel strongly that the FASB principle is not appropriate in their particular situation—they almost always conform to the FASB pronouncements.

The FASB has established a 14-member group called the Emerging Issues Task Force (EITF). As its name suggests, the EITF publishes guides, referred to as consen- suses, on accounting issues that need to be resolved in a timely manner. Typically, these consensuses are adopted where appropriate by corporations.

Another source of pressure to conform to GAAP is the U.S. Securities and Exchange Commission (SEC). This agency, which exists to protect the interests of in- vestors, has jurisdiction over any corporation with a class of securities listed on a national stock exchange or, if traded over the counter, with 500 or more shareholders and $10 million or more total assets. The SEC requires these companies to file accounting reports prepared in accordance with GAAP. In its Regulation S–X, its

Chapter 1 The Nature and Purpose of Accounting 11

Source of Accounting Principles

1 Financial accounting and reporting standards for state and local governments and government- owned entities, such as colleges and universities, are set by the Government Accounting Standards Board. 2 Authoritative pronouncements consist of Statements and interpretations of the Financial Accounting Standards Board and certain pronouncements of predecessor bodies established by the AICPA. We shall refer to these earlier pronouncements as Accounting Research Bulletins and Opinions.

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Financial Reporting Series Releases, and its Staff Accounting Bulletins, the SEC spells out acceptable accounting principles in more detail than, but generally consis- tent with, the pronouncements of the FASB. Legally, the Securities Exchange Act of 1934 gave the SEC the authority to promulgate GAAP; but over the years, for the most part the SEC has relied on the FASB and its predecessors for carrying out the standard-setting process.

In its past, the AICPA has issued pronouncements called Statements of Position (SOP) for accounting in a number of industries, including finance companies, govern- ment contractors, and real estate investment trusts. Although these pronouncements do not have the force of FASB Standards, organizations have followed them. Recently, the FASB has made it clear that AICPA pronouncements are not GAAP. It has asked the AICPA to cease issuing these pronouncements.

Various regulatory bodies also prescribe accounting rules for the companies they regulate. Among those subjected to such rules are banks and other financial institu- tions, insurance companies, and public utilities. These rules are not necessarily consis- tent with the principles of the FASB, although there has been a tendency in recent years for regulatory agencies to change their accounting rules so that they do conform.

The authority of the FASB and the other agencies discussed so for exists, of course, only in the United States of America. Accounting principles in other countries differ in some respects from American GAAP, but in general there is a basic similarity through- out the world. There is a major effort to codify a set of accounting principles that would apply internationally, and over 40 statements known as International Accounting Stan- dards (IAS) have been published by the International Accounting Standards Commit- tee (IASC)—now reorganized as the International Accounting Standards Board (IASB)—located in London, England. While retaining the name IAS for standards is- sued by its predecessor, standards issued by the IASB (http://www.iasb.org) are known as International Financial Reporting Standards (IFRS).

The IASB does not have the power to enforce its pronouncements. Their adoption by companies and accounting standard setters is voluntary. Neverthless, impressed by the potential value of a global set of accounting principles, the FASB and the IASB have initiated a joint-program to converge GAAP and IFRS. This effort is supported by the SEC, which has proffered a timetable for potential mandatory adoption of IFRS for SEC registered companies beginning in 2014. Currently, over 100 countries have either adopted IFRS in whole or part or are considering IFRS adoption.

Readers of this text can assume, unless noted otherwise, the accounting for a par- ticular transaction or event described in the text is essentially this same under both GAAP and IFRS.

A complete compilation of GAAP—FASB Accounting Standards Codification™— can be found on the FASB website. It is the single official source of authoritative, non- governmental GAAP issued by the FASB. Guidance issued by the SEC is also incor- porated in the site’s materials.

A major controversy in accounting is the extent to which accounting standards should be expressed in the form of broad principles versus detailed rules. IFRS tend to be stated in the form of broad principles. In contrast, much of GAAP tends to be stated in the form of bright-line rules. For example, as you will learn later, under GAAP if a term of a lease is equal to 75 percent of the economic life of the leased property, the lease will be accounted for as a capital lease.3 On the other hand, if the lease term is

12 Part 1 Financial Accounting

3 “Accounting for Leases,” FASB Statement No. 13.

Principles Vs. Rules

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equal to 74 or less percent of the leased property’s economic life, the lease will be ac- counted for as an operating lease. IFRS takes a different approach. It makes the dis- tinction between a capital and an operating lease based on which party—the lessor or the lessee—substantially bears the risks and rewards of owership.4

The distinction between the principle-based and rule-based accounting standards is important. Under a principle-based standards model, the accounting for transactions is more likely to reflect the substance of the transaction. Under a rule-based standards model, the accounting for a transaction is more likely to reflect the form of the trans- action.

As GAAP and IFRS converge, it is anticipated that GAAP will become more prin- ciple based.

Financial Statements

The end product of the financial accounting process is a set of reports that are called financial statements. Generally accepted accounting principles require that three such reports be prepared: (1) a statement of financial position, which is generally referred to as a balance sheet; (2) an income statement; and (3) a statement of cash flows.5 As we examine the details of the financial accounting process, it is important to keep in mind the objective toward which the process is aimed: the preparation of these three finan- cial statements.

Most reports, in any field, can be classified into one of two categories: (1) stock, or status, reports and (2) flow reports. The amount of water in a reservoir at a given mo- ment of time is a measure of stock, whereas the amount of water that moves through the reservoir in a day is a measure of flow. Reports of stocks are always as of a specified instant in time; reports of flow always cover a specified period of time. Reports of stocks are like snapshots; reports of flows are more like motion pictures. One of the accounting reports, the balance sheet, is a report of stocks. It shows information about the resources and obligations of an organization at a specified moment of time. The other two reports, the income statement and the cash flow statement, are reports of flows. They report activities of the organization for a period of time, such as a quarter or a year.

Companies listed on stock exchanges publish annual and quarterly financial reports. These reports can be obtained either directly from the company or from the Securities and Exchange Commission (SEC). Typically, these reports are also available directly from companies through the Internet.

For example, the Coca-Cola Company’s home page (http://www.cocacola.com) contains information about Coca-Cola’s products, history, and financial performance and position. (You might want to access this site to get a sense of a complete set of financial statements. After completing the financial reporting section of this book, you should be able to read and interpret these reports with confidence that you understand them.)6

Chapter 1 The Nature and Purpose of Accounting 13

4 “Leases,” IAS No. 17. 5 Company financial reports also may include other financial displays, such as changes in owners’ equity. This display will be explained in Chapter 10. 6 The home pages of other well-known companies you might want to access are General Electric (http://www.ge.com), Microsoft (http://www.microsoft.com), General Motors (http://www.gm.com), Walmart (http://www.walmart.com), and IBM (http://www.ibm.com).

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Listed company financial reports are also available electronically through the Secu- rities and Exchange Commission’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system. All companies registered with the SEC use EDGAR to transmit their required filings to the SEC (http://www.sec.gov).

In this chapter we will give a brief introduction to the balance sheet and income state- ment. The definitions provided should be considered as only working definitions for the purposes of this introductory chapter. The next nine chapters describe more precisely and in greater detail the balance sheet and income statement. We shall defer a descrip- tion of the statement of cash flows until Chapter 11. Because this report is derived from data originally collected for the other two reports, it is inappropriate to defer the discus- sion of the cash flow statement until after the balance sheet and income statement have been thoroughly explained.

Illustration 1–3 presents the December 31, 2010, balance sheet of the Holden Company. (Do not worry if you do not know what all of the account titles mean. They will be dis- cussed in later chapters.)

The Holden balance sheet is a snapshot of the financial position of the company. It has two sides: the left, Assets, and the right, Liabilities and Owners’ Equity. We will give working descriptions of each side. (More precise descriptions will be provided in Chapter 2.)

Assets An entity needs cash, equipment, and other resources in order to operate. These re- sources are its assets. Assets are valuable resources owned by the entity. The left side of the balance sheet shows the amounts of these assets as of a certain date. For example, the amount of Cash that Holden Company owned on December 31, 2010, was $1,449,000.

Assets are resources owned by Holden Company. Its employees, although perhaps its most valuable resource, are not assets in accounting, because the company does not own its employees.

Liabilities and Owners’ Equity The right side of the balance sheet shows the sources that provided the entity’s assets. As the heading indicates, there are two general types of sources, Liabilities and Own- ers’ Equity.

Liabilities are obligations of the entity to outside non owner parties who have fur- nished resources. These parties are generally called creditors because they have ex- tended credit to the entity. As Illustration 1–3 indicates, suppliers have extended credit in the amount of $5,602,000, as indicated by Accounts Payable.

Creditors have a claim against the assets in the amount shown as the liability. For example, a bank has loaned $1,000,000 to Holden Company, and therefore has a claim of this amount, as indicated by Bank Loan Payable.

Because an entity will use its assets to pay off its claims, those claims are against assets. They are claims against all the assets, not any particular assets.

The other source of the funds that an entity uses to acquire its assets is called Owners’ Equity. There are two sources of equity funds: (1) the amount provided di- rectly by equity investors, which is called Total Paid-In Capital; and (2) the amount retained from profits (or earnings), which is called Retained Earnings.

Creditors can sue the entity if the amounts due them are not paid. Equity investors have only a residual claim; that is, if the entity is dissolved, they get whatever is left

14 Part 1 Financial Accounting

The Balance Sheet

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Chapter 1 The Nature and Purpose of Accounting 15

after the liabilities have been paid, which may be nothing. Liabilities therefore are a stronger claim against the assets than equity.

We can describe the right-hand side of the balance sheet in two somewhat different ways: (1) as the amount of funds supplied by creditors and equity investors and (2) as the claims of these parties against the assets. Use whichever way is more meaningful to you.

Dual-Aspect Concept The assets that remain after the liabilities are taken into account will be claimed by the equity investors. If an entity has assets that total $10,000 and liabilities that total $4,000, its owners’ equity must be $6,000.

Because (1) any assets not claimed by creditors will be claimed by equity investors and (2) the total amount of claims (liabilities � owners’ equity) cannot exceed what there is to be claimed, it follows that the total amount of assets will always be equal to the total amount of liabilities plus owners’ equity.

The fact that total assets must equal, or balance, total liabilities plus owners’ equity is why the statement is called a balance sheet. This equality tells nothing about the entity’s financial condition; it always exists unless the accountant has made a mistake.

ILLUSTRATION 1–3 The Balance Sheet

HOLDEN COMPANY Balance Sheet

As of December 31, 2010 (000 omitted)

Assets Liabilities and Owners’ Equity

Current assets: Current liabilities:

Cash $ 1,449 Accounts payable $ 5,602

Marketable securities 246 Bank loan payable 1,000

Accounts receivable, net 9,944 Accrued liabilities 876

Inventories 10,623 Estimated tax liability 1,541

Prepaid expenses 389 Current portion of long-term debt 500_______ _______ Total current assets 22,651 Total current liabilities 9,519_______ _______

Noncurrent assets: Noncurrent liabilities:

Property, plant, equipment Long-term debt, less at cost 26,946 current portion 2,000

Less: Accumulated Deferred income taxes 824_______ depreciation 13,534 Total liabilities 12,343_______ _______

Property, plant, equipment—net 13,412 Owners’ equity:

Investments 1,110 Common stock 1,000

Patents and trademarks 403 Additional paid-in capital 11,256_______ Goodwill 663 Total paid-in capital 12,256_______

Retained earnings 13,640_______ Total owners’ equity 25,896

Total assets $38,239 Total liabilities and owners’ equity $38,239_______ ______________ _______

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This fact leads to what is called the dual-aspect concept. The two aspects that this concept refers to are (1) assets and (2) liabilities plus owners’ equity. The concept states that these two aspects are always equal. (This equality exists even if liabilities are greater than assets. For example, if assets in an unprofitable business were $100,000 and liabilities were $120,000, owners’ equity would be a negative amount of $20,000.)

The dual-aspect concept is 1 of 11 basic accounting concepts we shall describe in Chapters 2 and 3. The dual-aspect concept can be written as an equation:

Assets � Liabilities � Owners’ equity

This equation is fundamental. It governs all accounting. We can write a similar equa- tion in a form that emphasizes the fact that owners’ equity is a residual interest:

Assets � Liabilities � Owners’ equity

For example, if the assets of Violet Company total $19,000 and its liabilities total $3,000, its owners’ equity must total $16,000.

The term net assets is sometimes used instead of owners’ equity. It refers to the fact that owners’ equity is always the difference between assets and liabilities.

Every accounting transaction can be described in terms of its effect on this funda- mental accounting equation. For example, the Violet Company spends $15,000 cash for a new car. The company’s accountant would record a reduction in the asset Cash (�$15,000) and an increase in the asset Cars (�$15,000). After recording this trans- action, the fundamental equation is still in balance. Similarly, if the company had bought the car on credit rather than for cash, the equation would be in balance because the liability Accounts Payable would have increased (�$15,000) and the asset Cars would have increased by a like amount (�$15,000).

The amounts of an entity’s assets and liabilities will change from day to day. Any balance sheet reports the amounts of assets, liabilities, and owners’ equity at one point in time. The balance sheet therefore must be dated. (From here on we shall sometimes use the term 20x1 to refer to the first year, 20x2 for the next year, and so on. Thus, a bal- ance sheet as of December 31 of the first year is dated “as of December 31, 20x1.” It refers to the close of business on that day.)

Returning to Illustration 1–3, if the Holden Company prepared a balance sheet as of the beginning of business the next day, January 1, 2011, it would be the same as the one in Illustration 1–3 because nothing changes between the close of business on one day and the beginning of business on the next day.

Illustration 1–4 shows the Holden Company’s 2010 income statement. The amount added to Retained Earnings as a result of profitable operations during a period is the income of the period. An income statement explains how this income was earned. There is no standard format for an income statement. Illustration 1–4 shows one common format. (The income statement is discussed in greater detail in Chapter 3.)

The basic income statement equation is

Revenues � Expenses � Net income

The first item on this income statement is Sales Revenue, which is the amount of products (i.e., goods and services) sold or delivered to customers during the period.

The item on the second line is labeled Cost of Sales. It reports the cost of the goods or services whose revenue is reported on the first line.

The difference between sales and cost of sales is called gross margin. Thus,

Gross margin � Sales revenue � Cost of sales

16 Part 1 Financial Accounting

The Income Statement

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Chapter 1 The Nature and Purpose of Accounting 17

Operating expenses are subtracted from gross margin, leaving income before taxes. These expenses include costs related to the current period and costs that do not benefit future periods.

The next item in Illustration 1–4, provision for income taxes, is shown separately because it is an especially important expense.

The final item (the bottom line) on an income statement is called net income (or net loss, if expenses were larger than revenues).

Illustration 1–5 is a “package” of financial reports for the Holden Company consisting of two balance sheets and an income statement. (A complete package of financial re- ports also would include a cash flow statement.) The illustration shows how the balance sheet, statement of retained earnings, and income statement relate to each other through the Retained Earnings account.

An income statement is a summary of certain changes in Retained Earnings that have taken place during an accounting period. In other words, an income statement reports cer- tain changes in Retained Earnings that have taken place between two balance sheet dates.

Thus, a useful accounting “report package” consists of a balance sheet at the begin- ning of the accounting period, an income statement for the period, and a balance sheet at the end of the period.

The statement of retained earnings at the bottom of Illustration 1–5 shows that the Retained Earnings on December 31, 2009, was $13,640,000. During 2010 profitable operations resulted in net income of $6,122,000, which increased Retained Earnings by this amount. (Net income is the bottom line on the income statement.) Retained Earnings was decreased by $4,390,000, representing a distribution to the shareholders in the form of dividends. As a result, the total Retained Earnings on December 31, 2010, was $15,372,000 ($13,640,000 � $6,122,000 � $4,390,000).

Dividends are deducted from Retained Earnings because dividends are a distribu- tion of earnings to owners. Dividends are not an expense.

We indicated earlier that financial accounting statements, while also of use to manage- ment, are intended primarily to provide relevant information to parties external to the business. The Financial Accounting Standards Board (FASB) issued a formal state- ment of financial reporting objectives. The entire statement is too lengthy to describe here in detail. We will simply highlight the key objectives. (The numbering is ours, not that of the FASB.)

ILLUSTRATION 1–4 The Income Statement

HOLDEN COMPANY Income Statement For the Year 2010

(000 omitted)

Sales revenue $75,478

Less cost of sales 52,227________ Gross margin 23,251

Less operating expenses 10,785________ Income before taxes 12,466

Provision for income taxes 6,344________ Net income $ 6,122________________

“Package” of Financial Reports

Financial Statement Objectives

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Financial reporting should provide information that

1. Is useful to present and potential investors and creditors in making rational invest- ment and credit decisions.

2. Is comprehensible to those who have a reasonable understanding of business and eco- nomic activities and are willing to study the information with reasonable diligence.

3. Is about the economic resources of an enterprise, the claims to those resources, and the effects of transactions and events that change resources and claims to those resources.

4. Is about an enterprise’s financial performance during a period. 5. Helps users assess the amounts, timing, and uncertainty of prospective cash receipts

from dividends or interest and the proceeds from the sale or redemption of securi- ties or loans.

18 Part 1 Financial Accounting

1ILLUSTRATION 1–5 A “Package” of Accounting Reports

HOLDEN COMPANY (000 OMITTED)

Condensed Balance Sheet Condensed Balance Sheet As of December 31, 2009 As of December 31, 2010

Assets Assets

Current assets $22,651 Current assets $24,062

Buildings and equipment 13,412 Buildings and equipment 14,981

Other assets 2,176 Other assets 3,207________ ________ Total assets $38,239 Total assets $42,250________ ________________ ________

Liabilities and Owners’ Equity Liabilities and Owners’ Equity

Liabilities $12,343 Liabilities $14,622

Owners’ equity: Owners’ equity:

Paid-in capital 12,256 Paid-in capital 12,256

Retained earnings 13,640 Retained earnings 15,372________ ________ Total liabilities and owners’ equity $38,239 Total liabilities and owners’ equity $42,250________ ________________ ________

Income Statement For the Year 2010

Sales revenue $75,478

Less cost of sales 52,127_______ Gross margin 23,351

Less operating expenses 10,885_______ Income before taxes 12,466

Provision for income taxes 6,344_______ Net income, 2010 $ 6,122______________

Statement of Retained Earnings

Retained earnings, 12/31/09 $13,640

Add net income 6,122________ 19,762

Less dividends 4,390________ Retained earnings, 12/31/10 $15,372________________

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Chapter 1 The Nature and Purpose of Accounting 19

Objectives 1 and 2 apply to all financial accounting information. Note that the in- tended users are expected to have attained a reasonable level of sophistication in using the statements; the statements are not prepared for uninformed persons. Objective 3 is related to the balance sheet, objective 4 to the income statement, and objective 5 to the cash flow statement. As the five objectives collectively suggest, financial statements provide information about the past to aid users in making predictions and decisions related to the future financial status and flows of the business.

In July 2002 the U.S. president signed into law the Sarbanes-Oxley Act. It requires chief executives and chief financial officers of public companies to certify that their company’s financial statements filed with the SEC are materially accurate and com- plete, and that in all material respects they present fairly the financial condition and results of operations of the issuer. These certifications subject the signers to potential civil and criminal liability for false certifications.

The Internal Revenue Service (IRS) specifies the ways in which taxable income is calculated for the purpose of assessing income taxes. Because the tax laws’ purposes differ from the objectives of financial reporting, the IRS accounting regulations differ in some respects from GAAP. These differences mean that the amount of pretax in- come or loss shown on the taxpayer’s income statement prepared according to GAAP will probably not be equal to the taxable income or loss shown on the taxpayer’s in- come tax return.7 How GAAP handles this difference will be covered in Chapter 10.

Thus, in the United States, financial accounting, management accounting, and in- come tax accounting are essentially separate processes. GAAP provides the principles for financial accounting; top management for management accounting; and the IRS and Congress for income tax accounting. The underlying operating information that is the basic data for all three processes is the same. The pieces or building blocks of op- erating information simply are put together in different ways for these three different processes. Though differences among the three processes do exist, in practice the sim- ilarities are greater than the differences.

An organization has four types of accounting information: (1) operating information, which has to do with the details of operations; (2) management accounting information, which is used internally for planning, implementation, and control; (3) financial accounting informa- tion, which is used both by management and by external parties; and (4) tax accounting in- formation, which is used to file tax returns with taxing authorities.

Financial accounting is governed by ground rules that in America are referred to as gen- erally accepted accounting principles. Outside the United States, there rules are increasingly most likely to be IFRS, rather than local standards. In either case, these ground rules may be different from what the reader believes them to be, based on previous exposure to account- ing information. There rules attempt to strike a balance between the criterion of relevance on the one hand and the criteria of objectivity and feasibility on the other.

The end products of the financial accounting process are three financial statements: the balance sheet, the income statement, and the cash flow statement. The balance sheet is a

Summary

Sarbanes-Oxley Act

Income Tax Reporting

7 In contrast to the United States, the governments of many countries require a company’s financial accounting and tax accounting to be identical. This is changing. In many countries public companies listed on stock exchanges and, in some cases, unlisted companies are now being allowed or required to use IASB standards in reports to stockholders that differ from the local tax accounting rules.

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20 Part 1 Financial Accounting

report of status or stocks as of a moment of time, whereas the other two statements sum- marize flows over a period of time.

In the United States, calculating taxable income for income tax purposes differs from the process of calculating income for the financial accounting income statement.

The basic accounting equation is

Assets � Liabilities � Owners’ equity

Problems Problem 1–1.

As of December 31, Charles Company had $12,000 in cash, held $95,000 of inventory, and owned other items that originally cost $13,000. Charles Company also had bor- rowed $40,000 from First City Bank. Prepare a balance sheet for Charles Company as of December 31. Be sure to label each item and each column with appropriate terms.

Problem 1–2. Selected balance sheet items are shown for the Microtech Company. Compute the missing amounts for each of the four years. What basic accounting equation did you apply in mak- ing your calculations?

Year 1 Year 2 Year 3 Year 4

Current assets $113,624 $ ? $ 85,124 $ ? Noncurrent assets ? 198,014 162,011 151,021_________ _________ _________ _________ Total assets $524,600 $ ? $ ? $220,111_________ _________ _________ __________________ _________ _________ _________ Current liabilities $ 56,142 $ 40,220 $ ? $ ? Noncurrent liabilities ? ? 60,100 30,222 Paid-in capital 214,155 173,295 170,000 170,000 Retained earnings 13,785 (3,644) 1,452 2,350_________ _________ _________ _________ Total liabilities and

owners’ equity $524,600 $288,456 $ ? $220,111_________ _________ _________ __________________ _________ _________ _________

Problem 1–3. Selected income statement items are shown for Astrotech Company. Compute the missing amounts for each of the four years. What basic accounting equation did you apply in mak- ing your calculations?

(Hint: To estimate the Year 4 missing numbers, compute the typical percentage each ex- pense item is of sales for Years 1 to 3 and apply the percentage figure for each expense item to Year 4’s sales.)

Year 1 Year 2 Year 3 Year 4

Sales $12,011 $ ? $11,545 $10,000 Cost of goods sold 3,011 2,992 ? ?________ ________ ________ ________ Gross margin ? 8,976 8,659 ? Other expenses 6,201 6,429 ? ?________ ________ ________ ________ Profit before taxes 2,799 ? 2,363 ? Tax expense ? 1,019 945 ?________ ________ ________ ________ Net income $ 1,679 $1,528 $ 1,418 ?________ ________ ________ ________________ ________ ________ ________

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Chapter 1 The Nature and Purpose of Accounting 21

Problem 1–4. An analysis of the transactions made by Acme Consulting for the month of July is shown below.

Cash � Accounts � Supplies � Equipment � Accounts � Owners’ Description of Receivable Inventory Payable Equity Transaction

1. �$20,000 �$20,000 Investment 2. �$ 5,000 �$7,000 �$2,000 3. �$ 1,000 �$1,000 4. �$ 4,500 �$ 4,500 Salaries 5. �$ 5,000 �$5,000 �$10,000 Revenues 6. �$ 1,500 �$1,500 7. �$ 1,000 �$1,000 8. �$ 750 �$ 750 Rent 9. �$ 500 �$ 500 Utilities

10. �$ 200 �$ 200 Travel 11. �$ 200 �$ 200

Required: a. Explain each transaction.

b. List the changes in the company’s balance sheet during the month of July.

c. Prepare an income statement for the month (ignore taxes).

d. Explain the changes in the Cash account.

e. Explain why the change in the Cash account and the month’s income are not the same. Problem 1–5.

During the month of June, Bon Voyage Travel recorded the following transactions:

1. Owners invested $25,000 in cash to start the business. They received common stock.

2. The month’s rent of $500 was prepaid in cash.

3. Equipment costing $8,000 was bought on credit.

4. $500 was paid for office supplies.

5. Advertising costing $750 was paid for with cash.

6. Paid $3,000 employee salaries in cash.

7. Earned travel commissions of $10,000 of which $2,000 was received in cash.

8. Paid $5,000 of the $8,000 owed to the equipment supplier.

9. Used $100 of the office supplies.

10. Charged $1,000 of miscellaneous expenses on the corporate credit card.

Required: a. Prepare an analysis of the month’s transactions using the same tabular format as

shown in Problem 1–4 (ignore taxes).

b. Explain how the transactions during the month changed the basic accounting equa- tion (Assets � Liabilities � Owners’ equity) for the company.

c. Prepare an income statement for the month.

d. Explain the changes in the Cash account.

e. Explain why the change in the Cash account and the month’s income are not the same.

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22 Part 1 Financial Accounting

In January 2010, Carmen Diaz, a recent arrival from Cuba, decided to open a small ribbon shop in the Coconut Grove section of Miami, Florida. During the month, she put together a simple business plan, which she took to several relatives whom she believed would be interested in helping her finance the new venture. Two of her cousins agreed to loan the business $10,000 for one year at a 6 percent interest rate. For her part, Carmen agreed to invest $1,000 in the equity of the business.

On March 1, 2010, with the help of an uncle who practiced law, Carmen formally incorporated her busi- ness, which she named “Ribbons an’ Bows.’’ Nor- mally, the uncle would have charged a fee of $600 for handling the legal aspects of a simple incorporation, but, since Carmen was family, he waived the fee.

As soon as the new business was incorporated, Carmen opened a bank account and deposited the cousins’ $10,000 loan and her $1,000 equity contribu- tion. The same day, she signed an agreement to rent store space for $600 per month, paid on the last day of the month. The agreement was for an 18-month period beginning April 1. The agreement called for a prepay- ment of the last two months’ rent, which Carmen paid out of the company bank account at the signing.

Over the next few weeks, Carmen was actively en- gaged in getting ready to open the store for business on April 1. Fortunately for Carmen, the previous ten- ant had left counters and display furniture that Carmen could use at no cost to her. In addition, the landlord agreed to repaint the store at no cost, using colors of Carmen’s choice. For her part, Carmen ordered, re- ceived, and paid for the store’s opening inventory of ribbons and ribbon accessories; acquired for free a simple cash register with credit-card processing capa- bilities from the local credit-card charge processing company after paying a refundable deposit; signed service agreements with the local phone and utility companies; ordered, received, and paid for some store supplies; and placed and paid for advertising an- nouncing the store opening in the April 2 edition of the local paper. In addition, she bought and paid for a used desktop computer with basic business software

already installed to keep track of her business transac- tions and correspondence.

On March 31, before opening for business the next day, Carmen reviewed the activity in the company’s cash bank account. Following the deposit of the loans and equity contribution, the following payments were made.

1. Last two months’ rent $1,200

2. Opening merchandise inventory $3,300

3. Cash register deposit $ 250

4. Store supplies $ 100

5. April 2 edition advertising $ 150

6. Used computer purchase $2,000

After reviewing her cash transaction records, Carmen prepared a list of Ribbons an’ Bows assets and sources of its capital (see Exhibit 1).

EXHIBIT 1 Carmen’s March 31, 2010, Ribbons an’ Bows Assets and Capital Sources List

Sources of Assets Capital

Cash $ 4,000 Inventory 3,300 Supplies 100 Prepaid rent 1,200 Prepaid advertising 150 Computer/ Cousin’s

software 2,000 loan $10,000 Cash register Carmen’s

deposit 250 equity 1,000 $11,000 $11,000

Carmen eventually decided to expand her business by selling custom-designed ribbon table arrangements for weddings and other special events. This decision led to the purchase of a used commercial sewing ma- chine for $1,800 cash on May 1.

Later, at a family Fourth of July celebration, one of Carmen’s cousins reminded her that she had promised to send the cousins a financial report covering the four- month period from March 1 to June 30.

Cases

Case 1–1

Ribbons an’ Bows, Inc.

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Chapter 1 The Nature and Purpose of Accounting 23

The next day, Carmen reviewed the following Ribbons an’ Bows information she had gathered over the last four months.

1. Customers had paid $7,400 cash for ribbons and ac- cessories, but she was still owed $320 for ribbon arrangements for a large wedding delivered to the customer on June 30.

2. A part-time employee had been paid $1,510 but was still owed $90 for work performed during the last week of June.

3. Rent for the three-month period had been paid in cash at the end of each month, as stipulated in the rental agreement.

4. Inventory replenishments costing $2,900 had been delivered and paid for by June 30. Carmen esti- mated the June 30 merchandise inventory on hand had cost $4,100.

5. The small opening office supplies inventory was nearly all gone. She estimated supplies costing $20 had not been used.

Carmen believed that the initial three months of business had been profitable, but she was puzzled by the fact that the cash in the company’s June 30 bank account was $3,390, which was less than the April 1 balance of $4,000.

Carmen also was concerned about how she should reflect the following in her financial report:

1. No interest had been paid on the cousins’ loan.

2. The expenditures made for the desktop computer and its related software and the commercial sewing machine. She believed these expenditures would be beneficial to the business long after June 30. At

the time she purchased the commercial sewing ma- chine, Carmen estimated that it would be used for about five years from its May 1 purchase date, when it would then have to be replaced. Similarly, on March 31, she had estimated the desktop computer and its software would have to be replaced in two years’ time. Carmen believed the sewing machine and the computer along with its software would have no resale value at the end of their useful lives.

3. The free legal work performed by her uncle and the free cash register provided by the local credit-card charge processor.

4. Carmen had not paid herself a salary or dividends during the four months of operations. If cash was available, she anticipated that sometime in July she would pay herself some compensation for the four months spent working in the business. Before start- ing her business, Carmen had worked for $1,300 a month as a cashier in a local grocery store.

Questions

1. How would you report on the three-month opera- tions of Ribbons an’ Bows, Inc., through June 30? Was the company profitable? (Ignore income taxes.) Why did its cash in the bank decline during the three-month operating period?

2. How would you report the financial condition of the business on June 30, 2010?

3. Do you believe Carmen’s first three months of operation could be characterized as “successful’’? Explain your answer.