Survey of Accounting

survey of

accounting

5e

Carl S. Warren

Professor Emeritus of Accounting

University of Georgia, Athens

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Survey of Accounting, Fifth Edition

Carl S. Warren

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PREFACE

S

urvey of Accounting, Fifth Edition, is designed for a one-term in￾troductory accounting course. It provides an overview of the basic

topics in financial and managerial accounting, without the extra￾neous accounting principles topics that must be skipped or other￾wise modified to fit into a one-term course. Written for students who have no

prior knowledge of accounting, this text emphasizes how managers, in￾vestors, and other business stakeholders use accounting reports.

Hallmark Features

The fifth edition of this text continues to emphasize elements designed to

help instructors and enhance the learning experience of students. These

features include the following:

● Integrated Financial Statement Framework shows how transactions impact

each of the three primary financial statements and stresses the integrated

nature of accounting.

● Infographic art examples help students visualize important accounting

concepts within the chapter.

The Operating Cycle

The operations of a merchandising business involve

the purchase of merchandise for sale (purchasing), the

sale of the products to customers (sales), and the re￾ceipt of cash from customers (collection). This overall

process is referred to as the operating cycle. Thus, the

operating cycle begins with spending cash, and it ends

with receiving cash from customers. The operating

cycle for a merchan￾dising business is

shown to the right.

Operating cycles for

retailers are usually

shorter than for man￾ufacturers because

retailers purchase

goods in a form ready

for sale to the custo￾mer. Of course, some

retailers will have

shorter operating

cycles than others because of the nature of their pro￾ducts. For example, a jewelry store or an automobile

dealer normally has a longer operating cycle than a

consumer electronics store or a grocery store. Busi￾nesses with longer operating cycles normally have

higher profit margins on their products than businesses

with shorter operating cycles. For example, it

is not unusual for

jewelry stores to

price their jewelry at

30%–50% above

cost. In contrast,

grocery stores oper￾ate on very small

profit margins, often

below 5%. Grocery

stores make up the

difference by selling

their products more

quickly.

The

Operat ing Cycle

Sales

Purchasing

Collect ion

iii

● Illustrative Problems help students apply what they learn by walking them

through problems that cover the most important concepts addressed

within the chapter.

McCollum Company, a furniture wholesaler, acquired new equipment at a cost

of $150,000 at the beginning of the fiscal year. The equipment has an estimated

life of five years and an estimated residual value of $12,000. Ellen McCollum, the

president, has requested information regarding alternative depreciation

methods.

Instructions

Determine the annual depreciation for each of the five years of estimated useful

life of the equipment, the accumulated depreciation at the end of each year, and

the book value of the equipment at the end of each year by (a) the straight-line

method and (b) the double-declining-balance method.

Solution

Year

Depreciation

Expense

Accumulated

Depreciation,

End of Year

Book Value,

End of Year

a. 1 $27,600* $ 27,600 $122,400

2 27,600 55,200 94,800

3 27,600 82,800 67,200

4 27,600 110,400 39,600

5 27,600 138,000 12,000

*$27,600 = ($150,000 – $12,000) 5

b. 1 $60,000** $ 60,000 $ 90,000

2 36,000 96,000 54,000

3 21,600 117,600 32,400

4 12,960 130,560 19,440

5 7,440*** 138,000 12,000

**$60,000 = $150,000 40%

***The asset is not depreciated below the estimated residual value of $12,000.

● “Integrity, Objectivity, and Ethics in Business” features describe real-world

dilemmas, helping students apply accounting concepts within an ethical

context, using integrity and objectivity.

INTEGRITY, OBJECTIVITY, AND ETHICS IN BUSINESS

A History of Ethical Conduct

The Wrigley Company, which is now a subsidiary of

Mars Incorporated, has a long history of integrity,

objectivity, and ethical conduct. When pressured to

become part of a cartel, known as the Chewing Gum

Trust, the company founder, William Wrigley Jr., said, “We

prefer to do business by fair and square methods or we

prefer not to do business at all.” In 1932, Phillip

K. Wrigley, called “PK” by his friends, became president of

the Wrigley Company after his father, William Wrigley Jr.,

died. PK also was president of the Chicago Cubs, which

played in Wrigley Field. He was financially generous to

his players and frequently gave them advice on and off

the field. However, as a man of integrity and high ethical

standards, PK docked (reduced) his salary as president

of the Wrigley Company for the time he spent working on

Cubs-related activities and business.

Source: St. Louis Post-Dispatch, “Sports—Backpages,” January 26,

2003.

iv Preface

● “How Businesses Make Money” vignettes emphasize practical ways in which

businesses apply accounting concepts when generating profit strategies.

How Businesses Make Money

Not Cutting Corners

Have you ever ordered a hamburger from Wendy’s and noticed that the meat patty is

square? The square meat patty reflects a business emphasis instilled in Wendy’s by

its founder, Dave Thomas. Mr. Thomas emphasized offering high-quality products at a

fair price in a friendly atmosphere, without “cutting corners”; hence, the square meat

patty. In the highly competitive fast-food industry, Dave Thomas’s approach has en￾abled Wendy’s to become the third largest fast-food restaurant chain in the world,

with annual sales of over $7 billion.

Source: Douglas Martin, “Dave Thomas, 69, Wendy’s Founder, Dies,” New York Times, January 9,

2002.

● An attractive design engages students and clearly presents the material.

The Integrated Financial Statement Framework benefits from this peda￾gogically sound use of color, as each statement within the framework is

shaded to reinforce the integrated nature of accounting.

Integrated Financial Statement (IFS)

Approach

This framework clearly demonstrates the impact of transactions on the bal￾ance sheet, income statement, and the statement of cash flows and the cor￾responding relationship among these financial statements. The IFS frame￾work moves the student from the simple to the complex and explains the

how and why of financial statements.

Chapter 1 introduces students to this integration in the form of actual

company financials from The Hershey Company, a well-known manufacturer

of chocolates.

EXHIBIT 10 Integrated Financial Statements

The Hershey Company

Balance Sheet

December 31, 2008

Assets Liabilities Stockholders’

Equity

Cash •

• •

•

•

•

• Retained Earnings

$ 37

$3,635 $3,285

$3,976

$ 350

The Hershey Company

Statement of Cash Flows

For the Year Ended Dec. 31, 2008

Operating act. $ 520

Financing act.

Investing act. (199)

(413)

Increase in cash (92)

Cash, Jan. 1 129

Cash, Dec. 31 $ 37

The Hershey Company

Retained Earnings Statement

For the Year Ended Dec. 31, 2008

Retained earnings, Jan. 1 $3,928

Add: Net income $311

Less: Dividends 263 48

Retained earnings, Dec. 31 $3,976

The Hershey Company

Income Statement

For the Year Ended Dec. 31, 2008

Revenues $5,133

Expenses 4,822

Net income $ 311

3 1 2

$3,635

Total Liabilities + Stockholders’ Equity

$

Preface v

Chapter 2 begins with an example format of the integrated framework

used throughout the financial chapters. Early in the course, students will

gain a greater understanding of how important trends or events can impact a

company’s financial statements, which add valuable insight into the financial

condition of a business.

EXHIBIT 1 Integrated Financial Statement Framework

INTEGRATED

FINANCIAL

STATEMENT

FRAMEWORK

/ Operating activities XXX

/ Investing activities XXX

/ Financing activities XXX

Increase or decrease in cash XXX

Beginning cash XXX

Ending cash XXX

Statement of

Cash Flows

Statement of Cash Flows

Revenues XXX

Expenses XXX

Net income or loss XXX

Income Statement

Income

Statement

Transactions XXX XXX XXX XXX

XXX XXX XXX XXX

Balance Sheet

Assets Liabilities Stockholders’ Equity

Assets Liabilities Capital Stock Retained Earnings

The primary focus in Chapter 2 is on cash transactions, which helps

eliminate confusion for students who may have difficulty determining whe￾ther an event or transaction should be recorded.

Transaction (d)

During the first month of operations, Family Health Care earned patient fees of

$5,500, receiving the fees in cash.

The effects of this transaction on Family Health Care’s financial statements

are recorded as follows:

1. Under the Statement of Cash Flows column, Cash from Operating ac￾tivities is increased by $5,500.

2. Under the Balance Sheet column, Cash under Assets is increased by

$5,500. To balance the accounting equation, Retained Earnings under

Stockholders’ Equity is also increased by $5,500.

3. Under the Income Statement column, Fees earned is increased by $5,500.

This transaction illustrates an inflow of cash from operating activities by

earning revenues (fees earned) of $5,500. Retained Earnings is increased

under Stockholders’ Equity by $5,500 because fees earned contribute to net

income and net income increases stockholders’ equity. Since fees earned are

a type of revenue, Fees earned of $5,500 is also entered under the Income

Statement column.

vi Preface

Statement of

Cash Flows

Income

Statement

Balances 4,000 12,000 10,000 6,000

d. Fees earned 5,500 5,500 d.

Balances 9,500 12,000 10,000 6,000 5,500

Statement of Cash Flows

d. Operating 5,500

Income Statement

d. Fees earned 5,500

Balance Sheet

Assets Liabilities Stockholders’ Equity

Notes Capital Retained

Cash Land Payable Stock Earnings

The effects of this transaction on Family Health Care’s financial state￾ments are shown below.

Fifth Edition Changes and

Enhancements

● Designed for today’s students, the fifth edition has been extensively revised

using an innovative, high-impact writing style that emphasizes topics con￾cisely and clearly. Direct sentences, concise paragraphs, numbered lists,

and step-by-step calculations provide students with an easy-to-follow struc￾ture for learning accounting without sacrificing content or rigor.

● All real-world company data has been updated. This includes The Hershey

Company, Home Depot, Starbucks, and Microsoft, among other real-world

examples included in the text.

● Data and solutions to all end-of-chapter exercises and problems have been

updated.

● Chapters 1–3 have been revised to incorporate the new high-impact writing

style.

● In Chapter 4, “Accounting for Merchandising Businesses,” “transportation”

terminology has been changed to “freight” for added clarity. For example,

instead of “transportation costs,” “freight costs” or simply “freight” is used.

● In Chapter 5, “Sarbanes-Oxley, Internal Control, and Cash,” “Depositor”

terminology has been changed to “Company” in the bank reconciliations.

In addition, based on user feedback, check numbers have been added to

Exhibit 5, Illustration of a Bank Statement, to reflect that most banks do

not return checks but simply list the cleared checks (by check number) on

the bank statement. Finally, a stepwise illustration of how to prepare the

bank reconciliation has been added.

● In Chapter 6, “Receivables and Inventories,” the illustrations for allowance

methods have been revised to enhance the ability to compare the percent

of sales and aging of receivables methods. In addition, a new Exhibit 3 has

been added comparing percent of sales and aging of receivables methods.

● In Chapter 7, “Fixed Assets and Intangible Assets,” new Exhibits 5 and 6

have been added that summarize and compare depreciation methods.

● In Chapter 8, “Liabilities and Stockholders’ Equity,” the contingent lia￾bility discussion has been revised, including the addition of Exhibit 2.

Preface vii

● In Chapter 9, “Financial Statement Analysis,” a new chapter opener features

Nike, Inc. Each ratio is highlighted in equation form for easier review. Finally,

an appendix on “Unusual Items on the Income Statement” has been added.

● In Chapter 11, “Cost Behavior and Cost-Volume-Profit Analysis,” a new

opener based on Netflix has been added. Also, contribution margin and

unit contribution margin equations have been added to the cost-volume￾profit discussion, including how to compute the “change in income from

operations” equation based on unit contribution margin. An equation for

computing the percent change in income from operations using “operat￾ing leverage” has been added. Finally, the discussion of margin of safety

has been expanded to indicate that margin of safety may be expressed in

sales dollars, units, or percent of current sales.

● In Chapter 12, “Differential Analysis and Product Pricing,” a new opener

based on RealNetworks has been added.

● In Chapter 13, “Budgeting and Standard Cost Systems,” a new equation

format for computing standard cost variances is now utilized so that a

positive amount indicates an unfavorable variance while a negative amount

indicates a favorable variance.

● In Chapter 14, “Performance Evaluation for Decentralized Operations,”

equations have been added for computing service department charge rates

and determining service department charges. An example format for de￾termining residual income and equations for computing increases and

decreases in divisional income using different negotiated transfer prices

have also been added.

● Chapter 15, “Capital Investment Analysis,” now includes a new opener

based on Carnival Corporation. New graphics have been added, and the

format for using the net present value method was changed to be con￾sistent with the format shown in the solutions manual.

Technology

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viii Preface

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the PowerPointâ presentations, Instructor’s Manual, Solutions Manual, Test

Bank, ExamViewâ, an Instructor’s Guide to Online Resources, and Excelâ ap￾plication solutions.

● Test Bank For each chapter, the Test Bank includes true/false questions,

multiple-choice questions, and problems. Each question is marked with a

difficulty level, chapter objective association, and a tie-in to standard

course outcomes. Available on the IRCD.

● ExamViewâ Pro Testing Software A computerized version of the Test

Bank allows instructors to quickly and easily customize tests for their stu￾dents. Instructors can add or edit questions, instructions, and answers and

select questions by previewing them on screen. Instructors can also create

and administer quizzes and tests online, whether over the Internet, a local

area network (LAN), or a wide area network (WAN). Available on the

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● PowerPointâ Presentation Slides Included on the IRCD and on the pro￾duct support site, each presentation enhances lectures and simplifies class

preparation. Available on the IRCD.

● Instructor Excelâ Templates This resource provides the solutions for the

problems and exercises that have enhanced Excelâ templates for students.

Available on the IRCD.

● Instructor’s Manual Each chapter contains a number of resources designed

to aid instructors as they prepare lectures, assign homework, and teach in

the classroom. Available on the IRCD.

● Solutions Manual The Solutions Manual contains answers to all exercises,

problems, and activities that appear in the text. As always, the solutions are

author-written and verified multiple times for numerical accuracy and

consistency with the core text. Available on the IRCD.

Acknowledgments

Many people deserve thanks for their contributions to this text over the past

several editions. Jose´ Hortensi and Jeff Rhinock were outstanding resources

Preface ix

for their careful verification of the end-of-chapter materials. The comments

from the following reviewers also influenced recent editions of the text:

Tim Alzheimer, Montana State University–Bozeman

Scott R. Berube, University of New Hampshire, Whittemore School of Business &

Economics

Suzanne Lyn Cercone, Keystone College

H. Edward Gallatin, Indiana State University

Robert E. Holtfreter, Central Washington University

Jose´ Luis Hortensi, Miami Dade College

Ann E. Martel, Marquette University

Craig Pence, Highland Community College

Patricia G. Roshto, University of Louisiana at Monroe

Geeta Shankar, University of Dayton

Alice Sineath, Forsyth Technical Community College

Hans Sprohge, Wright State University

Your comments and suggestions as you use this text are sincerely

appreciated.

Carl S. Warren

x Preface

ABOUT THE AUTHOR

Carl S. Warren

Dr. Carl S. Warren is Professor Emeritus of Accounting at the University of

Georgia, Athens. For over twenty-five years, Professor Warren has taught all

levels of accounting classes. In recent years, Professor Warren has focused

his teaching efforts on principles of accounting and auditing courses. Pro￾fessor Warren has taught classes at the University of Iowa, Michigan State

University, and University of Chicago. Professor Warren received his doc￾torate degree (PhD) from Michigan State University and his undergraduate

(BBA) and master’s (MA) degrees from the University of Iowa. During his

career, Professor Warren published numerous articles in professional jour￾nals, including The Accounting Review, Journal of Accounting Research, Journal of

Accountancy, The CPA Journal, and Auditing: A Journal of Practice & Theory.

Professor Warren’s outside interests include writing short stories and novels,

oil painting, handball, golf, skiing, backpacking, and fly-fishing.

xi

BRIEF CONTENTS

1 The Role of Accounting in Business 1

2 Basic Accounting Concepts 44

3 Accrual Accounting Concepts 80

4 Accounting for Merchandising Businesses 127

5 Sarbanes-Oxley, Internal Control, and Cash 167

6 Receivables and Inventories 206

7 Fixed Assets and Intangible Assets 243

8 Liabilities and Stockholders’ Equity 274

9 Financial Statement Analysis 312

10 Accounting Systems for Manufacturing Businesses 360

11 Cost Behavior and Cost-Volume-Profit Analysis 419

12 Differential Analysis and Product Pricing 463

13 Budgeting and Standard Cost Systems 503

14 Performance Evaluation for Decentralized Operations 571

15 Capital Investment Analysis 613

Appendix A: Double-Entry Accounting Systems 649

Appendix B: Process Cost Systems 665

Glossary 681

Subject Index 691

Company Index 699

xii

CONTENTS

Preface iii

About the Author xi

chapter 1 The Role of Accounting in Business 1

NATURE OF BUSINESS AND ACCOUNTING 2

Types of Businesses 2 / Forms of Business 2 / How Do Businesses Make Money?

3 / Business Stakeholders 5

BUSINESS ACTIVITIES 7

Financing Activities 7 / Investing Activities 8 / Operating Activities 8

WHAT IS ACCOUNTING AND ITS ROLE IN BUSINESS? 9

FINANCIAL STATEMENTS 10

Income Statement 11 / Retained Earnings Statement 12 / Balance Sheet 13 /

Statement of Cash Flows 13 / Integrated Financial Statements 15

ACCOUNTING CONCEPTS 16

Business Entity Concept 17 / Cost Concept 18 / Going Concern Concept 19 /

Matching Concept 19 / Objectivity Concept 19 / Unit of Measure Concept 20 /

Adequate Disclosure Concept 20 / Accounting Period Concept 20 / Responsible

Reporting 20

chapter 2 Basic Accounting Concepts 44

ELEMENTS OF AN ACCOUNTING SYSTEM 45

Rules 45 / Framework 45 / Controls 46

RECORDING A CORPORATION’S FIRST PERIOD OF OPERATIONS 48

FINANCIAL STATEMENTS FOR A CORPORATION’S FIRST PERIOD OF

OPERATIONS 54

Income Statement 55 / Retained Earnings Statement 56 / Balance Sheet 56 /

Statement of Cash Flows 57 / Integration of Financial Statements 57

RECORDING A CORPORATION’S SECOND PERIOD OF OPERATIONS 57

FINANCIAL STATEMENTS FOR A CORPORATION’S SECOND PERIOD OF

OPERATIONS 59

Income Statement 59 / Retained Earnings Statement 60 / Balance Sheet 60 /

Statement of Cash Flows 61 / Integration of Financial Statements 61

chapter 3 Accrual Accounting Concepts 80

BASIC ACCRUAL ACCOUNTING CONCEPTS, INCLUDING THE MATCHING

CONCEPT 81

USING ACCRUAL CONCEPTS OF ACCOUNTING FOR FAMILY HEALTH CARE’S

NOVEMBER TRANSACTIONS 82

xiii

THE ADJUSTMENT PROCESS 88

Deferrals and Accruals 89 / Adjustments for Family Health Care 90

FINANCIAL STATEMENTS 94

Income Statement 94 / Retained Earnings Statement 96 / Balance Sheet 96 /

Statement of Cash Flows 98 / Integration of Financial Statements 99

ACCRUAL AND CASH BASES OF ACCOUNTING 99

Using the Cash Basis of Accounting 100 / Using the Accrual Basis of

Accounting 101 / Cash and Accrual Bases of Accounting 101 / Importance of

Accrual Basis of Accounting 102 / The Accounting Cycle for the Accrual Basis of

Accounting 103

APPENDIX 103

chapter 4 Accounting for Merchandising Businesses 127

MERCHANDISE OPERATIONS 128

FINANCIAL STATEMENTS FOR A MERCHANDISING BUSINESS 129

Multiple-Step Income Statement 129 / Single-Step Income Statement 134 / Retained

Earnings Statement 134 / Balance Sheet 134 / Statement of Cash Flows 135

SALES TRANSACTIONS 136

Sales 136 / Sales Discounts 138 / Sales Returns and Allowances 140

PURCHASE TRANSACTIONS 141

Purchase Discounts 141 / Purchase Returns and Allowances 142

FREIGHT AND SALES TAXES 143

Freight 143 / Sales Taxes 144

DUAL NATURE OF MERCHANDISE TRANSACTIONS 145

MERCHANDISE SHRINKAGE 147

APPENDIX 147

Cash Flows from Operating Activities 149 / Cash Flows Used for Investing

Activities 150 / Cash Flows Used for Financing Activities 150

chapter 5 Sarbanes-Oxley, Internal Control, and Cash 167

SARBANES-OXLEY ACT OF 2002 168

INTERNAL CONTROL 169

Objectives of Internal Control 169 / Elements of Internal Control 170 / Control

Environment 170 / Risk Assessment 172 / Control Procedures 172 /

Monitoring 174 / Information and Communication 174 / Limitations of Internal

Control 175

CASH CONTROLS OVER RECEIPTS AND PAYMENTS 176

Control of Cash Receipts 176 / Control of Cash Payments 178

BANK ACCOUNTS 179

Bank Statement 179 / Using the Bank Statement as a Control Over Cash 182

BANK RECONCILIATION 183

xiv Contents