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Part 1 Introduction to Financial Statements xxiv

The Nature and Purpose of Financial Accounting 1

What is Accounting and Why Does it Exist? 4

Financial Statements 6

Income Statement 7

Statement of Cash Flows 7

Who Uses Financial Accounting Information 8

Lenders 8

Investors 8

Business Context 1-1 How to Get Your Own Copy of McDonald's Financial Statements 9

Management 9

Suppliers and Customers 10

Employees 10

Competitors 10

Government Agencies 11

Politicians 11

The Press 11

The Need for Financial Accounting Standards 11

Other Important Accounting-Related Organizations 13

Securities and Exchange Commission 13

Corporate Governance 1-1 What is Corporate Governance? 14

American Institute of Certified Public Accountants 15

Public Company Accounting Oversight Board 15

Internal Revenue Service 15

International Accounting Standards Board 16

Right Now Is an Exciting Time to Be Studying Accounting 17

Review of Key Points 18

Key Terms 20

Questions 20

Exercises 21

Applications and Extensions 21

Overview of the Financial Statements 27

The Need for Financial Statements 29

Liabilities 34

Owners' Equity 35

Business Context 2-1 Should I Incorporate? 36

Balance Sheet Format 37

The Accounting Equation 38

Concepts and Conventions Related to the Balance Sheet 39

Data Mining 2-1 The Accounting Equation 40

Income Statement 41

Expenses 42

Gains and Losses 42

Net Income 43

Earnings Per Share 43

Concepts and Conventions Related to the Income Statement 43

Data Mining 2-2 Price-Earnings (PE) Ratio 44

Statement of Cash Flows 45

Notes to the Financial Statements 47

Summary of Significant Accounting Policies 47

Corporate Governance 2-1 The Importance of Transparency 48

Additional Information about Summary Totals 49

Disclosure of Information Not Recognized 49

Supplementary Information 49

The External Audit 49

Other Accounting Concepts and Conventions 51

Relevance and Reliability 51

Comparability and Consistency 51

Conservatism 51

Materiality 52

Articulation 52

Review of Key Points 53

Key Terms 55

Questions 56

Exercises 56

Problems 62

Applications and Extensions 67

Introduction to Financial Statement Analysis 75

The Need for Financial Statement Analysis 76

Widely Used Financial Ratios 78

Debt Ratio 78

Current Ratio 78

Return on Sales 79

Asset Turnover 79

Return on Equity 80

Price-Earnings Ratio 80

Common-Size Financial Statements 81

Corporate Governance 3-1 Undervalued Companies and Entrenched Management 82

DuPont Framework 86

Data Mining 3-1 Margin and Turnover 91

Business Context 3-1 Market Efficiency: Can Financial Statement Analysis Help You Win in the Stock Market? 94

Cash Flow Ratios 95

Usefulness of Cash Flow Ratios 95

Cash Flow to Net Income 96

Cash Flow Adequacy 96

Cash Times Interest Earned 97

Potential Pitfalls 97

Financial Statements Don't Contain All Information 97

Data Mining 3-2 Identifying LBO Targets 98

Lack of Comparability 98

Search for the Smoking Gun 99

Anchoring, Adjustment, and Timeliness 99

Review of Key Points 100

Key Terms 101

Questions 101

Exercises 102

Problems 108

Applications and Extensions 116

The Balance Sheet 123

Individual Asset, Liability, and Equity Accounts 125

Current Assets 126

Long-Term Assets 129

Current Liabilities 131

Long-Term Liabilities 132

Stockholders' Equity 133

Data Mining 4-1 Paid-in Capital, Retained Earnings, and Treasury Stock 136

Form of the Balance Sheet 137

Format of Foreign Balance Sheets 137

Recognition and Valuation 138

Recognition 138

Data Mining 4-2 Efficient Use of Working Capital 139

Valuation 140

Introduction to Transaction Analysis 141

Sample Transactions for a New Company 142

Analyzing the Impact of Transactions on the Balance Sheet 142

Business Context 4-1 Do Accountants Record the Most Important Events? 145

Asset and Financing Mix 146

Corporate Governance 4-1 Strategic Direction and Mission Statement 149

Review of Key Points 150

Key Terms 151

Questions 152

Exercises 152

Problems 161

Applications and Extensions 167

The Income Statement 177

Different Measures of Income 180

Gross Profit 182

Operating Income 182

Income from Continuing Operations 182

Net Income 183

Comprehensive Income 184

Individual Income Statement Items 184

Revenues 184

Expenses 186

Data Mining 5-1 Gross Profit Percentage 188

Gains and Losses 189

``Below-the-Line'' Items 190

Comprehensive Income 192

Earnings per Share 193

Corporate Governance 5-1 Aligning Incentives: Management Bonuses Based on Reported Income 194

Format of the Income Statement 195

Revenue Recognition and Matching 195

Revenue Recognition 195

Expense Recognition 197

Transaction Analysis 198

January 1, 2006, through December 31, 2006 198

Business Context 5-1 Why Doesn't the U.S. Government Use Accrual Accounting? 199

Analyzing the Impact of Transactions on the Income Statement 200

Forecasting The Future 204

Forecast of Balance Sheet Accounts 205

Forecast of Income Statement Accounts 207

Review of Key Points 208

Key Terms 209

Questions 210

Exercises 210

Problems 217

Applications and Extensions 222

The Statement of Cash Flows 231

What Is the Purpose of a Statement of Cash Flows? 233

Sometimes Earnings Fail 233

Everything on One Page 234

Forecasting Tool 235

What Information Is Reported in the Statement of Cash Flows? 235

Three Categories of Cash Flows 235

Non-cash Investing and Financing Activities 238

Corporate Governance 6-1 Free Cash Flow and Management Perks 239

Preparing a Statement of Cash Flows--A Simple Example 240

Analyzing the Other Primary Financial Statements to Prepare a Statement of Cash Flows 244

A Six-Step Process for Preparing a Statement of Cash Flows 245

An Illustration of the Six-Step Process 246

Business Context 6-1 Disagreements within the FASB 252

Data Mining 6-1 Differences between Income and Cash from Operations 254

Data Mining 6-2 American and British Operating Cash Flow 256

Using Cash Flow Information to Forecast Future Financial Position 257

Review of Key Points 260

Key Terms 262

Questions 262

Exercises 263

Problems 269

Applications and Extensions 279

Case 1 IBM 289

Part 2 The Accounting Information System 295

The Accounting Information System 296

How Can We Collect All This Information? 297

Transaction Analysis Using Debits and Credits 298

Debits and Credits for Revenues, Expenses, and Dividends 300

Business Context 7-1 Luca Pacioli 302

How Do We Record the Effects of Transactions? 302

Posting Journal Entries and Preparing a Trial Balance 308

Posting 308

Trial Balance 309

Adjusting and Closing Entries 311

Adjusting Entries 311

Closing Entries 313

Computers and Accounting 314

Corporate Governance 7-1 Sarbanes-Oxley Section 404: Internal Controls 315

Review of Key Points 316

Key Terms 318

Questions 318

Exercises 319

Problems 324

Applications and Extensions 331

Earnings Management 338

Factors that Motivate Earnings Management 342

Meet Internal Targets 342

Meet External Expectations 343

Income Smoothing 344

Corporate Governance 8-1 How Far Do We Go to Meet Wall Street Expectations? 345

Window Dressing for an IPO or a Loan 347

Common Techniques Used to Manage Earnings 347

The Earnings Management Continuum 348

Pro Forma Earnings 349

Business Context 8-1 Microsoft Charged With Establishing Cookie Jar Reserves 350

Should a Company Manage Earnings? 352

Financial Reporting as a Part of Public Relations 352

Is Earnings Management Ethical? 353

Personal Ethics 355

Common Elements of Earnings Management Meltdown 355

Downturn in Business 356

Pressure to Meet Expectations 356

Attempted Accounting Solution 357

Auditor's Calculated Risk 357

Insufficient User Skepticism 358

Regulatory Investigation 358

Massive Loss of Reputation 359

Accounting Standards, Ethical Behavior, and Cost of Obtaining Capital 360

What is the Cost of Capital? 360

The Role of Accounting Standards 361

The Necessity of Ethical Behavior 362

Review of Key Points 363

Key Terms 364

Questions 364

Discussion Cases 365

Applications and Extensions 371

Part 3 Operating Decisions 375(158)

Revenue Cycle: Sales, Reccivables, and Cash 376

Revenue Recognition 379

When Should Revenue Be Recognized? 380

How Revenue Is Recognized 381

Corporate Governance 9-1 SEC and SAB 101: Closing Loopholes 382

Pressure to Recognize Revenue 383

Application of the Revenue Recognition Criteria 383

Business Context 9-1 ZZZZ Best 385

Selling on Credit and Collecting Cash 386

Granting Credit 386

Particular Credit Policies 387

Accounting for Credit Customers Who Don't Pay 389

Percentage-of-Sales Method 390

Aging Method 391

Write-offs of Bad Debts 392

The Allowance for Bad Debts T-Account 392

Real-World Illustrations of Accounting for Bad Debts 393

Accounting for Warranties 394

Data Mining 9-1 Bank Credit Losses 395

Cash Management: Controls and Factoring 395

Control of Cash 396

Cash Management 396

Foreign Currencies 397

Foreign Currency Transactions 397

Exchange Rates 398

Foreign Currency Transaction Example 398

Data Mining 9-2 Valuing a Foreign Currency Portfolio 399

Evaluating Credit Policy and Budgeting Cash Receipts 400

Quantity of Receivables 400

Quality of Receivables 402

Budgeting Cash Receipts 402

Review of Key Points 404

Key Terms 405

Questions 405

Exercises 406

Problems 412

Applications and Extensions 418

Cost of Goods Sold and Inventory 425

What Is Reported as Inventory? 428

What Is Inventory? 429

Who Owns the Inventory? 430

The Cost of Inventory 431

Accounting for Inventory and Cost of Goods Sold 432

Overview of Perpetual and Periodic Systems 432

Perpetual and Periodic Inventory Systems---an Illustration 433

Taking a Physical Count of Inventory 434

The Income Effect of an Error in Ending Inventory 435

Inventory Valuation Methods 436

Business Context 10-1 Inventory Fraud and Instant Profits 437

Inventory Valuation Example 437

Specific Identification 438

Average Cost Method 439

First-In, First-Out Method 439

Last-In, First-Out Method 440

Comparison of Methods: Cost of Goods Sold and Ending Inventory 440

Corporate Governance 10-1 Should Management Use Accounting Strategically? 442

Complications with a Perpetual Inventory System 442

More About LIFO 443

LIFO Layers 443

Data Mining 10-1 Magnitude of the LIFO Reserve 445

LIFO Liquidation 445

Business Context 10-2 As American as Mom, Apple Pie, and LIFO 446

Inventory Estimation and Valuation 447

Gross Profit Method 447

Lower of Cost or Market 449

Evaluating Inventory Levels and Budgeting Cash Disbursements 450

Evaluating the Level of Inventory 450

Impact of the Inventory Cost Flow Assumption 451

Data Mining 10-2 Inventory Efficiency 452

Number of Days' Purchases in Accounts Payable 452

Budgeting Cash Outflows 453

Review of Key Points 455

Key Terms 457

Questions 458

Exercises 458

Problems 465

Applications and Extensions 472

Expenditure Cycle: Other Operating Items 477

Employee Compensation 480

Payroll 481

Compensated Absences 481

Bonuses 482

Stock Options 482

Post-employment Benefits 484

Pensions 484

Corporate Governance 11-1 The Accounting Scapegoat: Deceiving Naive Stakeholders 489

Data Mining 11-1 Overfunded and Underfunded Pension Plans 490

Postretirement Benefits other than Pensions 491

Income Taxes 492

Introductory Deferred Tax Example 493

Sources of Differences between Financial Accounting Income and Taxable Income 494

Simple Deferred Income Tax Liability 495

Business Context 11-1 International Accounting for Deferred Taxes 496

Simple Deferred Income Tax Asset 496

Income Tax Disclosure 497

Data Mining 11-2 Income Taxes: Current and Deferred, Domestic and Foreign 498

Capitalize versus Expense 500

Research and Development Costs 501

Oil and Gas Exploration Costs 502

Advertising Costs 503

Contingencies 503

Accounting for Contingencies: Probable, Possible, and Remote 504

Business Context 11-2 Frequent Flyer Miles 505

Accounting for Lawsuits 506

Accounting for Environmental Liabilities 507

Review of Key Points 508

Key Terms 510

Questions 510

Exercises 511

Problems 516

Applications and Extensions 519

Case 2 Procter & Gamble 529

Part 4 Investing Decisions 533(222)

Investments in Operating Assets 534

What Are Long-Term Operating Assets? 537

Deciding Whether to Acquire a Long-Term Operating Asset 538

Acquisition of Property, Plant, and Equipment 539

Corporate Governance 12-1 Location of Production Facilities: Which Stakeholders Are #1? 540

Acquisition for Cash 541

Acquisition through Leasing 541

Acquisition via Exchange 542

Acquisition through Donation 542

Acquisition with a Basket Purchase 543

Acquisition of an Entire Company 543

Acquisition through Self-Construction 544

The Acquisition of Intangible Assets 545

Accounting for Goodwill 546

Difficulties of Accounting for Intangible Assets: The Case of Brand Names 547

Depreciation and Amortization 548

What Causes Depreciation? 549

Factors to Consider when Computing Depreciation 549

Methods of Computing Depreciation 550

Data Mining 12-1 Accumulated Depreciation and the Age of the Assets 551

Comparison of Depreciation Methods 552

Selecting a Depreciation Method for Financial Reporting Purposes 553

Choosing a Depreciation Method for Tax Purposes 554

Does Depreciation Create Cash Flow? 555

Accounting for Changes in Estimated Useful Lives 556

Amortization of Intangible Assets 557

Impairments of Asset Value 557

Business Context 12-1 Does the Market Understand Depreciation Accounting: The Case of Blockbuster Video 558

Recording Decreases in the Value of Property, Plant, and Equipment 559

Impairment of Intangible Assets 560

Recording Increases in the Value of Property, Plant, and Equipment 561

Disposal of Long-Term Assets 561

Retirement of Operating Assets 561

Sale of Operating Assets 561

Business Context 12-2 Asset Write-Ups 562

Trade-in of Operating Assets 563

Measuring Property, Plant, and Equipment Efficiency 563

Evaluating the Level of Property, Plant, and Equipment 563

Dangers in Using Fixed Asset Turnover 564

Review of Key Points 565

Key Terms 567

Questions 568

Exercises 569

Problems 574

Applications and Extensions 581

Investments in Securities 588

Why Companies Invest in Other Companies 591

Safety Cushion 591

Cyclical Cash Needs 592

Investment for a Return 593

Investment for Influence 593

Purchase for Control 594

Corporate Governance 13-1 Independent Directors and Interlocking Boards 595

Classification of Investment Securities 595

Difference between Debt and Equity Securities 595

Accounting Classification of Investment Securities 596

Purchasing, Selling, and Earning a Return on Trading and Available-for-Sale Securities 598

Accounting for the Purchase of Securities 598

Accounting for Interest and Dividends 598

Realized Gains and Losses on the Sale of Securities 599

Recognizing and Recording the Changing Value of Securities 599

Changes in the Value of Trading Securities 599

Changes in the Value of Available-for-Sale Securities 600

Computation of Overall Rate of Return 601

Subsequent Changes in Value 601

Data Mining 13-1 Computing Overall Rate of Return 603

Accounting for Held-to-Maturity Securities 603

Purchase of a Bond 603

Recognizing Interest Revenue 604

Accounting for Equity Method Securities 605

Underlying Concepts 605

Illustrating the Equity Method 606

Consolidated Financial Statements 607

Business Context 13-1 The FASB Votes to Put a Stop to Cherry-Picking 608

Derivatives 610

Types of Risks 611

Types of Derivatives 612

Types of Hedging Activities 614

Accounting for Derivatives and for Hedging Activities 615

Notional Amounts 617

Data Mining 13-2 Derivatives: Fair Value and Notional Value 618

Review of Key Points 618

Key Terms 620

Questions 621

Exercises 621

Problems 628

Applications and Extensions 634

Case 3 Intel 642

Part 5 Financing Decisions

Financing with Debt 648

Debt Financing: Conceptual Issues 650

Definition of a Liability 650

Classifications of Liabilities 651

Measurement of Liabilities 652

Short-Term Operating Liabilities, Short-Term Debt, and Lines of Credit 653

Short-Term Operating Liabilities 653

Short-Term Debt 654

Lines of Credit 654

Data Mining 14-1 Lines of Credit 655

Present Value of Long-Term Debt 655

Illustration of the Importance of Present Value 656

A Note on Calculators and Computers 658

Mortgage Illustration 659

Bonds 660

Features of Bonds 660

Business Context 14-1 Will Mickey Mouse Be Around in 100 Years? 661

Types of Bonds 661

Bond Prices 662

Corporate Governance 14-1 Bankruptcy and the Fiduciary Responsibility to Creditors 663

Data Mining 14-2 Bond Prices 664

Accounting for the Issuance of Bonds 667

Reporting of Bonds Subsequent to Issuance 669

Retiring Bonds 671

Leases 672

Economic Advantages of Leasing 672

Simple Lease Example 673

Lease Classification Criteria 675

Accounting for Leases 675

Operating versus Capital Leases 676

Off-Balance-Sheet Financing 678

Unconsolidated Subsidiaries 678

Joint Ventures 679

Debt-Related Ratios and the Impact of Operating Leases 679

Debt-Related Financial Ratios 680

Debt-to-Equity and Debt Ratio 680

Times Interest Earned Ratio 681

Operating Leases 681

Review of Key Points 683

Key Terms 685

Questions 685

Exercises 686

Problems 690

Applications and Extensions 695

Financing with Equity 701

Choosing Equity Financing 704

Difference Between a Loan and an Investment 704

Different Ways of Organizing a Business 705

Data Mining 15-1 Volume of Business by Sole Proprietorships, Partnerships, and Corporations 706

Corporations and Corporate Stock 707

Business Context 15-1 Going Public with a Dot.com Company 708

Common Stock 709

Preferred Stock 710

Issuance and Repurchase of Stock 710

Issuance of Stock 710

Accounting for Stock Repurchases 711

Corporate Governance 15-1 Aligning Incentives: Management Stock Options 712

Cash Dividends, Stock Dividends, and Stock Splits 713

Business Context 15-2 Strategic Timing of Stock Repurchases 714

Cash Dividends 714

Declaration of Dividends 716

Dividends and Preferred Stock 716

Stock Dividends 716

Business Context 15-3 Using Stock Dividends as Signals 718

Stock Splits 719

Data Mining 15-2 Microsoft's Stock Splits 720

Other Equity Items 720

Equity Items That Bypass the Income Statement 720

Business Context 15-4 Do You Want a Stock Tip? 721

International Accounting: Equity Reserves 723

Equity Valuation 725

Equity Valuation 726

Review of Key Points 730

Key Terms 732

Questions 732

Exercises 733

Problems 737

Applications and Extensions 743

Case 4 AT&T 749

Part 6 Additional Reporting and Analysis 755

Accounting in a Global Market 756

Foreign Currency Transactions 759

Translating Foreign Currency Financial Statements 760

Translation 761

Data Mining 16-1 Foreign Currency Translation Adjustments 763

International Financing Strategies and Reporting Practices 764

Corporate Governance 16-1 The Far-Reaching Impact of Listing on a U.S. Stock Exchange 765

Significant Differences in GAAP 766

Meeting the Needs of International Investors 766

Business Context 16-1 How Do Foreign Companies List in the United States? 771

The Role of the International Accounting Standards Board 771

Reconciliation of Foreign GAAP to U.S. GAAP: Form 20F 772

Detailed Examination of the Form 20F Reconciliation for BASF 772

Capitalization of Interest 773

Business Context 16-2 Does One Size Fit All? 774

Capitalization of Software Costs 774

Provisions for Pensions 775

Provisions for Various Liabilities 775

Foreign Currency Items and Financial Derivatives 775

Valuation of Securities 776

Companies Accounted for Under the Equity Method 776

Goodwill 776

Deferred Taxes 776

Minority Interest 776

Summary 777

Review of Key Points 777

Key Terms 778

Questions 779

Exercises 779

Problems 785

Applications and Extensions 789

Case 5 Coca-Cola 795

Appendix A McDonald's: Excerpts from Form 10-K for 2003 801

Appendix B The Present Value Module 821

Simple Versus Compound Interest 822

Simple Interest 822

Compound Interest 822

Future Value of a Single Amount 823

Simple Versus Compound Interest 822

Simple Interest 822

Compound Interest 822

Future Value of a Single Amount 823

Interest Compounded More Often Than Annually 825

Determination of the Number of Periods or the Interest Rate 826

Present Value of a Single Amount 827

Present Value Tables 828

Other Present Value Situations 829

The Distinction between Future Value and Present Value 829

Future Value of an Annuity 830

Understanding the Future Value of an Annuity 830

Solving Problems Involving the Future Value of an Annuity 831

Present Value of an Annuity 833

Determining the Present Value of an Annuity 833

Problems Involving the Present Value of an Annuity 834

Summary 836

Key Terms 836

Problems for Your Review 837

Solution 837

Questions 837

Exercises 838

Problems 840

Glossary of Terms 845

Subject Index 852

Company Name Index 861