Financial accounting: in an economic context

Fifth Edition

FINANCIAL ACCOUNTING

In an Economic Context

JAMIE PRATT

Professor of Accounting

Chair, Department o f Accounting and Information Systems

Kelley School o f Business

Indiana University

John W iley & S ons, Inc.

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Brief Contents

Part 1

Part 2

Part 3

Part 4

Part 5

Appendices

An Overview of Financial Accounting 1

1 Financial Accounting and Its Economic Context 2

2 The Financial Statements 33

M easurement, Mechanics, and Use of Financial Statem ents 71

3 The M easurem ent Fundam entals of Financial Accounting 72

4 The M echanics o f Financial Accounting 103

5 Using Financial Statement Information 179

Assets: A Closer Look 235

6 The Current Asset Classification, Cash, and Accounts Receivable 236

7 M erchandise Inventory 284

8 Investments in Equity Securities 323

9 Long-Lived Assets 369

Liabilities and Stockholders' Equity: A Closer Look 415

10 Introduction to Liabilities: Economic Consequences,

C urrent Liabilities, and Contingencies 416

11 Long-Term Liabilities: Notes. Bonds, and Leases 461

12 Stockholders’ Equity 513

Income and Cash Flows 565

13 The Com plete Income Statement 566

14 The Statem ent of Cash Flows 606

A W al-Mart Inc. 2001 Annual Report 663

B The Time Value of Money 688

C Quality of Earnings Cases: A Com prehensive Review 711

Glossary 744

Subject Index 770

Company Index 780 Số hóa bởi Trung tâm Học liệu – ĐH TN http://www.lrc-tnu.edu.vn

Contents

X

PART 1: AN OVERVIEW OF FINANCIAL ACCOUNTING 1

1 Financial Accounting and Its Economic Context 2

Financial Reporting and Investment Decisions 3

Economic Consequences 4 User Orientation 4

The Demand for Financial Information: A User’s Orientation 5

Consumption and Investment 5 Where to Invest? 5 The Demand for Documentation 6

The Demand for an Independent Audit 6 Martin and the CPA: Different Incentives 6 The

Auditor's Report, the Management Letter, and the Financial Statements 7 Descriptions of

Financial Statements 11 Analysis of Financial Statements 12 What Form of Investment:

Debt or Equity? 12 A Decision Is Made, but Important Questions Still Remain 14

The Environment of Financial Accounting 14

Financial Accounting Information: More Than the Financial Statements 15 Providers of

Capital: Investors and Creditors 16 Companies (Managers) 17 Independent Auditors 18

Relationships Among Capital Providers, Management and the Independent Auditor 19

Legal Liability 20 Ethics and Professional Reputation 20

Economic Consequences: Management’s Perspective 21

Generally Accepted Accounting Principles 22

The Securities and Exchange Commission 23 The Role of the Accounting Profession 23

The Financial Accounting Standards Board 23 Accounting Standard Setting: A Political

Process 23 Reactions to Economic Consequences: Lobbying Accounting Numbers 24

International Perspective: Accounting Practices and Standards Throughout

the World 25

Different Accounting Systems 25 International Accounting Standard Setting 26

iv

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Contents v

2 The Financial Statem ents 33

Businesses Are Like Fruit Trees 34

The Classified Balance Sheet 36

A Photograph of Financial Condition 36 Balance Sheet Classifications 36 Assets 38

Liabilities 42 Stockholders’ Equity 43

The Income Statement 45

Operating Revenues 45 Operating Expenses 46 Other Revenues and Expenses 46

The Statement of Retained Earnings 47

The Statement of Cash Flows 48

Cash Flows from Operating Activities 48 Cash Flows from Investing Activities 50 Cash

Flows from Financing Activities 50

Relationships Among the Financial Statements 50

International Perspective: Financial Statements and Analyses in Other Countries 52

PART 2: MEASUREMENT, MECHANICS, AND USE

OF FINANCIAL STATEMENTS 71

3 The M easurem ent Fundam entals of Financial Accounting 72

Assumptions of Financial Accounting 73

Economic Entity Assumption 73 Fiscal Period Assumption 74 Going Concern

Assumption 75 Stable Dollar Assumption 75 Summary of Basic Assumptions 77

Valuations on the Balance Sheet 77

Four Valuation Bases 78 Valuation Bases Used on the Balance Sheet 79

The Principles of Financial Accounting Measurement 81

The Principle of Objectivity 81 The Principles of Matching and Revenue Recognition 83

The Principle of Consistency 85

Two Exceptions to the Basic Principles: Materiality and Conservatism 86

Materiality 87 Conservatism 88

International Perspective: An Extreme Form of Conservatism That Encourages Income

Manipulation 88

4 The Mechanics of Financial Accounting 103

Economic Events 104

Relevant Events 104 Objectivity 104

The Fundamental Accounting Equation 105

Assets 105 Liabilities 106 Stockholders’ Equity 106

Business Transactions, the Accounting Equation, and the Financial Statements 106

Transactions and the Accounting Equation 107 The Accounting Equation and the Financial

Statements 108

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v i Contents

The Journal Entry 112

Recognizing Gains and Losses 118

Periodic Adjustments 119

Accruals 119 Deferrals 122 Revaluation Adjustments 128

Financial Statement Presentation in a Multinational Environment 129

Appendix 4A

The Accounting Cycle— An Overview 130

The Journal 132 The Ledgers 133 The Work Sheet 134 Preparation of the Financial

Statements 140

A Comprehensive Example of the Accounting Cycle 141

Appendix 4B

Mechanics—A User’s Perspective 146

5 Using Financial Statem ent Inform ation 179

Control and Prediction 180

Financial Accounting Numbers and Management Control 180 Financial Accounting

Numbers as Prediction Aids 181

Framework for Using Financial Statements to Predict Future Earnings and Cash

Flows 182

Business Environment 182 Unrecorded Events 183 Management Bias 183

Elements of Financial Statement Analysis 184

Assessing the Business Environment 184

Reading and Studying the Financial Statements and Footnotes 185

The Audit Report 185 Significant Transactions 186 Financial Statements and

Footnotes 186

Assessing Earnings Quality 187

Overstating Operating Performance 187 Taking a Bath 187 Creating Hidden

Reserves 187 Employing Off-Balance-Sheet Financing 188 Earnings Quality and

Unrecorded Events 188

Analyzing the Financial Statements 189

Comparisons Across Time 189 Comparison Within the Industry 190 Comparisons Within

the Financial Statements: Common-Size Statements and Ratio Analysis 190

Predict Future Earnings and/or Cash Flow 197

Annual Report Information and Predicting Stock Prices 197

International Perspective: Financial Statement Analysis in an International Setting 198

Appendix 5A

Financial Ratio (Dupont) and Cash Flow Analysis 199

Analyzing Financial Ratios 199

Example of Ratio Analysis: Wal-Mart vs. Kmart 201

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Contents v ii

Cash Flow Analysis 201

Cash Flow Profiles 204

PART 3: ASSETS: A CLOSER LOOK 235

6 The Current Asset Classification, Cash, and Accounts Receivable 236

The Current Asset Classification 237

The Relative Size of Current Assets Across Industries 238 Measures Using Current Assets:

Working Capital, Current Ratio, and Quick Ratio 239 The Economic Consequences of

Working Capital, the Current Ratio, and the Quick Ratio 240 Limitations of the Current

Asset Classification 240

Cash 242

Restrictions on the Use of Cash 243 Proper Management of Cash 244 Control of

Cash 244

Accounts Receivable 245

Importance of Accounts Receivable 246 Net Realizable Value: The Valuation Base for

Accounts Receivable 247 Cash Discounts 248 The Allowance Method of Accounting for

Bad Debts (Uncollectibles) 250 Inaccurate Bad Debt Estimates 254 Accounting for Sales

Returns 256

Accounts Receivable from a User’s Perspective 257

When Should a Receivable Be Recorded? 257 Balance Sheet Valuation of Receivables 258

Appendix 6A

Accounting for Receivables and Payables Expressed in Foreign Currencies 261

Exchange Rates Among Currencies 261 Receivables and Payables Held in Other

Currencies 262

7 M erchandise Inventory 284

The Relative Size of Inventories 285

Accounting for Inventory: Four Important Issues 286

Acquiring Inventory: What Costs to Capitalize? 287

What Items or Units to Include? 287 What Costs to Attach? 289

Carrying Inventory: The Perpetual or Periodic Method? 291

Errors in the Inventory Count 293

Selling Inventory: Which Cost Flow Assumption? 295

Specific Identification 295 Three Inventory Cost Flow Assumptions: Averaging, FIFO, and

LIFO 296 Inventory Cost Flow Assumptions: Effects on the Financial Statements 298

Inventory Cost Flow Assumptions: Effects on Federal Income Taxes 299 Choosing an

Inventory Cost Flow Assumption: Trade-Offs 300

Ending Inventory: Applying the Lower-of-Cost-or-Market Rule 304

The Lower-of-Cost-or-Market Rule and Hidden Reserves 305

International Perspective: Japanese Business and Inventory Accounting 306

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viii Contents

8 Investm ents in Equity Securities 323

Equity Securities Classified as Current 324

The Existence of a Ready Market 325 The Intention to Convert: Another Area of

Subjectivity 326

Trading and Available-for-Sale Securities 326

Purchasing Trading and Available-for-Sale Securities 327 Declaration and Receipt of Cash

Dividends 327 Sale of Securities 328 Price Changes of Securities on Hand at the End of

the Accounting Period 328 Reclassifications and Permanent Market Value Declines 331

Mark-to-Market Accounting and Comprehensive Income 331

Long-Term Equity Investments 332

Accounting for Long-Term Equity Investments 332 The Cost Method 333 The Equity

Method 333 Some Cautions to Financial Statement Users About the Equity Method 336

Business Acquisitions, Mergers, and Consolidated Financial Statements 337 The Equity

Method or Consolidated Statements? 339 Accounting for Equity Investments: A

Summary 340

Goodwill Accounting: Controversy, Change, and International Implications 342

Appendix 8A

Consolidated Financial Statements 342

Accounting for Business Acquisitions and Mergers: The Purchase Method 343 Other Issues

Concerning Consolidated Financial Statements 346

9 Long-Lived Assets 369

The Relative Size of Long-Lived Assets 370

Long-Lived Asset Accounting: General Issues and Financial Statement Effects 371

An Overview of Long-Lived Asset Accounting 374

Acquisition: What Costs to Capitalize? 374

The Acquisition of Land 375 Lump-Sum Purchases 375 Construction of Long-Lived

Assets 377

Postacquisition Expenditures: Betterments or Maintenance? 377

Cost Allocation: Amortizing Capitalized Costs 379

Estimating the Useful Life and Salvage Value 379 Revising the Useful-Life Estimate 380

Cost Allocation (Depreciation) Methods 381 Cost Allocation Methods and the Matching

Principle 386 How Does Management Choose an Acceptable Cost Allocation Method? 386

Depreciation Methods for Income Tax Purposes 387

Disposal: Retirements, Sales, and Trade-Ins 389

Retirement of Long-Lived Assets 389 Sale of Long-Lived Assets 391 Trade-Ins of Long￾Lived Assets 391

International Perspective: Long-Lived Assets and Current Values 392

Appendix 9A

Intangible Assets and Deferred Costs 393

Copyrights, Patents, and Trademarks 394

The Costs of Developing Computer Software 394

Goodwill 395

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Contents ix

Organizational Costs 395

Research and Development Costs 396

PART 4: LIABILITIES AND STOCKHOLDERS' EQUITY: A CLOSER LOOK 415

10 Introduction to Liabilities: Economic Consequences, Current Liabilities, and

Contingencies 416

What Is A Liability? 417

The Relative Size of Liabilities on the Balance Sheet 418

Reporting Liabilities on the Balance Sheet: Economic Consequences 418

Stockholders and Investors 419 Creditors 419 Management 419 Auditors 420

Current Liabilities 421

The Relative Size of Current Liabilities on the Balance Sheet 421 Valuing Current

Liabilities on the Balance Sheet 422 Reporting Current Liabilities: An Economic

Consequence 422

Determinable Current Liabilities 423

Accounts Payable 424 Short-Term Debts 424 Dividends Payable 426 Unearned

Revenues 426 Third-Party Collections 427 Income Tax Liability 427 Incentive

Compensation 427 Incentive Compensation Using Stock Options 429

Contingencies and Contingent Liabilities 430

Contingent Liabilities: A Scenario 430 Accounting for Contingencies 432

International Perspective: Executive Compensation and U.S. Business in the Global

Marketplace 435

Appendix 10A

Retirement Costs: Pensions and Postretirement Health Care and Insurance 436

Pensions 436

Defined Contribution Plan 436 Defined Benefit Plan 437

Postretirement Health Care and Insurance Costs 439

Appendix 10B

Deferred Income Taxes 439

The Concept of Deferred Income Taxes 440

Accounting Entries for Deferred Income Taxes 440

Deferred Income Taxes: Additional Issues 441

The Conservatism Ratio 442

11 Long-Term Liabilities: Notes, Bonds, and Leases 461

The Relative Size of Long-Term Liabilities 462

The Economic Consequences of Reporting Long-Term Liabilities 463

Basic Definitions and Different Contractual Forms 464

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X Contents

Effective Interest Rate 466

I n s t a l l m e n t a n d Non-Interest-Bearing Obligations 466 Interest-Bearing Obligations 467

Accounting for Long-Term Obligations: The Effective Interest Method 468

Accounting for Long-Term Notes Payable 468

Bonds Payable 470

Bond Terminology 471 The Price of a Bond 473 The Effective Rate and the Stated

Rate 474 Accounting for Bonds Payable 475 The Effective Interest Method and Changing

Interest Rates 480 Bond Redemptions 482

Financial Instruments and Off-Balance-Sheet Risks 483

Leases 484

Operating Leases 484 Capital Leases 485 Operating Leases, Capital Leases, and Off￾Balance-Sheet Financing 486

International Perspective: The Importance of Debt Financing in Other Countries 488

Appendix 11A

The Determination of Bond Prices 489

Determine the Effective (Actual) Rate of Return 489 Determine the Required Rate of

Return 489 Compare the Effective Rate to the Required Rate 490 Factors Determining

Bond Prices 490

12 Stockholders' Equity 513

The Relative Importance of Liabilities, Contributed Capital, and Earned Capital 514

Debt and Equity Distinguished 515

Characteristics of Debt 516 Characteristics of Equity 516 Why Is It Important to

Distinguish Debt from Equity? 517

The Economic Consequences Associated with Accounting for Stockholders’ Equity 520

Accounting for Stockholders’ Equity 521

Preferred Stock 522 Common Stock 525 Market Value 525 Book Value 525 Market￾to-Book Ratio 526 Par Value 526

Accounting for Common and Preferred Stock Issuances 526

Treasury Stock 527 Stock Options 531 Retained Earnings 532 Cumulative Translation

Adjustment 538

The Statement of Stockholders’ Equity 539

International Perspective: The Rise of International Equity Markets 539

PART 5: INCOME AND CASH FLOWS 565

13 The Complete Income Statem ent 566

The Economic Consequences Associated with Income Measurement and Disclosure 567

The Measurement of Income: Different Measures for Different Objectives 568

Financing, Investing, and Operating Transactions: A Framework 570 Classifying Operating

Transactions 573

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Contents xi

A Complete Income Statement: Disclosure and Presentation 574

(1) Operating Revenues and Expenses: Usual and Frequent 576 (2) Other Revenues and

Expenses: Unusual or Infrequent 576 (3) Disposal of a Business Segment 577

(4) Extraordinary Items: Unusual and Infrequent 578 (5) Changes in Accounting

Principles 579

Intraperiod Tax Allocation 581

Eamings-Per-Share Disclosure 582

Income Statement Categories: Useful for Decisions but Subjective 584

International Perspective: Investments and Income Statement Disclosure 585

14 The Statem ent of Cash Flows 606

The Definition of Cash 608

A General Description of the Statement of Cash Flows 608

Cash Provided (Used) by Operating Activities 608 Cash Provided (Used) by Investing

Activities 611 Cash Provided (Used) by Financing Activities 611

How the Statement of Cash Flows Can Be Used 611

Analyzing the Statement of Cash Flows 613 The Importance of Cash from Operating

Activities 613 The Importance of Significant Noncash Transactions 614

The Statement of Cash Flows: Economic Consequences 615

Deriving Cash Flow from Accrual Financial Statements 616

Cash Provided (Used) by Operating Activities 618 Cash Provided (Used) by Investing

Activities 621 Cash Provided (Used) by Financing Activities 623

The Complete Statement of Cash Flows 625

The Direct Method 625 The Indirect Method 625

Analyzing the Statement of Cash Flows: An Application 628

Summarizing the Cash Effects of Operating Transactions 628 Summarizing the Cash Effect

of Investing and Financing Transactions 628 Two Additional Observations 629

International Perspective: the Statement of Cash Flows 630

APPENDICES

A Wal-Mart 2001 Annual Report 663

B The Time Value of Money 688

C Quality of Earnings Cases: A Comprehensive Review 711

Glossary 744

Subject Index 770

Company Index 780

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Financial Accounting in an Economic Context is a trendsetting textbook in the area of

introductory financial reporting and analysis. Since the publication of the first edition

in 1989. this text has become an important part of the curriculum at a large and im pres￾sive group o f forward-thinking schools. The fifth edition continues to build upon the

strengths of previous editions, while introducing several new ideas and refinements

that better communicate the book's economic decision-m aking theme.

The fifth edition contains several new elements designed to improve and sharpen the

text’s econom ic decision-m aking theme, and the real-w orld references have been

updated to include substantial coverage of our Internet-based economy. For the most

part, however, this fifth edition maintains the same style and content o f the fourth edi￾tion, which was very well received by a wide variety of universities, colleges, and

other institutions.

In responding to our reviewers and adapting to the changing needs o f students and fac￾ulty in their technological environment, the following changes have been made.

U pdated Real-World References. The text contains hundreds of real-w orld refer￾ences. Virtually every concept covered includes some reference to a real company, a

real situation, or a real event. Current topics of concern to the SEC, the FASB, indus￾try, the accounting profession, and various users o f financial accounting inform ation

are woven throughout the discussion. A large percentage of these references has been

updated to reflect the m ost current thinking in the area, including the dot-com boom

and bust and the advent o f the new Integrated Q uestions for D iscussion and Review.

Past editions have included a section at the end of each chapter containing Questions

for Discussion and Review. This edition does not contain these sections but instead has

CONTINUING TO CHANGE THE WAY STUDENTS LEARN

New to th is Edition

xiii

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xiv Preface

integrated the questions into the chapter text itself, strategically placing them im m e￾diately after the coverage o f the concepts to which they refer. The questions them ­

selves are distinguished from the actual text by highlighted boxes, allowing the stu￾dent to consider them without disrupting the flow o f the text. Also, unlike in previous

editions, these questions are no longer hypothetical; in every case they refer to some

real-world company, event, or situation. This feature once again em phasizes and illus￾trates the timely and relevant nature of the text.

Real-World End-of-Chapter Exercises and Problems. Past editions have included

sections at the end of each chapter containing Exercises, Problems, and Issues for D is￾cussion. The Exercises and Problems asked students to perform com putations and/or

provide commentary on hypothetical situations; the Issues for D iscussion asked stu￾dents to perform com putations and/or provide com m entary on real-w orld situations.

In this edition many additional Exercises and Problems have been added that ask stu￾dents to respond to real-world information or situations. Thus the fifth edition’s

enhanced real-world em phasis is reflected not just in the Issues for Discussion; it is

also reflected in the Exercises and Problems.

Minor Change in Chapter Sequencing. In the fourth edition Chapter 3 covered

“Using Financial Statement Information.” Chapter 4 covered “The M easurement Funda￾mentals of Financial Accounting,” and Chapter 5 covered the “The Mechanics of Finan￾cial Accounting." Although Financial Accounting in an Economic Context continues to

present these chapters in a manner that provides instructors with maximum flexibility,

the sequencing of particular topics within chapters has been adjusted for additional ease

of use. So although the independence of these three chapters has been m aintained,

measurement fundamentals are now covered in Chapter 3; m echanics is now covered

in Chapter 4; and using financial statements is now covered in C hapter 5— a sequence

believed by many users to be the best way to cover the material.

CONTINUING THE APPROACH

The fifth edition has retained and improved upon many of the popular features used in

previous editions, such as ethics cases, Internet exercises, brief end-of-chapter real￾world exercises and issues for discussion, and a set of interesting and challenging

“quality of earnings” cases. This edition also includes a glossary considered by many

to be the very best of its kind. But perhaps most importantly, this edition has m ain￾tained and improved upon its most distinctive feature— the econom ic decision-m aking

approach and the balanced coverage o f three im portant themes: econom ic factors,

m easurement issues, and mechanics.

Economic Factors

Financial accounting is meaningless without an understanding of the econom ic envi￾ronment in which it exists. Each chapter in the fifth edition, therefore, includes frequent

references to actual events and companies; quotes from well-known business publica￾tions and corporate annual reports; inform ation about industry practices, debt

covenants, compensation arrangements, and debt and equity markets; and in-depth dis￾cussions of legal liability, ethical issues, and m anagem ent’s incentives and influence on

financial reports. The annual report of Wal-Mart, which is the subject of short case

questions at the end of each chapter, is also provided at the end of the text. Further, ratio

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Preface xv

analysis and international issues are introduced early and integrated throughout the text,

and the coverage still reflects a strong user orientation with a distinct “quality and per￾sistence o f earnings” flavor. The important role of the economic environment in this

text makes it more than simply a study of financial accounting. It is a study of modem

business management as seen through the financial accounting process.

Measurement Issues

As future managers and users, students must understand the m easurem ent issues

underlying the financial statements before they can interpret and m eaningfully use

them. The fifth edition devotes considerable attention to the conceptual and theoreti￾cal foundation of financial accounting measurement, with special em phasis on how

the financial statements provide useful measures of solvency and earning power. Cash

and accrual statements are treated as equally important, with the statement of cash

flows being covered from the very beginning. Chapter 3 provides a framework for

accounting measurement that is used throughout the rem ainder of the text.

Mechanics

Using financial statements without understanding the underlying m echanics is like

trying to interpret a foreign language without knowing the vocabulary. Consequently,

the fifth edition provides a strong mechanical foundation and stresses m echanics early

and throughout the text. Journal entries and T-accounts play an im portant role, but they

are never treated as a goal. Rather, they are characterized as an efficient way to com ­

m unicate how economic events are reflected on the financial statements. A special

coding is used throughout the text to link the form of each entry to the basic account￾ing equation and financial statements. Thorough m echanical coverage is especially

im portant in a text that takes a user orientation, because effective users m ust be able

to infer transactions from the financial statements. This m echanical skill, referred to

as reverse T-account analysis, is covered several times in the text, and many exercises

and problem s are designed to test it.

Decision-M aking Perspective

This text presents financial accounting in a way that helps m anagers make decisions—

a decision-m aking perspective. At a fundamental level, m anagers make two kinds of

decisions: attracting capital and investing capital. Simply put, m anagers m ust attract

capital from debt and equity investors and then invest it in operations, producing

assets, and investment securities. Successful m anagem ent is defined by generating a

return from these investments that exceeds the cost of capital. As depicted in Figure

P -I , these two kinds of decisions can be matched with the three them es discussed

above (m echanics, m easurem ent issues, and econom ic factors) to produce six basic

questions that must be answered by m anagers who use financial accounting inform a￾tion when making decisions.

In their effort to attract capital, managers must address three questions when con￾sidering whether to enter into certain transactions: How do the transactions affect the

financial statements? (cell I); How do these financial statement effects influence out￾side perceptions o f the com pany’s earning power and solvency? (cell 2); and How do

these financial statement effects influence the decisions of outsiders as well as debt and

com pensation contracts? (cell 3). These questions m ust be answered if m anagem ent is

to understand the economic consequences of the transactions under consideration.

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