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Donald E. Kieso PhD, CPA Northern Illinois University DeKalb, Illinois

Jerry J. Weygandt PhD, CPA University of Wisconsin—Madison Madison, Wisconsin

Terry D. Warfield, PhD University of Wisconsin—Madison Madison, Wisconsin

INTERMEDIATE ACCOUNTING 16E

D E D I C A T E D T O

Our wives, Donna, Enid, and Mary, for their love, support,

and encouragement

Director Michael McDonald Acquisitions Editor Emily McGee Associate Development Editor Rebecca Costantini Editorial Supervisor Terry Ann Tatro Editorial Associate Margaret Thompson Senior Content Manager Dorothy Sinclair Senior Production Editor Valerie Vargas Marketing Manager Lauren Harrell Product Design Manager Allison Morris Senior Product Designer Greg Chaput Media Specialist Elena Santa Maria Design Director Harry Nolan Senior Designer Maureen Eide Senior Photo Editor Mary Ann Price Editorial Assistant Elisa Wong Cover Photo JB Broccard/Getty Images, Inc. Chapter Opener Photo JB Broccard/Getty Images, Inc. Cover Credit Art Wager/Getty Images

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Material from the Uniform CPA Examinations and Unofficial Answers, copyright © 1965, 1966, 1967, 1968, 1969, 1970, 1971, 1972, 1973, 1974, 1975, 1976, 1977, 1978, 1979, 1980, 1981, 1982, 1983, 1984, 1985, 1986, 1987, 1988, 1990, 1991, 1992, and 1993 by the American Institute of Certified Public Accountants, Inc., is adapted with permission.

This book contains quotations from Accounting Research Bulletins, Accounting Principles Board Opinions, Accounting Principles Board Statements, Accounting Interpretations, and Accounting Terminology Bulletins, copyright © 1953, 1956, 1966, 1968, 1969, 1970, 1971, 1972, 1973, 1974, 1975, 1976, 1977, 1978, 1979, 1980, 1981, 1982 by the American Institute of Certified Public Accountants, Inc., 1211 Avenue of the Americas, New York, NY 10036.

This book contains citations from various FASB pronouncements. Copyright © by Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856 U.S.A. Reprinted with permission. Copies of complete documents are available from Financial Accounting Standards Board.

Material from the Certificate in Management Accounting Examinations, copyright © 1975, 1976, 1977, 1978, 1979, 1980, 1981, 1982, 1983, 1984, 1985, 1986, 1987, 1988, 1989, 1990, 1991, 1992, and 1993 by the Institute of Certified Management Accountants, 10 Paragon Drive, Montvale, NJ 07645, is adapted with permission.

Material from the Certified Internal Auditor Examinations, copyright © May 1984, November 1984, May 1986 by The Institute of Internal Auditors, 249 Maitland Ave., Altemonte Springs, FL 32701, is adapted with permission.

ISBN-13 978-1-118-74320-1

BRV ISBN-13 978-1-118-74297-6

The inside back cover will contain printing identification and country of origin if omitted from this page. In addition, if the ISBN on the back cover differs from the ISBN on this page, the one on the back cover is correct.

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

iii

1 Financial Accounting and Accounting Standards 2

2 Conceptual Framework for Financial Reporting 36

3 The Accounting Information System 78 4 Income Statement and Related Information 152 5 Balance Sheet and Statement of Cash

Flows 200 6 Accounting and the Time Value of Money 266 7 Cash and Receivables 324 8 Valuation of Inventories: A Cost-Basis

Approach 386 9 Inventories: Additional Valuation Issues 442 10 Acquisition and Disposition of Property, Plant,

and Equipment 502 11 Depreciation, Impairments, and Depletion 552 12 Intangible Assets 610 13 Current Liabilities and Contingencies 658 14 Long-Term Liabilities 718 15 Stockholders’ Equity 774 16 Dilutive Securities and Earnings per Share 834 17 Investments 898 18 Revenue Recognition 978 19 Accounting for Income Taxes 1052 20 Accounting for Pensions and Postretirement

Benefits 1116 21 Accounting for Leases 1194 22 Accounting Changes and Error Analysis 1266 23 Statement of Cash Flows 1330 24 Full Disclosure in Financial Reporting 1402

APPENDICES A Private Company Accounting A-1 B Specimen Financial Statements: The Procter &

Gamble Company B-1 C Specimen Financial Statements: The Coca-Cola

Company C-1 D Specimen Financial Statements: PepsiCo, Inc. D-1 E Specimen Financial Statements: Marks and

Spencer plc E-1

Brief Contents

iv

Through many editions, this textbook has continued to reflect the constant changes taking place in the GAAP environment. This edition continues this tradition, which has become even more significant as the financial reporting environment is exploding with major change. Here are three areas of major importance that are now incorporated extensively into this edition of the textbook.

Convergence of GAAP and IFRS One of the most important innovations shaping our capital markets was the idea of GAAP. It might be said that it would be even better if we had one common set of accounting rules for the whole world, which would make it easier for interna- tional investors to compare the financial results of companies from different countries. Fortunately, GAAP and international accounting standards have converged to result in a number of common standards between GAAP and International Financial Reporting Standards (IFRS). And you have the chance to be on the ground floor as we develop for you the similarities and differences in the two systems that ultimately will be one.

A Fair Value Movement The FASB believes that fair value information is more relevant to users than historical cost. As a result, there is more information that is being reported on this basis, and even more will occur in the future. The financial press is full of articles discussing how financial institutions must fair value their assets, which has led to massive losses during the recent credit crisis. In addition, additional insight into the reliability related to fair values is being addressed and disclosed to help investors make important capital allocation decisions. We devote a considerable amount of material that discusses and illustrates fair value concepts in this edition.

A New Way of Looking at Generally Accepted Accounting Principles (GAAP) Learning GAAP used to be a daunting task, as it is comprised of many standards that vary in form, completeness, and structure. Fortunately, the profession has developed the Financial Accounting Standards Board Codification (often referred to as the Codification). This Codification provides in one place all the GAAP related to a given topic. This textbook is the first to incorporate this Codification—it will make learning GAAP easier and more interesting!

Intermediate Accounting is the market-leading textbook in providing the tools needed to under- stand what GAAP is and how it is applied in practice. With this Sixteenth Edition, we strive to con- tinue to provide the material needed to understand this subject area. The textbook is comprehen- sive and up-to-date. We also include proven pedagogical tools, designed to help you learn more effectively and to answer the changing needs of this course.

We are excited about Intermediate Accounting, Sixteenth Edition. We believe it meets an important objective of providing useful information to educators and students interested in learning about both GAAP and IFRS. Suggestions and comments from users of this textbook will be appreciated. Please feel free to e-mail any one of us at AccountingAuthors@yahoo.com.

Donald E. Kieso Jerry J. Weygandt Terry D. Warfield Somonauk, Illinois Madison, Wisconsin Madison, Wisconsin

“If this textbook helps you appreciate the challenges, worth, and limitations of financial reporting, if it encourages you to evaluate critically and understand financial accounting concepts and practice, and if it p repares you for advanced study, profes- sional examinations, and the successful and ethical pursuit of your career in accounting or business in a global economy, then we will have attained our objectives.”

From the Authors

v

Author Commitment Don Kieso DONALD E. KIESO, PhD, CPA, received his bachelor's degree from Aurora University and his doctorate in accounting from the University of Illinois. He has served as chairman of the Department of Accountancy and is currently the KPMG Emeritus Professor of Accountancy at Northern Illinois University. He has public accounting experience with Price Waterhouse & Co. (San Francisco and Chicago) and Arthur Andersen & Co. (Chicago) and research experience with the Research Division of the American Institute of Certified Public Accountants (New York). He has done post-doctorate work as a Visiting Scholar at the University of California at Berkeley and is a recipient of NIU’s Teaching Excellence Award and four Golden Apple Teaching Awards. Professor Kieso is the author of other accounting and business books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Illinois CPA Society. He has served as a member of the Board of Directors of the Illinois CPA Society, then AACSB’s Accounting Accreditation Committees, the State of Illinois Comptroller’s Commission, as Secretary-Treasurer of the Federation of Schools of Accountancy, and as Secretary-Treasurer of the American Accounting Association. Professor Kieso is currently serving on the Board of Trustees and Executive Committee of Aurora University, as a member of the Board of Directors of Kishwaukee Community Hospital, and as Treasurer and Director of Valley West Community Hospital. From 1989 to 1993, he served as a charter member of the National Accounting Education Change Commission. He is the recipient of the Outstanding Accounting Educator Award from the Illinois CPA Society, the FSA’s Joseph A. Silvoso Award of Merit, the NIU Foundation’s Humanitarian Award for Service to Higher Education, a Distinguished Service Award from the Illinois CPA Society, and in 2003 an honorary doctorate from Aurora University.

Jerry Weygandt JERRY J. WEYGANDT, PhD, CPA, is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin—Madison. He holds a Ph.D. in accounting from the University of Illinois. Articles by Professor Weygandt have appeared in the Accounting Review, Journal of Accounting Research, Accounting Horizons, Journal of Accountancy, and other academic and professional j ournals. These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports. Professor Weygandt is author of other accounting and financial reporting books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Wisconsin Society of Certified Public Accountants. He has served on numerous committees of the American Accounting Association and as a member of the editorial board of the Accounting Review; he also has served as President and Secretary-Treasurer of the American Accounting Association. In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Standards Executive Committee (AcSEC) of that organization. He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accounting Foundation. Professor Weygandt has received the Chancellor’s Award for Excellence in Teaching and the Beta Gamma Sigma Dean’s Teaching Award. He is on the board of directors of M & I Bank of Southern Wisconsin. He is the recipient of the Wisconsin Institute of CPA’s Outstanding Educator’s Award and the Lifetime Achievement Award. In 2001, he received the American Accounting Association’s Outstanding Educator Award.

Terry Warfield TERRY D. WARFIELD, PhD, is the PwC Professor in Accounting at the University of Wisconsin—Madison. He received a B.S. and M.B.A. from Indiana University and a Ph.D. in accounting from the University of Iowa. Professor Warfield’s area of expertise is financial reporting, and prior to his academic career, he worked for five years in the banking industry. He served as the Academic Accounting Fellow in the Office of the Chief Accountant at the U.S. Securities and Exchange Commission in Washington, D.C. from 1995–1996. Professor Warfield’s primary research interests concern financial accounting standards and disclosure policies. He has published scholarly articles in The Accounting Review, Journal of Accounting and Economics, Research in Accounting Regulation, and Accounting Horizons, and he has served on the editorial boards of The Accounting Review, Accounting Horizons, and Issues in Accounting Education. He has served as president of the Financial Accounting and Reporting Section, the Financial Accounting Standards Committee of the American Accounting Association (Chair 1995–1996), and on the AAA- FASB Research Conference Committee. He also served on the Financial Accounting Standards Advisory Council of the Financial Accounting Standards Board, and he currently serves as a trustee of the Financial Accounting Foundation. Professor Warfield has received teaching awards at both the University of Iowa and the University of Wisconsin, and he was named to the Teaching Academy at the University of Wisconsin in 1995. Professor Warfield has developed and published several case studies based on his research for use in accounting classes. These cases have been selected for the AICPA Professor-Practitioner Case Development Program and have been published in Issues in Accounting Education.

vi

The Sixteenth Edition expands our emphasis on student learning and improves upon a teaching and learning package that instructors and students have rated the highest in customer satisfaction. Based on extensive reviews, focus groups, and interactions with other intermediate accounting instructors and students, we have developed a number of new pedagogical features and content changes, designed both to help students learn more effectively and to answer the changing needs of the course.

WileyPLUS with ORION Over 3,500 questions, including new medium-level, computational, and accounting-cycle- based questions, are available for practice and review. is an adaptive study and practice tool that helps students build proficiency in course topics.

WileyPLUS Videos Over 150 videos are available in WileyPLUS. The videos walk students through relevant home- work problems and solutions and review important concepts.

Review and Practice and Solutions New practice opportunities with solutions are integrated throughout the textbook and WileyPLUS course. Each textbook chapter now provides students with a Review and Practice section that includes learning objective summaries, a key term listing, and a practice problem with solution.

Updated IFRS Insights Content We have updated the end-of-chapter section, IFRS Insights, throughout the textbook. In addition, in the Relevant Facts section, we now present Similarities as well as Differences between GAAP and IFRS to increase student understanding.

Major Content Revisions In response to the changing environment, we have signifi cantly revised several chapters.

CHAPTER 4 Income Statement and Related Information

• Revised discussion and presentation of unusual and infrequent gains and losses, as well as discontinued operations, per recent accounting standards.

• Deleted discussion of extraordinary items to reflect the most recent accounting standards.

CHAPTER 9 Inventories: Additional Valuation Issues

• New discussion and end-of-chapter material on lower-of-cost-or-net realizable value and lower-of-cost-or-market to reflect the most recent accounting standards.

CHAPTER 17 Investments

• Discussion and update of material in response to the recent standard on classification and measurement.

CHAPTER 18 Revenue Recognition

• New discussion based on the recent FASB ruling on the revenue recognition principle. Legacy GAAP discussion is available online.

See the next two pages for a complete list of content revisions by chapter.

WHAT’S NEW?

vii

Content Changes by Chapter Chapter 1: Financial Accounting and Accounting

Standards • Updated discussion on diminishing role of AICPA in

standard-setting process. • Added discussion on potential abuse of historical cost

valuation within Evolving Issue box on fair value. • New discussion on whether convergence of GAAP

and IFRS will really occur. • New Concepts of Analysis case on financial crisis of

2008. • Significantly updated IFRS Insights section to include

most recent information on convergence efforts.

Chapter 2: Conceptual Framework for Financial Reporting

• New discussion on how the IASB is now moving for- ward on its own conceptual framework instead of a continuation of a joint FASB/IASB project.

• New WDNM boxes on (1) how the use of unconven- tional financial terms in statements can mislead inves- tors and (2) the use of pro forma measures.

Chapter 3: The Accounting Information System • Completely revised and updated opening story on

economic crime and importance of effective inter- nal controls of a company’s accounting information system.

Chapter 4: Income Statement and Related Information • New opening story on how Groupon’s adjusted

EBITDA reflects trend of companies employing pro forma reporting and concerns with that practice.

• Completely revised Discontinued Operations section per recent FASB standard.

• Completely revised Unusual and Infrequent Gains and Losses section per recent FASB standard.

• Deleted Extraordinary Items section per recent FASB standard.

Chapter 5: Balance Sheet and Statement of Cash Flows • New discussion of IBM’s financial flexibility within

WDNM box on importance of cash flow information for investors.

• Moved P&G’s financial statements to Appendix B at end of textbook; the complete annual report is available online.

Chapter 6: Accounting and the Time Value of Money • Changed interest rates on many of the in-chapter

examples to reflect more realistic data.

Chapter 7: Cash and Receivables • New opening story on companies moving their prof-

its to overseas operations to avoid taxes. Previous

opening story, on sources of companies’ earnings, now updated and placed as a WDNM box.

• New WDNM box, on where companies park their cash. • Thoroughly updated discussion of recognition and

valuation of accounts receivable, per latest FASB stan- dard, including deleting percentage-of-sales approach.

• Updated discussion of securitizations, now placed as a WDNM box.

• Appendix 7B, Impairments of Receivables, now Collectibility Assessment Based on Expected Cash Flows, per recent FASB standard. Impairment Evaluation Process in IFRS Insights section also delet- ed accordingly.

Chapter 8: Valuation of Inventories: A Cost-Basis Approach

• Updated discussion on ownership of goods and costs to include in inventory, per recent FASB standard.

• Inventory errors discussion moved to end of chapter, for improved flow of discussion.

Chapter 9: Inventories: Additional Valuation Issues • Updated discussion of lower-of-cost-and-net realizable

value and lower-of-cost-or-market, per recent FASB pronouncement. New EOC Exercises and Problems related to this discussion.

• New table highlighting disadvantages of the gross profit method.

• New WDNM box on price fixing, and how new tech- nology on changing store prices can reduce the cost of implementing the retail inventory method.

Chapter 10: Acquisition and Disposition of Property, Plant, and Equipment

• Updated opening story on importance of and capital expenditures related to property, plant, and equipment for many companies.

Chapter 11: Depreciation, Impairments, and Depletion • Generally updated for new design, content, and recent

developments.

Chapter 12: Intangible Assets • New WDNM boxes on (1) including internally gener-

ated intangible assets in the financial statements and (2) global R&D incentives.

• New footnotes on recent guidance for private companies in the accounting for goodwill.

• Moved up Presentation of Intangible Assets section within chapter for improved flow of topics.

Chapter 13: Current Liabilities and Contingencies • Moved discussion of current maturities of long-term

debt and short-term obligations expected to be

refinanced to end of Current Liabilities section for improved flow of discussion.

• New illustrations highlighting the entries required to record unearned revenues, payroll deductions, and bonus agreements.

• New footnote on refinancing criteria, to inform about FASB’s latest deliberations regarding them in light of the Board’s simplification initiative.

• Rewritten discussion of warranties, per latest FASB standard.

• New WDNM box, on how companies’ extension of payment terms affects their current ratios and there- fore analysis of them.

Chapter 14: Long-Term Liabilities • Updated WDNM box on bond ratings for most recent

trends and information. • New footnote explaining why the effective-interest

rate will be higher on bonds issued at a discount rate based on the reduced carrying value.

• Deleted Costs of Issuing Bonds section per latest FASB standard.

Chapter 15: Stockholders’ Equity • Moved up discussion of preferred stock for improved

flow of discussion. • New illustrations on common stock issuance, cash

dividends, property dividends, liquidating dividends, and stock dividends to highlight journal entry proce- dures.

• Updated WDNM boxes for the most recent corporate information and trends on stock buybacks, classes of stock, stock splits, and dividends.

Chapter 16: Dilutive Securities and Earnings per Share • Revised WDNM box on convertible bonds, to include

most recent information and trends. • New WDNM box on FASB’s proposal of fair value

method for accounting for stock options.

Chapter 17: Investments • Discussion reflects proposed 2016 FASB pronounce-

ment on accounting for investments. • New WDNM boxes on (1) recent trend of many large

banks shifting debt investment portfolios into the held- to-maturity category as protection against market volatility, and (2) issue of how mutual funds assign a current value to private technology companies.

• Rewrote Impairment section, as well as Fair Value Hedge section in Appendix 17A, to reflect proposed FASB pronouncement.

• Deleted Appendix 17B on variable-interest entities.

Chapter 18: Revenue Recognition • New section with extended example of the five-step

revenue recognition model, to give students a good understanding/overview before more advanced issues are discussed.

• Right of Return section completely rewritten as Sales Returns and Allowances, with more explanations and examples, per new FASB standard.

• EOC material includes many new Brief Exercises, Exercises, and Problems, to reflect new FASB stand- ard and terminology.

Chapter 19: Accounting for Income Taxes • New section on financial statement effects of future

taxable amounts and deferred taxes. • Rewrote balance sheet classification section, to reflect

recent FASB pronouncement. • Completely revised Financial Statement Presentation

section, including new material on note disclosure.

Chapter 20: Accounting for Pensions and Postretirement Benefits

• Generally updated for new design, content, and recent developments.

Chapter 21: Accounting for Leases • Updated Evolving Issue boxes, to coincide with

expected new FASB leasing rules. • New WDNM box on how GM realized losses due to

inaccurate estimates of residual value profits.

Chapter 22: Accounting Changes and Error Analysis • New WDNM box on whether changes for accounting

estimates are motivated by attempt to provide more useful information or to make financial results look better.

• Motivations for Change of Accounting Method section now a WDNM box.

Chapter 23: Statement of Cash Flows • Extraordinary Items section now Unusual and

Infrequent Items, to conform to new FASB treatment. • Expanded footnote on reporting of significant noncash

transactions, as they can significantly affect analysts’ assessments of capital expenditures and free cash flow.

• New marginal T-accounts in Use of a Worksheet section, to help demonstrate adjustments made to the accounts.

• New WDNM box, on COROA (cash operating return on assets), a new measure of profitability.

Chapter 24: Full Disclosure in Financial Reporting • Updated Evolving Issue box on issue of financial

disclosure, to include recent developments on the FASB’s Disclosure Framework project.

• Deleted discussion of extraordinary items, to conform to new FASB treatment.

New Appendices A-E • Appendix A: Private Company Accounting (private

company alternatives for intangible assets and goodwill)

• Appendix B: Financial statements for The Procter & Gamble Company

• Appendix C: Financial statements for The Coca-Cola Company

• Appendix D: Financial statements for PepsiCo, Inc. • Appendix E: Financial statements for Marks and

Spencer plc

viii

ix

This edition continues to provide numerous key learning aids to help you master the textbook material and prepare you for a successful career.

CHAPTER PREVIEW The Chapter Preview summarizes the major issues discussed in the chapter, and provides students with a visual outline of the key topics.

PREVIEW OF CHAPTER 12 As our opening story indicates, sustainability strategies are taking on increased importance for companies like Southwest Airlines and Clorox. Reporting challenges for effective sustainability investments are similar to those for intangible assets. In this chapter, we explain the basic conceptual and reporting issues related to intangible assets. The content and organization of the chapter are as follows.

INTANGIBLE ASSETS

INTANGIBLE ASSET ISSUES

• Characteristics • Valuation • Amortization

TYPES OF INTANGIBLES

• Marketing-related • Customer-related • Artistic-related • Contract-related • Technology-related • Goodwill

IMPAIRMENT AND PRESENTATION OF INTANGIBLES

• Limited-life intangibles • Indefinite-life intangibles

other than goodwill • Goodwill • Presentation

RESEARCH AND DEVELOPMENT COSTS

• Identifying R&D • Accounting for R&D • Similar costs • Presentation

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

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WHAT DO THE NUMBERS MEAN? The “What do the numbers mean?” boxes further students’ understanding of key concepts with practical, real-world examples.

WHAT DO THE NUMBERS MEAN? KEEP YOUR HANDS OFF MY INTANGIBLE!

Source: “Converse Sues to Protect Its Chuck Taylor All Stars,” The New York Times (October 14, 2014).

Companies go to great extremes to protect their valuable intangible assets. Consider how the creators of the highly suc- cessful game Trivial Pursuit protected their creation. First, they copyrighted the 6,000 questions that are at the heart of the game. Then they shielded the Trivial Pursuit name by applying for a registered trademark. As a third mode of protection, they obtained a design patent on the playing board’s design as a unique graphic creation.

Another more recent example is the case of Converse and its efforts to protect its classic Chuck Taylor trademark. Converse (owned by Nike) accused 31 companies (including

Wal-Mart Stores, Inc., Kmart, and Skechers) of trademark infringement for co-opting its widely recognizable Chuck Taylor® sneakers. While Converse is suing for monetary dam- ages, its main goal is to get these imposters off store shelves. The company went as far as fi ling a separate complaint with the International Trade Commission to stop any shoes consid- ered to be counterfeit from entering the country. That Converse (Nike) is going to these ends to protect its trademark is under- standable given that Nike reinvigorated the brand by expanding the franchise, introducing more colors and styles, and helping to push All Stars® into overseas markets.

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UNDERLYING CONCEPTS The Underlying Concepts highlight and explain major conceptual topics in the chapter.

INTERNATIONAL PERSPECTIVE International Perspectives provide students with specific examples of how global companies (and countries) implement key accounting regulations. They also provide examples of how and where IFRS differs from GAAP.

UNDERLYING CONCEPTS

The controversy sur- rounding the accounting for R&D expenditures refl ects a debate about whether such expendi- tures meet the defi nition of an asset. If so, then an “expense all R&D costs” policy results in overstated expenses and understated assets.

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INTERNATIONAL PERSPECTIVE

IFRS requires the capitalization of certain development expendi- tures. This confl icts with GAAP.

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EVOLVING ISSUE The Evolving Issue feature introduces and discusses a current topic in the accounting industry in which the profession may be encountering controversy or nearing resolution. The feature shows how the key standard- setting organizations make decisions to adjust to the changing global business environment.

The requirement that companies expense immediately all R&D costs (as well as start-up costs) incurred internally is a practical solution. It ensures consistency in practice and uniformity among companies. But the practice of immediately writing off expenditures made in the expectation of benefi ting future peri- ods is conceptually incorrect.

Proponents of immediate expensing contend that from an income statement standpoint, long-run application of this stan- dard frequently makes little difference. They argue that because of the ongoing nature of most companies’ R&D activities, the amount of R&D cost charged to expense each accounting period is about the same, whether there is immediate expens- ing or capitalization and subsequent amortization.

Others criticize this practice. They believe that the balance sheet should report an intangible asset related to expenditures that have future benefi t. To preclude capitalization of all R&D expenditures removes from the balance sheet what may be a company’s most valuable asset.

Indeed, research fi ndings indicate that capitalizing R&D costs may be helpful to investors. For example, one study showed a signifi cant relationship between R&D outlays and subsequent benefi ts in the form of increased productivity, earnings, and share- holder value for R&D-intensive companies. Another study found that there was a signifi cant decline in earnings’ usefulness for companies that were forced to switch from capitalizing to expens- ing R&D costs, and that the decline appears to persist over time.

The current accounting for R&D and other internally gener- ated intangible assets represents one of the many trade-offs made among relevance, faithful representation, and cost- benefi t considerations. The FASB and IASB have completed some lim- ited-scope projects on the accounting for intangible assets, and the Boards have contemplated a joint project on the accounting for identifi able intangible assets (i.e., excluding goodwill). Such a project would address concerns that the current accounting requirements lead to inconsistent treatments for some types of intangible assets depending on how they arise.

Sources for research studies: Baruch Lev and Theodore Sougiannis, “The Capitalization, Amortization, and Value-Relevance of R&D,” Journal of Accounting and Economics (February 1996); and Martha L. Loudder and Bruce K. Behn, “Alternative Income Determination Rules and Earnings Useful- ness: The Case of R&D Costs,” Contemporary Accounting Research (Fall 1995).

EVOLVING ISSUE RECOGNITION OF R&D AND INTERNALLY GENERATED INTANGIBLES

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Key Learning Features

BRIDGE TO THE PROFESSION NEW to this edition, this section now includes FASB Codification References, Codification Exercises, and a Codification Research Case, all designed to refer students to the relevant FASB literature for key concepts in the text and provide assessment of their understanding.

REVIEW AND PRACTICE NEW Review and Practice section includes Key Terms Review, Learning Objectives Review, and a Practice Problem with Solution. In addition, multiple-choice questions with solutions, review exercises with solutions, and a full glossary of all key terms are available online.

LEARNING OBJECTIVES REVIEW 1 Describe the characteristics, valuation, and amortization of intangible assets. Intangible assets have two main

characteristics: (1) they lack physical existence, and (2) they are not financial instruments. In most cases, intangible assets provide services over a period of years and so are normally classified as long-term assets.

Intangibles are recorded at cost. Cost includes all acquisition costs and expenditures needed to make the intangible asset ready for its intended use. If intangibles are acquired in exchange for stock or other assets, the cost of the intangible is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident. When a company makes a “basket purchase” of several intangibles or a combination of intangibles and tangibles, it should allocate the cost on the basis of fair values.

Intangibles have either a limited useful life or an indefinite useful life. Companies amortize limited-life intangibles. They do not amortize indefinite-life intangibles. Limited-life intangibles should be amortized by systematic charges to expense over their useful life. The useful life should reflect the period over which these assets will contribute to cash flows. The amount

REVIEW AND PRACTICE KEY TERMS REVIEW

amortization, 613 bargain purchase, 622 business combination,

612(n) copyright, 616 development activities, 628 fair value test, 623

franchise, 617 goodwill, 619 impairment, 622 indefinite-life

intangibles, 613 intangible assets, 612 license (permit), 617

limited (finite)-life intangibles, 613

master valuation approach, 621

organizational costs, 631 patent, 617 recoverability test, 623

research activities, 628 research and development

(R&D) costs, 628 start-up costs, 631 trademark, trade name, 615

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PRACTICE PROBLEM

Sky Co., organized in 2017, provided you with the following information.

1. Purchased a license for $20,000 on July 1, 2017. The license gives Sky exclusive rights to sell its services in the tri-state region and will expire on July 1, 2025.

2. Purchased a patent on January 2, 2018, for $40,000. It is estimated to have a 5-year life. 3. Costs incurred to develop an exclusive Internet connection process as of June 1, 2018, were $45,000. The process has an

indefinite life. 4. On April 1, 2018, Sky purchased a small circuit board manufacturer for $350,000. Goodwill recorded in the transaction

was $90,000.

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USING YOUR JUDGMENT The Using Your Judgment section provides students with real-world homework problems covering topics such as financial reporting and financial statement analysis.

USING YOUR JUDGMENT

Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix B. The company’s complete annual report, including the notes to the financial statements, is available online.

Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions.

(a) Does P&G report any intangible assets, especially goodwill, in its 2014 financial statements and accompanying notes? (b) How much research and development (R&D) cost was expensed by P&G in 2013 and 2014? What percentage of sales rev-

enue and net income did P&G spend on R&D in 2013 and 2014?

Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ complete annual reports, including the notes to the financial statements, are available online.

Instructions Use the companies’ financial information to answer the following questions.

(a) (1) What amounts for intangible assets were reported in their respective balance sheets by Coca-Cola and PepsiCo at year-end 2014?

(2) What percentage of total assets is each of these reported amounts at year-end 2014? (3) What was the change in the amount of intangibles from 2013 to 2014 for Coca-Cola and PepsiCo?

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BRIDGE TO THE PROFESSION

FASB Codifi cation References [1] FASB ASC 350-10-05. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting

Standards No. 142 (Norwalk, Conn.: FASB, 2001).] [2] FASB ASC 350-30-35. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting

Standards No. 142 (Norwalk, Conn.: FASB, 2001), par. 11.] [3] FASB ASC 805-10. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No. 141R

(Norwalk, Conn.: FASB, 2007).] [4] FASB ASC 350-30-35. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting

Standards No. 142 (Norwalk, Conn.: FASB, 2001), par. B55.] [5] FASB ASC 805-10-20. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No.

141R (Norwalk, Conn.: FASB, 2007).] [6] FASB ASC 805-10-30. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No.

141R (Norwalk, Conn.: FASB, 2007).] [7] FASB ASC 805-20-15. [Predecessor literature: None]

[8] FASB ASC 350 20 15 [Predecessor literature: None]

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IFRS INSIGHTS IFRS Insights offer students a detailed discussion and assessment material of international accounting standards at the end of each chapter.

IFRS Insights There are some significant differences between IFRS and GAAP in the accounting for both intan- gible assets and impairments. IFRS related to intangible assets is presented in IAS 38 (“Intangible Assets”). IFRS related to impairments is found in IAS 36 (“Impairment of Assets”).

RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to intangible assets.

Similarities • Like GAAP, under IFRS intangible assets (1) lack physical substance and (2) are not fi nancial

instruments. In addition, under IFRS an intangible asset is identifi able. To be identifi able, an intangible asset must either be separable from the company (can be sold or transferred) or it arises from a contractual or legal right from which economic benefi ts will fl ow to the company.

LEARNING OBJECTIVE 6 Compare the accounting for intangible assets under GAAP and IFRS.

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x

1 Financial Accounting and Accounting Standards 2

WE CAN DO BETTER 2

FINANCIAL REPORTING ENVIRONMENT 4

Accounting and Capital Allocation 4 What Do the Numbers Mean? It’s the

Accounting 5 Objective of Financial Reporting 5 What Do the Numbers Mean? Don’t Forget

Stewardship 6 The Need to Develop Standards 7

PARTIES INVOLVED IN STANDARD-SETTING 7

Securities and Exchange Commission (SEC) 7 American Institute of Certified Public

Accountants (AICPA) 9 Financial Accounting Standards Board (FASB) 9

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES 13

What Do the Numbers Mean? You Have to Step Back 13

FASB Codification 13

MAJOR CHALLENGES IN FINANCIAL REPORTING 15

GAAP in a Political Environment 15 Evolving Issue Fair Value, Fair Consequences? 16 The Expectations Gap 16 Financial Reporting Issues 17 International Accounting Standards 18 What Do the Numbers Mean? Can You

Do That? 20 Ethics in the Environment of Financial

Accounting 20 Conclusion 20

IFRS INSIGHTS 29

2 Conceptual Framework for Financial Reporting 36

WHAT IS IT? 36

CONCEPTUAL FRAMEWORK 38

Need for a Conceptual Framework 38 What Do the Numbers Mean? What’s Your

Principle? 39 Development of a Conceptual Framework 39 Overview of the Conceptual Framework 40

FIRST LEVEL: BASIC OBJECTIVE 40

SECOND LEVEL: FUNDAMENTAL CONCEPTS 41

Qualitative Characteristics of Accounting Information 41

What Do the Numbers Mean? Living in a Material World 44

What Do the Numbers Mean? Show Me the Earnings! 46 Basic Elements 48

THIRD LEVEL: RECOGNITION AND MEASUREMENT CONCEPTS 49

Basic Assumptions 50 What Do the Numbers Mean? Whose

Company Is It? 50 Basic Principles of Accounting 52 Cost Constraint 57 Summary of the Structure 58 What Do the Numbers Mean? Don’t

Count These Please 59

FASB CODIFICATION 73

IFRS INSIGHTS 74

3 The Accounting Information System 78

NEEDED: A RELIABLE INFORMATION SYSTEM 78

ACCOUNTING INFORMATION SYSTEM 80

Basic Terminology 80 Debits and Credits 81 The Accounting Equation 82 Financial Statements and Ownership

Structure 84 The Accounting Cycle 85

RECORD AND SUMMARIZE BASIC TRANSACTIONS 87

Journalizing 87 Posting 88 Trial Balance 92

ADJUSTING ENTRIES 92

Types of Adjusting Entries 93 Adjusting Entries for Deferrals 93 Adjusting Entries for Accruals 98 What Do the Numbers Mean?

Am I Covered? 103 Adjusted Trial Balance 104

PREPARING FINANCIAL STATEMENTS 104

What Do the Numbers Mean? 24/7 Accounting 106

Closing 106 Post-Closing Trial Balance 109 Reversing Entries—An Optional Step 109 The Accounting Cycle Summarized 110 What Do the Numbers Mean? Hey, It’s Complicated 110

Table of Contents

xi

xii

FINANCIAL STATEMENTS FOR A MERCHANDISING COMPANY 110

Income Statement 110 Statement of Retained Earnings 111 Balance Sheet 111 What Do the Numbers Mean? Statements,

Please 113 Closing Entries 113

APPENDIX 3A: CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING 113

CONVERSION FROM CASH BASIS TO ACCRUAL BASIS 115

Service Revenue Computation 116 Operating Expense Computation 117

THEORETICAL WEAKNESSES OF THE CASH BASIS 118

APPENDIX 3B: USING REVERSING ENTRIES 119

ILLUSTRATION OF REVERSING ENTRIES— ACCRUALS 119

ILLUSTRATION OF REVERSING ENTRIES—DEFERRALS 120

SUMMARY OF REVERSING ENTRIES 121

APPENDIX 3C: USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED 121

WORKSHEET COLUMNS 121

Trial Balance Columns 121 Adjustments Columns 121

ADJUSTMENTS ENTERED ON THE WORKSHEET 123

Adjusted Trial Balance 123 Income Statement and Balance Sheet Columns 123

PREPARING FINANCIAL STATEMENTS FROM A WORKSHEET 124

IFRS INSIGHTS 147

4 Income Statement and Related Information 152

FINANCIAL STATEMENTS ARE CHANGING 152

INCOME STATEMENT 154

Usefulness of the Income Statement 154 Limitations of the Income Statement 154 Quality of Earnings 155 What Do the Numbers Mean? Four: The

Loneliest Number 156

FORMAT OF THE INCOME STATEMENT 156

Elements of the Income Statement 156 Intermediate Components of the

Income Statement 157 What Do the Numbers Mean? Top Line or

Bottom Line? 160 Condensed Income Statements 160 Single-Step Income Statements 161

REPORTING VARIOUS INCOME ITEMS 162

Unusual and Infrequent Gains and Losses 162 Discontinued Operations 164 Noncontrolling Interest 167 Earnings per Share 167 Summary of Various Income Items 169 What Do the Numbers Mean? Different Income

Concepts 169

OTHER REPORTING ISSUES 170

Accounting Changes and Errors 170 Retained Earnings Statement 172 Comprehensive Income 173 Evolving Issue Income Reporting 176

FASB CODIFICATION 194

IFRS INSIGHTS 195

5 Balance Sheet and Statement of Cash Flows 200

HEY, IT DOESN’T BALANCE! 200

BALANCE SHEET 202

Usefulness of the Balance Sheet 202 Limitations of the Balance Sheet 202 What Do the Numbers Mean? Grounded 203 Classification in the Balance Sheet 203 What Do the Numbers Mean? “Show Me the

Assets!” 210 What Do the Numbers Mean? Warning Signals 214 Balance Sheet Format 214

STATEMENT OF CASH FLOWS 216

What Do the Numbers Mean? Watch That Cash Flow 216

Purpose of the Statement of Cash Flows 217 Content and Format of the Statement

of Cash Flows 217 Preparation of the Statement of Cash Flows 218 Usefulness of the Statement of Cash Flows 221 What Do the Numbers Mean? “There Ought to Be a

Law” 223

ADDITIONAL INFORMATION 224

Supplemental Disclosures 224 What Do the Numbers Mean? What About Your

Commitments? 226 Techniques of Disclosure 227 Evolving Issue Balance Sheet Reporting:

Gross or Net? 230

APPENDIX 5A: RATIO ANALYSIS—A REFERENCE 231

USING RATIOS TO ANALYZE PERFORMANCE 231

FASB CODIFICATION 257

IFRS INSIGHTS 258

6 Accounting and the Time Value of Money 266

HOW DO I MEASURE THAT? 266

BASIC TIME VALUE CONCEPTS 268

Applications of Time Value Concepts 268 The Nature of Interest 269 Simple Interest 270 Compound Interest 270 What Do the Numbers Mean? A Pretty Good Start 271 Fundamental Variables 274

SINGLE-SUM PROBLEMS 274

Future Value of a Single Sum 275 Present Value of a Single Sum 276 Solving for Other Unknowns in Single-Sum Problems 278

ANNUITIES (FUTURE VALUE) 279

Future Value of an Ordinary Annuity 280 Future Value of an Annuity Due 282 What Do the Numbers Mean? Don't Wait to Make That

Contribution! 284 Examples of Future Value of Annuity Problems 284

ANNUITIES (PRESENT VALUE) 286

Present Value of an Ordinary Annuity 286 What Do the Numbers Mean? Up in Smoke 288 Present Value of an Annuity Due 288 Examples of Present Value of Annuity Problems 289

OTHER TIME VALUE OF MONEY ISSUES 291

Deferred Annuities 291 Valuation of Long-Term Bonds 293 Effective-Interest Method of Amortization of Bond

Discount or Premium 294 Present Value Measurement 295 What Do the Numbers Mean? How Low Can They Go? 297

FASB CODIFICATION 312

7 Cash and Receivables 324 LUCK OF THE IRISH 324

CASH 326

Reporting Cash 326 Summary of Cash-Related Items 328 What Do the Numbers Mean? Where Did I Park

My Cash? 329

RECEIVABLES 329

Recognition of Accounts Receivable 330 Valuation of Accounts Receivable 334

NOTES RECEIVABLE 338

Recognition of Notes Receivable 338 Valuation of Notes Receivable 342 What Do the Numbers Mean? Please Release Me? 343

SPECIAL ISSUES 343

Fair Value Option 344 Disposition of Accounts and Notes Receivable 344 What Do the Numbers Mean? Securitizations—

Good or Bad? 349 Presentation and Analysis 350 What Do the Numbers Mean? I'm Still Waiting 352

APPENDIX 7A: CASH CONTROLS 352

USING BANK ACCOUNTS 353

THE IMPREST PETTY CASH SYSTEM 353

PHYSICAL PROTECTION OF CASH BALANCES 355

RECONCILIATION OF BANK BALANCES 355

APPENDIX 7B: COLLECTABILITY ASSESSMENT BASED ON EXPECTED CASH FLOWS 358

MEASUREMENT OF COLLECTIBILITY 358

Example 358 Recording Bad Debts 359

FASB CODIFICATION 382

IFRS INSIGHTS 383

8 Valuation of Inventories: A Cost-Basis Approach 386

TO SWITCH OR NOT TO SWITCH 386

INVENTORY ISSUES 388

Classification 388 Inventory Cost Flow 389 Inventory Control 391 What Do the Numbers Mean? Staying Lean 392 Determining Cost of Goods Sold 392

GOODS AND COSTS INCLUDED IN INVENTORY 393

Goods Included in Inventory 393 What Do the Numbers Mean? No Parking! 395 Costs Included in Inventory 395 What Do the Numbers Mean? You May

Need a Map 397

WHICH COST FLOW ASSUMPTION TO ADOPT? 398

Specific Identification 398 Average-Cost 399 First-In, First-Out (FIFO) 400 Last-In, First-Out (LIFO) 401

SPECIAL ISSUES RELATED TO LIFO 402

LIFO Reserve 402 What Do the Numbers Mean? Comparing

Apples to Apples 403 LIFO Liquidation 403 Dollar-Value LIFO 405 What Do the Numbers Mean? Quite a Difference 410

xiii

Comparison of LIFO Approaches 410 Major Advantages of LIFO 411 Major Disadvantages of LIFO 412 Basis for Selection of Inventory Method 413 Evolving Issue Repeal LIFO! 415

EFFECT OF INVENTORY ERRORS 416

Ending Inventory Misstated 416 Purchases and Inventory Misstated 417

FASB CODIFICATION 441

9 Inventories: Additional Valuation Issues 442

NOT WHAT IT SEEMS TO BE 442

LOWER-OF-COST-OR-NET REALIZABLE VALUE 444

Definition of Net Realizable Value 444 Illustration of LCNRV 444 Methods of Applying LCNRV 445 Recording NRV Instead of Cost 446 Use of an Allowance 447 Use of an Allowance—Multiple Periods 447

LOWER-OF-COST-OR-MARKET 448

How Lower-of-Cost-or-Market Works 449 Methods of Applying Lower-of-Cost-or-Market 450 What Do the Numbers Mean? “Put It in Reverse” 451 Evaluation of the LCNRV and Lower-of-Cost-or-Market

Rules 451

OTHER VALUATION APPROACHES 452

Valuation at Net Realizable Value 452 Valuation Using Relative Sales Value 453 Purchase Commitments—A Special Problem 453

THE GROSS PROFIT METHOD OF ESTIMATING INVENTORY 455

Computation of Gross Profit Percentage 456 Evaluation of Gross Profit Method 458 What Do the Numbers Mean? The Squeeze 458

RETAIL INVENTORY METHOD 458

Retail-Method Concepts 459 Retail Inventory Method with Markups and Markdowns—

Conventional Method 460 What Do the Numbers Mean? Price Fixing 463 Special Items Relating to Retail Method 463 Evaluation of Retail Inventory Method 464

PRESENTATION AND ANALYSIS 464

Presentation of Inventories 464 Analysis of Inventories 465

APPENDIX 9A: LIFO RETAIL METHODS 466

STABLE PRICES—LIFO RETAIL METHOD 466

FLUCTUATING PRICES—DOLLAR-VALUE LIFO RETAIL METHOD 467

SUBSEQUENT ADJUSTMENTS UNDER DOLLAR-VALUE LIFO RETAIL 469

CHANGING FROM CONVENTIONAL RETAIL TO LIFO 470

FASB CODIFICATION 493

IFRS INSIGHTS 494

10 Acquisition and Disposition of Property, Plant, and Equipment 502

WATCH YOUR SPENDING 502

PROPERTY, PLANT, AND EQUIPMENT 504

Acquisition of Property, Plant, and Equipment 504 Self-Constructed Assets 506 Interest Costs During Construction 507 What Do the Numbers Mean? What’s in Your

Interest? 512 Observations 513

VALUATION OF PROPERTY, PLANT, AND EQUIPMENT 513

Cash Discounts 513 Deferred-Payment Contracts 513 Lump-Sum Purchases 514 Issuance of Stock 515 Exchanges of Nonmonetary Assets 516 What Do the Numbers Mean? About Those Swaps 521 Accounting for Contributions 521 Other Asset Valuation Methods 522

COSTS SUBSEQUENT TO ACQUISITION 522

What Do the Numbers Mean? Disconnected 523 Additions 524 Improvements and Replacements 524 Rearrangement and Reinstallation 525 Repairs 525 Summary of Costs Subsequent to Acquisition 526

DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT 526

Sale of Plant Assets 526 Involuntary Conversion 527 Miscellaneous Problems 527

FASB CODIFICATION 550

11 Depreciation, Impairments, and Depletion 552

HERE COME THE WRITE-OFFS 552

DEPRECIATION—A METHOD OF COST ALLOCATION 554

Factors Involved in the Depreciation Process 554 What Do the Numbers Mean? Alphabet Dupe 556 Methods of Depreciation 556

SPECIAL DEPRECIATION METHODS AND OTHER ISSUES 559

xiv

Special Depreciation Methods 559 What Do the Numbers Mean? Decelerating

Depreciation 561 Other Depreciation Issues 562 What Do the Numbers Mean? Depreciation Choices 565

IMPAIRMENTS 565

Recognizing Impairments 565 Measuring Impairments 566 Restoration of Impairment Loss 567 Impairment of Assets to Be Disposed Of 567

DEPLETION 568

Establishing a Depletion Base 569 Write-Off of Resource Cost 570 Estimating Recoverable Reserves 571 What Do the Numbers Mean? Reserve Surprise 571 Liquidating Dividends 571 Continuing Controversy 572 Evolving Issue Full-Cost or Successful-Efforts? 573

PRESENTATION AND ANALYSIS 573

Presentation of Property, Plant, Equipment, and Natural Resources 573

Analysis of Property, Plant, and Equipment 575

APPENDIX 11A: INCOME TAX DEPRECIATION 576

MODIFIED ACCELERATED COST RECOVERY SYSTEM 577

Tax Lives (Recovery Periods) 577 Tax Depreciation Methods 577 Example of MACRS 578

OPTIONAL STRAIGHT-LINE METHOD 579

TAX VERSUS BOOK DEPRECIATION 579

FASB CODIFICATION 600

IFRS INSIGHTS 601

12 Intangible Assets 610 IS THIS SUSTAINABLE? 610

INTANGIBLE ASSET ISSUES 612

Characteristics 612 Valuation 612 Amortization of Intangibles 613 What Do the Numbers Mean? Are All Brands the

Same? 614

TYPES OF INTANGIBLE ASSETS 614

Marketing-Related Intangible Assets 615 What Do the Numbers Mean? Keep Your Hands

Off My Intangible! 615 Customer-Related Intangible Assets 616 Artistic-Related Intangible Assets 616 Contract-Related Intangible Assets 617 Technology-Related Intangible Assets 617 What Do the Numbers Mean? Patent Battles 618

What Do the Numbers Mean? The Value of a Secret Formula 619

Goodwill 619

IMPAIRMENT AND PRESENTATION OF INTANGIBLE ASSETS 622

Impairment of Limited-Life Intangibles 623 Impairment of Indefinite-Life Intangibles Other Than

Goodwill 623 Impairment of Goodwill 624 Impairment Summary 625 What Do the Numbers Mean? Impairment Risk 625 Presentation of Intangible Assets 626

RESEARCH AND DEVELOPMENT COSTS 628

Identifying R&D Activities 628 Accounting for R&D Activities 629 What Do the Numbers Mean? Global R&D

Incentives 629 Costs Similar to R&D Costs 631 What Do the Numbers Mean? Branded 632 Presentation of Research and Development Costs 633 Evolving Issue Recognition of R&D and Internally

Generated Intangibles 634

FASB CODIFICATION 650

IFRS INSIGHTS 652

13 Current Liabilities and Contingencies 658

NOW YOU SEE IT, NOW YOU DON’T 658

CURRENT LIABILITIES 660

Accounts Payable 661 Notes Payable 661 Dividends Payable 663 Customer Advances and Deposits 663 Unearned Revenues 663 What Do the Numbers Mean? Microsoft’s Liabilities—

Good or Bad? 664 Sales Taxes Payable 665 Income Taxes Payable 665 Employee-Related Liabilities 666 Current Maturities of Long-Term Debt 671 Short-Term Obligations Expected to Be Refinanced 671 What Do the Numbers Mean? What About That Short-

Term Debt? 673

CONTINGENCIES 673

Gain Contingencies 673 Loss Contingencies 674 What Do the Numbers Mean? Frequent Flyers 680 Evolving Issue Greenhouse Gases: Let’s Be Standard-

Setters 682 What Do the Numbers Mean? More Disclosure,

Please 684

xv

PRESENTATION AND ANALYSIS 684

Presentation of Current Liabilities 684 Presentation of Contingencies 686 Analysis of Current Liabilities 687 What Do the Numbers Mean? I’ll Pay You Later 688

FASB CODIFICATION 708

IFRS INSIGHTS 710

14 Long-Term Liabilities 718 GOING LONG 718

BONDS PAYABLE 720

Issuing Bonds 720 Types of Bonds 720 What Do the Numbers Mean? All About Bonds 721 Valuation and Accounting for Bonds Payable 722 What Do the Numbers Mean? How’s My Rating? 723 Extinguishment of Debt 730 What Do the Numbers Mean? Your Debt Is Killing My

Equity 731

LONG-TERM NOTES PAYABLE 731

Notes Issued at Face Value 732 Notes Not Issued at Face Value 732 Special Notes Payable Situations 734 Mortgage Notes Payable 737 Fair Value Option 737 What Do the Numbers Mean? Fair Value

Fun House 738

REPORTING AND ANALYZING LIABILITIES 739

Off-Balance-Sheet Financing 739 What Do the Numbers Mean? Obligated 741 Presentation and Analysis of Long-Term Debt 741

APPENDIX 14A: TROUBLED-DEBT RESTRUCTURING 743

SETTLEMENT OF DEBT 744

Transfer of Assets 744 Granting of Equity Interest 745

MODIFICATION OF TERMS 745

Example 1—No Gain for Debtor 746 Example 2—Gain for Debtor 748

CONCLUDING REMARKS 749

FASB CODIFICATION 767

IFRS INSIGHTS 768

15 Stockholders’ Equity 774 IT’S A GLOBAL MARKET 774

CORPORATE CAPITAL 776

Corporate Form 776 What Do the Numbers Mean? 1209 North Orange

Street 776

Components of Stockholders’ Equity 778 Issuance of Stock 779 What Do the Numbers Mean? The Case of the

Disappearing Receivable 783 Preferred Stock 783 What Do the Numbers Mean?

A Class (B) Act 785

REACQUISITION OF SHARES 786

What Do the Numbers Mean? Buybacks—Good or Bad? 787

Purchase of Treasury Stock 788 Sale of Treasury Stock 789 Retiring Treasury Stock 790

DIVIDEND POLICY 791

Financial Condition and Dividend Distributions 791 Types of Dividends 792 Stock Dividends and Stock Splits 795 What Do the Numbers Mean? Splitsville 798 What Do the Numbers Mean? Dividends Up, Dividends

Down 800

PRESENTATION AND ANALYSIS OF STOCKHOLDERS' EQUITY 800

Presentation 800 Analysis 802

APPENDIX 15A: DIVIDEND PREFERENCES AND BOOK VALUE PER SHARE 804

DIVIDEND PREFERENCES 804

BOOK VALUE PER SHARE 805

FASB CODIFICATION 826

IFRS INSIGHTS 827

16 Dilutive Securities and Earnings per Share 834

KICKING THE HABIT 834

DILUTIVE SECURITIES 836

Debt and Equity 836 Accounting for Convertible Debt 836 Convertible Preferred Stock 838 What Do the Numbers Mean? How Low Can

You Go? 839

STOCK WARRANTS 839

Stock Warrants Issued with Other Securities 840 Rights to Subscribe to Additional Shares 842 Evolving Issue Is That All Debt? 842

STOCK COMPENSATION PLANS 843

Measurement—Stock Compensation 844 What Do the Numbers Mean? What's the Debate

About? 845 Recognition—Stock Compensation 846 Restricted Stock 847

xvi

Employee Stock-Purchase Plans 849 Disclosure of Compensation Plans 849

BASIC EARNINGS PER SHARE 851

Earnings per Share—Simple Capital Structure 851 Comprehensive Example 854

DILUTED EARNINGS PER SHARE 855

Diluted EPS—Convertible Securities 856 Diluted EPS—Options and Warrants 858 Contingent Issue Agreement 859 Antidilution Revisited 859 EPS Presentation and Disclosure 860 What Do the Numbers Mean? Pro Forma EPS

Confusion 861 Summary of EPS Computation 862

APPENDIX 16A: ACCOUNTING FOR STOCK-APPRECIATION RIGHTS 863

SARS—SHARE-BASED EQUITY AWARDS 864

SARS—SHARE-BASED LIABILITY AWARDS 864

STOCK-APPRECIATION RIGHTS EXAMPLE 865

APPENDIX 16B: COMPREHENSIVE EARNINGS PER SHARE EXAMPLE 866

DILUTED EARNINGS PER SHARE 867

FASB CODIFICATION 889

IFRS INSIGHTS 890

17 Investments 898 WHAT TO DO? 898

INVESTMENTS IN DEBT SECURITIES 900

Debt Investment Classifications 900 Held-to-Maturity Securities 901 Available-for-Sale Securities 903 Trading Securities 907 What Do the Numbers Mean? To Have

and To Hold 908

INVESTMENTS IN EQUITY SECURITIES 908

Holdings of Less Than 20% 909 What Do the Numbers Mean? More Disclosure,

Please 912 Holdings Between 20% and 50% 912 Holdings of More Than 50% 914 What Do the Numbers Mean? Who’s in Control

Here? 914

OTHER FINANCIAL REPORTING ISSUES 915

Fair Value Option 915 Evolving Issue Fair Value Controversy 916 Impairment of Value 916 Reclassification Adjustments 918 Transfers Related to Debt Securities 921 Summary of Reporting Treatment of Securities 922

What Do The Numbers Mean? So You Think It Is Easy! 923

APPENDIX 17A: ACCOUNTING FOR DERIVATIVE INSTRUMENTS 923

DEFINING DERIVATIVES 924

WHO USES DERIVATIVES, AND WHY? 924

Producers and Consumers 924 Speculators and Arbitrageurs 925

BASIC PRINCIPLES IN ACCOUNTING FOR DERIVATIVES 926

Example of Derivative Financial Instrument— Speculation 926

Differences Between Traditional and Derivative Financial Instruments 929

DERIVATIVES USED FOR HEDGING 929

What Do the Numbers Mean? Risky Business 930 Fair Value Hedge 930 Cash Flow Hedge 932

OTHER REPORTING ISSUES 934

Embedded Derivatives 934 Qualifying Hedge Criteria 935 Summary of Derivatives Accounting 936

COMPREHENSIVE HEDGE ACCOUNTING EXAMPLE 937

Fair Value Hedge 937 Financial Statement Presentation of an Interest Rate

Swap 939

CONTROVERSY AND CONCLUDING REMARKS 940

APPENDIX 17B: FAIR VALUE DISCLOSURES 941

DISCLOSURE OF FAIR VALUE INFORMATION: FINANCIAL INSTRUMENTS 941

DISCLOSURE OF FAIR VALUES: IMPAIRED ASSETS OR LIABILITIES 944

CONCLUSION 944

FASB CODIFICATION 965

IFRS INSIGHTS 966

18 Revenue Recognition 978 IT’S BACK 978

FUNDAMENTALS OF REVENUE RECOGNITION 980

Background 980 New Revenue Recognition Standard 980 Overview of the Five-Step Process—Boeing

Example 981 Extended Example of the Five-Step Process:

BEAN 982

THE FIVE-STEP PROCESS REVISITED 986

Identifying the Contract with Customers—Step 1 986 Identifying Separate Performance Obligations—

Step 2 987

xvii

Determining the Transaction Price—Step 3 988 Allocating the Transaction Price to Separate Performance

Obligations—Step 4 992 Recognizing Revenue When (or as) Each Performance

Obligation Is Satisfied—Step 5 994 Summary 995

ACCOUNTING FOR REVENUE RECOGNITION ISSUES 996

Sales Returns and Allowances 996 Repurchase Agreements 999 Bill-and-Hold Arrangements 1001 Principal-Agent Relationships 1001 Consignments 1002 What Do the Numbers Mean? Grossed Out 1004 Warranties 1004 Nonrefundable Upfront Fees 1006 Summary 1006

PRESENTATION AND DISCLOSURE 1007

Presentation 1007 Disclosure 1011 Evolving Issue Revenue: “It’s Like An

Octopus” 1012

APPENDIX 18A: LONG-TERM CONSTRUCTION CONTRACTS 1013

REVENUE RECOGNITION OVER TIME 1013

Percentage-of-Completion Method 1014 Completed-Contract Method 1019 Long-Term Contract Losses 1020

APPENDIX 18B: REVENUE RECOGNITION FOR FRANCHISES 1023

FRANCHISE ACCOUNTING 1024

RECOGNITION OF FRANCHISE RIGHTS REVENUE OVER TIME 1026

FASB CODIFICATION 1050

19 Accounting for Income Taxes 1052

HEY–LET’S PAY MORE INCOME TAXES! 1052

FUNDAMENTALS OF ACCOUNTING FOR INCOME TAXES 1054

Future Taxable Amounts and Deferred Taxes 1055 What Do the Numbers Mean?

“Real Liabilities” 1059 Future Deductible Amounts and

Deferred Taxes 1059 What Do the Numbers Mean? “Real Assets” 1062 Deferred Tax Asset—Valuation Allowance 1063

ADDITIONAL CONSIDERATIONS 1064

Income Statement Presentation 1064

Specific Differences 1064 Tax Rate Considerations 1067 What Do the Numbers Mean? Global Tax Rates 1068

ACCOUNTING FOR NET OPERATING LOSSES 1069

Loss Carryback 1069 Loss Carryforward 1070 Loss Carryback Example 1070 Loss Carryforward Example 1071 What Do the Numbers Mean? NOLs:

Good News or Bad? 1075

FINANCIAL STATEMENT PRESENTATION 1076

Balance Sheet 1076 Note Disclosure 1076 What Do the Numbers Mean? Imagination at Work 1077 Income Statement 1078 Evolving Issue Uncertain Tax Positions 1081 The Asset-Liability Method 1081

APPENDIX 19A: COMPREHENSIVE EXAMPLE OF INTERPERIOD TAX ALLOCATION 1083

FIRST YEAR—2016 1083

Taxable Income and Income Taxes Payable—2016 1084

Computing Deferred Income Taxes— End of 2016 1085

Deferred Tax Expense (Benefit) and the Journal Entry to Record Income Taxes—2016 1086

Financial Statement Presentation—2016 1086

SECOND YEAR—2017 1087

Taxable Income and Income Taxes Payable—2017 1088

Computing Deferred Income Taxes—End of 2017 1088 Deferred Tax Expense (Benefit) and the Journal Entry to

Record Income Taxes—2017 1089 Financial Statement Presentation—2017 1089

FASB CODIFICATION 1109

IFRS INSIGHTS 1110

20 Accounting for Pensions and Postretirement Benefits 1116

WHERE HAVE ALL THE PENSIONS GONE? 1116

FUNDAMENTALS OF PENSION PLAN ACCOUNTING 1118

Defined Contribution Plan 1119 Defined Benefit Plan 1119 What Do the Numbers Mean? Which Plan

Is Right for You? 1120 The Role of Actuaries in Pension Accounting 1121 Measures of the Liability 1121 What Do the Numbers Mean? Roller Coaster 1123 Components of Pension Expense 1123

xviii

USING A PENSION WORKSHEET 1126

2017 Entries and Worksheet 1127 Funded Status 1128

PRIOR SERVICE COST (PSC) 1128

Amortization 1128 2018 Entries and Worksheet 1130

GAINS AND LOSSES 1131

Smoothing Unexpected Gains and Losses on Plan Assets 1131

What Do the Numbers Mean? Pension Costs Ups and Downs 1132

Smoothing Unexpected Gains and Losses on the Pension Liability 1132

Corridor Amortization 1133 Evolving Issue Bye Bye Corridor 1136 2019 Entries and Worksheet 1136

REPORTING PENSION PLANS IN FINANCIAL STATEMENTS 1138

Within the Financial Statements 1138 Within the Notes to the Financial Statements 1140 Example of Pension Note Disclosure 1142 2020 Entries and Worksheet—A Comprehensive

Example 1143 Special Issues 1144 What Do the Numbers Mean? Who Guarantees the

Guarantor? 1146 Concluding Observations 1148

APPENDIX 20A: ACCOUNTING FOR POSTRETIREMENT BENEFITS 1148

ACCOUNTING GUIDANCE 1148

DIFFERENCES BETWEEN PENSION BENEFITS AND HEALTHCARE BENEFITS 1149

What Do the Numbers Mean? OPEBs—How Big Are They? 1150

POSTRETIREMENT BENEFITS ACCOUNTING PROVISIONS 1150

Obligations Under Postretirement Benefits 1150 Postretirement Expense 1151

ILLUSTRATIVE ACCOUNTING ENTRIES 1152

2017 Entries and Worksheet 1152 Recognition of Gains and Losses 1153 2018 Entries and Worksheet 1154 Amortization of Net Gain or Loss in 2019 1155

DISCLOSURES IN NOTES TO THE FINANCIAL STATEMENTS 1155

ACTUARIAL ASSUMPTIONS AND CONCEPTUAL ISSUES 1157

What Do the Numbers Mean? Want Some Bad News? 1157

FASB CODIFICATION 1179

IFRS INSIGHTS 1180

21 Accounting for Leases 1194 MORE COMPANIES ASK, “WHY BUY?” 1194

THE LEASING ENVIRONMENT 1196

Who Are the Players? 1196 Advantages of Leasing 1198 What Do the Numbers Mean? Off-Balance-Sheet

Financing 1199 Conceptual Nature of a Lease 1199

ACCOUNTING BY THE LESSEE 1200

Capitalization Criteria 1201 Asset and Liability Accounted for Differently 1204 Capital Lease Method (Lessee) 1204 Operating Method (Lessee) 1207 What Do the Numbers Mean? Restatements on the

Menu 1207 Comparison of Capital Lease with Operating Lease 1208 Evolving Issue Are You Liable? 1209

ACCOUNTING BY THE LESSOR 1210

Economics of Leasing 1210 Classification of Leases by the Lessor 1211 Direct-Financing Method (Lessor) 1212 Operating Method (Lessor) 1215

SPECIAL LEASE ACCOUNTING PROBLEMS 1215

Residual Values 1216 What Do the Numbers Mean? Residual Value

Regret 1222 Sales-Type Leases (Lessor) 1222 What Do the Numbers Mean? Xerox

Takes on the SEC 1224 Bargain-Purchase Option (Lessee) 1225 Initial Direct Costs (Lessor) 1225 Current versus Noncurrent 1226 Disclosing Lease Data 1227 Unresolved Lease Accounting Problems 1228 Evolving Issue Lease Accounting—If It Quacks

Like a Duck 1230

APPENDIX 21A: SALE-LEASEBACKS 1231

DETERMINING ASSET USE 1231

Lessee 1232 Lessor 1232

SALE-LEASEBACK EXAMPLE 1232

FASB CODIFICATION 1254

IFRS INSIGHTS 1256

22 Accounting Changes and Error Analysis 1266

IN THE DARK 1266

ACCOUNTING CHANGES 1268

xix

Background 1268 Changes in Accounting Principle 1268 What Do the Numbers Mean? Quite a Change 1270 What Do the Numbers Mean? Change Management 1272 Impracticability 1280

OTHER ACCOUNTING CHANGES 1281

Changes in Accounting Estimates 1281 What Do the Numbers Mean? A Change for the

Better? 1283 Changes in Reporting Entity 1283

ACCOUNTING ERRORS 1284

What Do the Numbers Mean? Can I Get My Money Back? 1286

Example of Error Correction 1286 Summary of Accounting Changes and

Correction of Errors 1288 What Do the Numbers Mean? What’s Your

Motivation? 1289

ERROR ANALYSIS 1290

Balance Sheet Errors 1291 Income Statement Errors 1291 Balance Sheet and Income Statement Errors 1291 Comprehensive Example: Numerous Errors 1294 What Do the Numbers Mean? Guard the Financial

Statements! 1296 Preparation of Financial Statements with Error

Corrections 1297

APPENDIX 22A: CHANGING FROM OR TO THE EQUITY METHOD 1299

CHANGE FROM THE EQUITY METHOD 1299

Dividends in Excess of Earnings 1299

CHANGE TO THE EQUITY METHOD 1300

FASB CODIFICATION 1325

IFRS INSIGHTS 1326

23 Statement of Cash Flows 1330 SHOW ME THE MONEY! 1330

STATEMENT OF CASH FLOWS 1332

Usefulness of the Statement of Cash Flows 1332 Classification of Cash Flows 1333 What Do the Numbers Mean? How’s My

Cash Flow? 1334 Format of the Statement of Cash Flows 1335

PREPARING THE STATEMENT OF CASH FLOWS 1335

Illustrations—Tax Consultants Inc. 1336 What Do the Numbers Mean? Earnings and Cash Flow

Management? 1338 Sources of Information for the Statement of

Cash Flows 1346

Net Cash Flow from Operating Activities—Direct Method 1346

Evolving Issue Direct versus Indirect 1352

SPECIAL PROBLEMS IN STATEMENT PREPARATION 1353

Adjustments to Net Income 1353 Accounts Receivable (Net) 1356 What Do the Numbers Mean? Not What It Seems 1358 Other Working Capital Changes 1358 Net Losses 1359 Significant Noncash Transactions 1360 What Do the Numbers Mean? Better Than ROA? 1361

USE OF A WORKSHEET 1361

Preparation of the Worksheet 1362 Analysis of Transactions 1363 Preparation of Final Statement 1369

FASB CODIFICATION 1395

IFRS INSIGHTS 1396

24 Full Disclosure in Financial Reporting 1402

HIGH-QUALITY FINANCIAL REPORTING—ALWAYS IN FASHION 1402

FULL DISCLOSURE PRINCIPLE 1404

Increase in Reporting Requirements 1405 Differential Disclosure 1405 Evolving Issue Disclosure—Quantity and Quality 1406 Notes to the Financial Statements 1407 What Do the Numbers Mean? Footnote Secrets 1409

DISCLOSURE ISSUES 1409

Disclosure of Special Transactions or Events 1409 Post-Balance-Sheet Events (Subsequent Events) 1411 Reporting for Diversified (Conglomerate)

Companies 1413 Interim Reports 1417 Evolving Issue It’s Faster but Is It Better? 1423

AUDITOR’S AND MANAGEMENT’S REPORTS 1423

Auditor’s Report 1423 What Do the Numbers Mean? Heart of the Matter 1426 Management’s Reports 1427

CURRENT REPORTING ISSUES 1428

Reporting on Financial Forecasts and Projections 1428 What Do the Numbers Mean? Global Forecasts 1430 Internet Financial Reporting 1431 Fraudulent Financial Reporting 1432 What Do the Numbers Mean? Disclosure Overload 1434 Criteria for Making Accounting and Reporting

Choices 1435

APPENDIX 24A: BASIC FINANCIAL STATEMENT ANALYSIS 1435

xx

PERSPECTIVE ON FINANCIAL STATEMENT ANALYSIS 1436

RATIO ANALYSIS 1437

Limitations of Ratio Analysis 1437

COMPARATIVE ANALYSIS 1439

PERCENTAGE (COMMON-SIZE) ANALYSIS 1440

FASB CODIFICATION 1460

IFRS INSIGHTS 1461

APPENDIX A Private Company Accounting A-1

THE PRIVATE COMPANY COUNCIL (PCC) A-1

Background on the PCC A-1 Private Company Decision-Making Framework A-1 PCC Accomplishments A-2

PRIVATE COMPANY ALTERNATIVES FOR INTANGIBLE ASSETS AND GOODWILL A-2

Accounting for Identifiable Intangible Assets A-2 Accounting for Goodwill A-4

SUMMARY A-6

APPENDIX B Specimen Financial Statements: The Procter & Gamble Company B-1

APPENDIX C Specimen Financial Statements: The Coca-Cola Company C-1

APPENDIX D Specimen Financial Statements: PepsiCo, Inc. D-1

APPENDIX E Specimen Financial Statements: Marks and Spencer plc E-1

Index I-1

xxi

xxii

Intermediate Accounting has benefited greatly from the input of focus group participants, manuscript reviewers, those who have sent comments by letter or e-mail, ancillary authors, and proofers. We greatly appreciate the constructive suggestions and innovative ideas of reviewers and the creativity and accuracy of the ancillary authors and checkers.

Melissa Aldredge Northwestern State University Elsie Ameen Sam Houston State University Sean Andre York College of Pennsylvania Jack Armitage University of Nebraska—Omaha Avinash Arya William Paterson University Jane Baldwin Baylor University

Kristin Bauer Financial Accounting Standards Board

Robert Bloom John Carroll University George Boland Queen’s University Eric Bostwick University of West Florida Naat Briscoe Northwestern State University D. Jeffrey Brothers University of Denver Stephen Brown University of Maryland Deanna Burgess Florida Gulf Coast University Andy Call Arizona State University Chuck Campbell University of British Columbia Suzanne Cansler University of Connecticut Karen Castro-González University of Puerto Rico Kam Chan Pace University Paul Cheney Vanderbilt University Xiaoyan Cheng University of Nebraska—Omaha Dhiman Chowdhury Dhaka University

Ming Lu Chun Santa Monica College Hyeesoo Chung California State University—Long Beach Lamine Conteh Saint Leo University Kelvie Crabb University of Kansas Ken Dalton University of Nevada—Las Vegas Robert Davis Canisius College Julie Dawson Carthage College Passard Dean Saint Leo University Alex Debbink Ernst & Young Andrew DeJoseph Nassau Community College Kristine Del Vecchio University of South Florida Shawna Denny Lipscomb University Mike Dugan Georgia Regents University Susetta Emery York College of Pennsylvania Cole Engel Fort Hays State University David Farber University of Texas at El Paso Barbara Farrell Pace University Linda Flaming Monmouth University Paul Foote California State University—Fullerton James Fuehrmeyer University of Notre Dame Kristen Fuhremann University of Wisconsin—Madison Pam Graybeal University of Central Florida

Tony Greig University of Wisconsin—Madison Elaine Guenthner Northern Kentucky University Amy Haas Kingsborough Community College Lizhong Hao California State University—Fresno John Hassell Kelley School of Business—Indianapolis Pamela Hillman Gateway Technical College Ken House Belmont University Pei-Hui Hsu California State University—East Bay Allen Hunt Western Kentucky University Kim Hurt Central Community College Dave Hurtt Baylor University Anthony Hurwitz UCLA Extension Christine Irujo Westfi eld State University Emil Jirik Gustavus Adolphus College Joseph Johnson University of Central Florida

Burch Kealey University of Nebraska—Omaha Marsha Keune University of Dayton Kate Konetzke PricewaterhouseCoopers Lisa Koonce University of Texas Lee Krueger UCLA Extension David Krug Johnson County Community College Jeffrey Kunz Carroll University

Acknowledgments

Prior Edition Reviewers We greatly appreciate the over 300 reviewers who have assisted with the prior editions of Intermediate Accounting. These instructors have been invaluable in the development and continued improvement of our textbook.

Sixteenth Edition

xxiii

Melissa Larson Brigham Young University Cynthia Lovick Austin Community College Daphne Main Loyola University New Orleans Leslie Mandel Fairleigh Dickinson University Anthony Masino East Tennessee State University Katie Maxwell University of Arizona Gerald Miller College of New Jersey Sally Mitzel Sheridan College Michael Motes University of Maryland University College

John Naegle University of Kansas R.D. Nair University of Wisconsin—Madison Sia Nassiripour William Paterson University Randy Nicholls Red Deer College Curt Norton Arizona State University Derek Oler Texas Tech University Steve Orpurt Arizona State University Alison Parker Camosun College Glenn Pate Palm Beach State College Denise Patterson California State University—Fresno Milo Peck Fairfi eld University Charles Pendola St Joseph’s University (NYC) Alee Phillips University of Kansas Catherine Plante University of New Hampshire Martha Pointer East Tennessee State University Theresa Presley Kansas State University Mark Riley Northern Illinois University Tracey Riley Suffolk University Francisco Roman George Mason University Eric Rothenburg Kingsborough Community College Martin Rudnick William Paterson University Mike Ruff Bentley College August Saibeni Los Rios Community College

Arpita Shroff Texas A&M University—Corpus Christi Tom Skogland Deloitte

Douglas Smith University of Montevallo Larry Stephens Austin Community College Ronald Stoltzfus Eastern Mennonite University Dan Teed Troy University

Walter Teets Gonzaga University

Tom Tierney University of Wisconsin—Madison John Valenzuela California State University—Long Beach Troy Vornholt Oglethorpe University Kat Walden Southern New Hampshire University Patricia Walters Texas Christian University Larry Walther Utah State University Suzanne Wright Pennsylvania State University Jialin Yin University of Wisconsin—Madison Brian York PricewaterhouseCoopers

Steve Zeff Rice University Mary Zenner College of Lake County Haiwen Zhang Ohio State University Special thanks to Kurt Pany, Arizona State University, for his input on auditor disclo- sure issues, and to Stephen A. Zeff, Rice University, for his comments on international accounting.

In addition, we thank the following colleagues who contributed to several of the unique features of this edition.

Codification Cases Katie Adler Deloitte LLP, Chicago Jack Cathey University of North Carolina—Charlotte Erik Frederickson Madison, Wisconsin Danielle Griffin KPMG, Chicago Jason Hart Deloitte LLP, Milwaukee Frank Heflin Florida State University Mike Katte SC Johnson, Racine, WI

Kelly Krieg Ernst & Young, Milwaukee Jeremy Kunicki Walgreens Courtney Meier Deloitte LLP, Milwaukee Andrew Prewitt KPMG, Chicago Jeff Seymour KPMG, Minneapolis Matt Sullivan Northwestern Mutual Matt Tutaj Deloitte LLP, Chicago Jen Vaughn PricewaterhouseCoopers, Chicago Erin Viel PricewaterhouseCoopers, Milwaukee

Ancillary Authors, Contributors, Proofers, and Accuracy Checkers Ellen Bartely St. Joseph’s University (NYC) LuAnn Bean Florida Institute of Technology Jack Borke University of Wisconsin—Platteville Melodi Bunting Edgewood College Bea Chiang The College of New Jersey Susetta Emery York College of Pennsylvania Jim Emig Villanova University Larry Falcetto Emporia State University Kim Hurt Central Community College Derek Jackson St. Mary’s University of Minnesota Mark Kohlbeck Florida Atlantic University Cynthia Lovick Austin Community College Kirk Lynch Sandhills Community College Anthony Masino East Tennessee University Jill Misuraca University of Tampa Barb Muller Arizona State University Alison Parker Camosun College Yvonne Phang Borough of Manhattan Community College Laura Prosser Blackhills State University Mark Riley Northern Illinois University

Alice Sineath University of Maryland University College Lynn Stallworth Appalachian State University Sheila Viel University of Wisconsin—Milwaukee Dick Wasson Southwestern College Suzanne Wright Pennsylvania State University Lori Zaher Bucks County Community College

Advisory Board We gratefully acknowledge the following members of the Intermediate Accounting Advisory Board for their advice and assis- tance with this edition. Barbara Durham University of Central Florida Pamela Graybeal University of Central Florida Jeffery Hales Georgia Institute of Technology Melissa Larson Brigham Young University—Provo

Ming Lu Santa Monica College Linda Matuszewski Northern Illinois University Kevin Rich Marquette University Angela Spencer Oklahoma State University—Stillwater

Practicing Accountants and Business Executives From the fields of corporate and public accounting, we owe thanks to the following practitioners for their technical advice and for consenting to interviews. Mike Crooch FASB (retired) Tracy Golden Deloitte LLP John Gribble PricewaterhouseCoopers (retired) Darien Griffin S.C. Johnson & Son

Michael Lehman Sun Microsystems, Inc. Tom Linsmeier FASB Michele Lippert Evoke.com Sue McGrath Vision Capital Management David Miniken Sweeney Conrad Robert Sack University of Virginia Clare Schulte Deloitte LLP Willie Sutton Mutual Community Savings Bank, Durham, NC Lynn Turner former SEC Chief Accountant Rachel Woods PricewaterhouseCoopers Arthur Wyatt Arthur Andersen & Co., and the University of Illinois—Urbana

Finally, we appreciate the exemplary support and professional com- mitment given us by the development, marketing, production, and editorial staffs of John Wiley & Sons, including the following: George Hoffman, Michael McDonald, Emily McGee, Rebecca Costantini, Valerie Vargas, Allie Morris, Greg Chaput, Harry Nolan, and Maureen Eide. Thanks, too, to Jackie Henry and the staff at Aptara®, Inc. for their work on the textbook, and the staff at SPI Global for their work on the solutions manual.

We also appreciate the cooperation of the American Institute of Certified Public Accountants and the Financial Accounting Standards Board in permitting us to quote from their pronouncements. We also acknowledge permission from the American Institute of Certified

Public Accountants, the Institute of Management Accountants, and the Institute of Internal Auditors to adapt and use material from the Uniform CPA Examinations, the CMA Examinations, and the CIA Examinations, respectively.

Suggestions and comments from users of this book will be appreciated. Please feel free to e-mail any one of us at AccountingAuthors@yahoo.com.

Donald E. Kieso Jerry J. Weygandt Terry D. Warfield Somonauk, Illinois Madison, Wisconsin Madison, Wisconsin

xxiv

WE CAN DO BETTER A recent report says it best: “Accounting information is central to the functioning of international capital mar- kets and to managing small businesses, conducting effective government, understanding business processes, and . . . how economic decisions are made. . . . Across the globe, a common characteristic of economies that flourish is the presence of reliable accounting information.”

Many in the United States take pride in our system of financial reporting as being the most robust and transparent in the world. But most would also comment that we can do better, particularly in light of the many accounting scandals that have occurred at companies like AIG, WorldCom, and Lehman Brothers, and the financial crisis of 2008.

To better understand where we are today, the Center for Audit Quality conducts a yearly survey that measures investor confidence in such categories as U.S. capital markets, audited financial information, and U.S. publicly traded companies. As shown in the chart on the right, the results indicate that the 2008 financial crisis took a bite out of investor confidence. While investor confidence in U.S. markets has stabi- lized, it has not returned to pre-crisis levels. So the question is, how can we improve? Here are some possibilities on how we can enhance the existing system of financial reporting.

1. Today, equity securities are broadly held, with approxi- mately half of American households investing in stocks. This presents a challenge—investors have expressed con- cerns that one-size-fi ts-all fi nancial reports do not meet the needs of the spectrum of investors who rely on those reports. While many individual investors are more interested in summarized, plain-English reports, mar- ket analysts and other investment professionals may desire information at a far more detailed level than is currently provided. Technology may help customize the information that the different types of investors desire.

2. Companies also express concerns with the complexity of the fi nancial reporting system. Companies assert that when preparing fi nancial reports, it is diffi cult to ensure compliance with the voluminous and com- plex requirements contained in U.S. GAAP and SEC reporting rules. This is a particularly heavy burden on smaller, non-public companies, which may have fewer resources to comply with the wide range of rules.

3. We also need to consider the broader array of information that investors need to make informed decisions. As some have noted, the percentage of a company’s market value that can be attributed to accounting book value has declined signifi cantly from the days of a bricks-and-mortar economy. Thus, we may want to

1 1 Understand the financial reporting

environment.

2 Identify the major policy-setting bodies and their role in the standard-setting process.

3 Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP.

4 Describe major challenges in the financial reporting environment.

Financial Accounting and Accounting Standards LEARNING OBJECTIVES After studying this chapter, you should be able to:

40

0

50

60

70

80

90%

2007 2008 2009 2010 2011 2012 2013 2014 2015

Confidence in Capital Markets

3

consider a more comprehensive business reporting model, including both fi nancial and nonfi nan- cial key performance indicators.

4. Finally, we must also consider how to deliver all of this information in a timelier manner. In a world where messages can be sent across the world in a blink of an eye, it is ironic that the analysis of fi nancial information is still subject to many manual processes, resulting in delays, increased costs, and errors.

Thus, improving financial reporting involves more than simply trimming or reworking the existing accounting literature. In some cases, major change is already underway. For example:

• The FASB and IASB are working on a convergence project, which will contribute to less-complex, more- understandable standards in the important areas of revenue recognition, leasing, and financial instruments.

• Standard-setters are exploring expanded reporting of key performance indicators, including reports on sustain- ability and a disclosure framework project to improve the effectiveness of disclosures to clearly communicate the information that is most important to users of financial statements. This project, combined with the intro- duction of a private-company reporting framework, could go a long way to address one-size-fits-all challenges.

• The SEC now requires the delivery of financial reports using eXtensible Business Reporting Language (XBRL). Reporting through XBRL allows timelier reporting via the Internet and allows statement users to transform accounting reports to meet their specific needs.

Each of these projects will hopefully support improvements in the quality of financial reporting and increase confidence in U.S. capital markets.

Sources: Adapted from The Pathways Commission, “Charting a National Strategy for the Next Generation of Accountants” (AAA, AICPA, July 2012); Conrad W. Hewitt, “Opening Remarks Before the Initial Meeting of the SEC Advisory Committee on Improvements to Financial Reporting,” U.S. Securities and Exchange Commission, Washington, D.C. (August 2, 2007); and Center for Audit Quality, Main Street Investor Survey (September 2015). See www.fasb.org for updates on FASB/IASB conver- gence, disclosure, and private company decision-making projects.

PREVIEW OF CHAPTER 1 As our opening story indicates, the U.S. system of financial reporting has long been the most robust and transparent in the world. However, to ensure that it continues to provide the most relevant and reliable financial information to users, a number of financial reporting issues must be resolved. These issues include such matters as evalu- ating global standards, increasing fair value reporting, and meeting multiple user needs. This chap- ter explains the environment of financial reporting and the many factors affecting it, as follows.

FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS

This chapter also includes numerous conceptual and international discussions that are integral to the topics presented here.

FINANCIAL REPORTING ENVIRONMENT

• Accounting and capital allocation

• Objective of financial reporting

• Need to develop standards

PARTIES INVOLVED IN STANDARD-SETTING

• Securities and Exchange Commission

• American Institute of CPAs

• Financial Accounting Standards Board

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

• FASB Codification

MAJOR CHALLENGES IN FINANCIAL REPORTING

• Political environment • Expectations gap • Financial reporting issues • International accounting

standards • Ethics

REVIEW AND PRACTICE Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary review and practice problem with solution. Multiple-choice questions with annotated solutions as well as additional exercises and practice problem with solutions are also available online.