Compiled By Nut Khorn Page 1 - WordPress.com 15 Leases Chapter 16 Accounting for Income Taxes Chapter 17 Pensions and Other Postretirement Benefit Plans Chapter 18 Shareholders’

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COURSE SYLLABUS FOR

Intermediate Accounting

By Nut Khorn (Course Facilitator) For BBA students

RESOURCE MATERIALS Text (Required): Intermediate Accounting, 4th Edition, Spiceland , Sepe, and Tomassini, (2007), McGra-Hill, USA. Study Guide to Accompany Intermediate Accounting (Optional) COURSE DESCRIPTION: Intermediate Accounting 1 is the first of two intermediate financial accounting subjects. The study of financial accounting is primarily concerned with the way in which the financial statements of companies are prepared and used. This subject focuses on the detailed recording and reporting of important items of financial information and explores how that information may be applied in better understanding the financial performance and position of a company. The intent is to build on the foundation laid in the first year introductory accounting subject with the goal of better equipping students with the skills needed to prepare and interpret financial statements. Further, the subject aims to provide the prerequisite knowledge that will enable students to progress and study further accounting topics. COURSE OBJECTIVES Intermediate Accounting I is the first in a series of courses intended to provide serious accounting and business students with an understanding of and appreciation for issues related to accounting and reporting to the public. This area of accounting is broadly referred to as financial accounting. The intermediate accounting course will develop in students an in-depth understanding of the traditional financial accounting topics, as well as introduce them to recent developments in accounting and reporting practices promulgated by the leading professional accounting organizations and applied by practitioners in public accounting and industry. Specifically, Intermediate Accounting I is concerned with the structure for developing and enforcing GAAP, basic financial statement form and content, accounting systems, and valuation. Intermediate Accounting is intended to be a course where students begin to integrate knowledge from accounting and other disciplines. Many problems and activities will expect the student to recall things learned in other instructional settings. In this regard, many problems become comprehensive and many require logical analysis based upon knowledge of the specific current instruction. They also require an integration of knowledge as to how the current instruction fits into the whole of financial accounting. Students who perform best are usually those who are able to regard the subject broadly and who develop a good foundation in the conceptual framework that defines the field of accounting. A purely mechanical approach to the study of accounting will rarely produce good results. COURSE LEARNING OUTCOMES:

Upon the successful completion of this course, students should: 1. Be able to explain and discuss the fundamentals of financial reporting.

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2. Know how to describe and analyze various financial statements and accounting information provided by bus3. Be familiar with the accounting process and the fundamental accounting concepts.4. Be able to present the different treatments between IFRS and US GAAP, if any.5. Be capable of identifying and discussing the ethical issues in

ASSESSMENT TASKS

Standards for Assessment:• The success of this course depends on your individual and collective contribution to the case analyses and class discussions. Please read the assigned readings and prepare the cases before each class so that you could contribute effectively to case discussions. Learning with cases occurs at three stages: at individualclassroom. So after you have prepared a case individually you should discuss it in your study group before coming to the class.• You are expected to participate voluntarily, or will be called upon, to contribute to set exercises and problems. The learning objective of this part of the course is to enhance your communication, listing, and articulatidepend on your ability to applylisten carefully to the discussion under way,thoughts and ideas in coherent and lo

TABLE OF CONTENTS

Section 1: The Role of Accounting as an Information SystemChapter 1 Environment and Theoretical Structure of Financial AccountingChapter 2 Review of the Accounting ProcessChapter 3 The Balance Sheet and Financial Chapter 4 The Income Statement and Statement of Cash FlowsChapter 5 Income Measurement and Profitability AnalysisChapter 6 Time Value of Money Concepts

2. Know how to describe and analyze various financial statements and accounting information provided by business entities. 3. Be familiar with the accounting process and the fundamental accounting concepts.4. Be able to present the different treatments between IFRS and US GAAP, if any.5. Be capable of identifying and discussing the ethical issues in accounting.

ASSESSMENT TASKS

Standards for Assessment: The success of this course depends on your individual and collective contribution to

the case analyses and class discussions. Please read the assigned readings and prepare each class so that you could contribute effectively to case discussions.

Learning with cases occurs at three stages: at individual-level, at groupclassroom. So after you have prepared a case individually you should discuss it in your

roup before coming to the class. You are expected to participate voluntarily, or will be called upon, to contribute to set

exercises and problems. The learning objective of this part of the course is to enhance your communication, listing, and articulations skills. Your grade for this part will depend on your ability to apply relevant theories and concepts to the case under study, listen carefully to the discussion under way, organize your remarks, and articulate your thoughts and ideas in coherent and logical manner.

TABLE OF CONTENTS

Section 1: The Role of Accounting as an Information System Chapter 1 Environment and Theoretical Structure of Financial AccountingChapter 2 Review of the Accounting Process Chapter 3 The Balance Sheet and Financial Disclosures Chapter 4 The Income Statement and Statement of Cash Flows Chapter 5 Income Measurement and Profitability Analysis Chapter 6 Time Value of Money Concepts

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2. Know how to describe and analyze various financial statements and accounting

3. Be familiar with the accounting process and the fundamental accounting concepts. 4. Be able to present the different treatments between IFRS and US GAAP, if any.

accounting.

The success of this course depends on your individual and collective contribution to the case analyses and class discussions. Please read the assigned readings and prepare

each class so that you could contribute effectively to case discussions. level, at group-level and in

classroom. So after you have prepared a case individually you should discuss it in your

You are expected to participate voluntarily, or will be called upon, to contribute to set exercises and problems. The learning objective of this part of the course is to enhance

Your grade for this part will relevant theories and concepts to the case under study,

organize your remarks, and articulate your

Chapter 1 Environment and Theoretical Structure of Financial Accounting


Section 2: Economic Resources Chapter 7 Cash and Receivables Chapter 8 Inventories: Measurement Chapter 9 Inventories: Additional Issues Chapter 10 Property, Plant, and Equipment and Intangible Assets: Acquisition and Disposition Chapter 11 Property, Plant, and Equipment and Intangible Assets: Utilization and Impairment

Section 3: Financial Instruments and Liabilities Chapter 12 Investments Chapter 13 Current Liabilities and Contingencies Chapter 14 Bonds and Long-Term Notes Chapter 15 Leases Chapter 16 Accounting for Income Taxes Chapter 17 Pensions and Other Postretirement Benefit Plans Chapter 18 Shareholders’ Equity

Section 4: Additional Financial Reporting Issues Chapter 19 Share-Based Compensation and Earnings Per Share Chapter 20 Accounting Changes and Errors Chapter 21 Statement of Cash Flows Revisited

Appendix A: Derivatives Appendix B: Dell Annual Report Appendix C: IFRS Comprehensive Case

Reference

1. J.David Spiceland, James F.Sepe, and Lawrence A. Tomassini,(2007), “ Intermediate Accounting”4 Edition, McGraw-Hill (USA).

2. NEEDLES. ANDERSON. CALDWELL Financial & Managerial Accounting A Corporate Approach Fourth Edition © 1996

3. Jam R. Williams, Susan F. Haka, and Mark S. Bettner. ( 2005). Financial & and Managerial Accounting 13 Edition, McGra-Hill (USA).

4. Ministry of Economy and Finance. 2003. The Cambodian Accounting Standards (CAS). Cambodia.

5. Ministry of Economy and Finance, National Accounting Council .2006. Financial Reporting Template for Small and Medium Sized Enterprises.

► Internet Web for these Courses: www.mhhe.com/hm My Web Blog: www.nutkhorn.wordpress.com www.mhhe.com/spiceland5e


COURSE REQUIREMENT

Student must have basic knowledge of Business mathematics, business, Accounting Principles, Financial Accounting and others fields of business.

EVALUATION OF THE STUDENT PERFORMANCE

Course assessment:

Attendance and participation……………. 20 % Home work……………. 20% Assignment………………................... 20% Mid-term Exam…………… 20% Final Examination ………….. 20 % Total: ………….. 100% COURSE DURATION

The duration of this course will take approximately one month and one week or forty-eight (48) hours to complete. Formal class room lectures/ discussion lasting 15 hours will be conducted once a week.

EVALUATION OF STUDENT PERFORMANCE

Beside formal classroom lectures and theoretical discussions, the students will also be introduced to class Self-study questions, questions, exercises, problems, and case-study and discussion that will provide them with a more comprehensive learning package in this course.

It is expected that formal class discussions will provide the conceptual and knowledge-oriented learning, while the class exercises and case study will provide students the experiential, development and sharpening of their managerial skills. Through this process, students can become more involved in the learning process. It is therefore essential that students participate actively in class discussions and during the Q & A group case study presentations. The class exercises and case study are generally action oriented in that individuals or groups of students investigate a situation, develop conclusions, and/or recommendations, and present their ideas/views to their class colleagues.

Work Requirement for a Accounting Principles Major under Mr. Nut Khorn

• I will apply the international standard when I teach all accounting courses I will require that you do all the assigned work before class:

Read your textbook (slide presentation is not complete) Read the power point materials Do the assignments


Prepare for all examinations. Internet research work.

• To perform well in my courses, you need to spend about a minimum of 15 hours per week for this class. If you do not want to make this commitment, then do not take my courses.

• You should be present in all my classes. If you do not show up for my lectures, I will consider you as absent (no need to give excuses).

• If you fail any of my courses (I hope you won’t), you must retake a new written examination plus an oral examination to prove that you know the subjects.

HOME WORK AND ASSIGNMENT

Students MUST COMPLY STRICTLY with the following instructions in writing their Home Work, Individual Assignments, Group Case-study and Group Case-Study Presentation. 1. The student(s) is expected to do his/her own research in order to write up individual assignments and home work. 2. All Individual Assignments/Home work and Group Case-Study MUST be type written on A-4 sized paper with adequate margins. You should include a TITLE PAGE and a LIST OF CONTENTS. 3. Use headings and sub-headings to organize your report, including supporting material(s) as attachments. 4. All reference books/published materials you refer to should be properly referenced (arrange in this order: name of author(s), year, and title of the book, publisher, and the country the book was published) and this must be included in a bibliography at the end of the assignment. 5. Use text referencing when you cite somebody else’s work from your references. Citation may mean direct quoting, or paraphrasing, or summarizing, or simply to make a statement of that author's view of finding. An example of text referencing: Beamer and Varner (2001), suggested that culture is not something we are born with, but rather it is learned. 6. Number all pages sequentially and securely staple and/or bind all sheets together. Schedule of Class Meetings and Assignments

Date Chapter Topic

Class Preparation and

Home work Assignments


Table of Contents

Chapter 01: Environment and Theoretical Structure of Financial Accounting .................... 10

OVERVIEW ........................................................................................................................... 10

LEARNING OBJECTIVES .................................................................................................. 10

FINANCIAL ACCOUNTING ENVIRONMENT ..................................................................... 11

The Economic Environment and Financial Reporting................................................................ 12

Cash versus Accrual Accounting ............................................................................................ 13

The Development of Financial Accounting and Reporting Standards ....................................... 15

Historical Perspective and Standards ...................................................................................... 15

EARLY STANDARD SETTING ........................................................................................... 16

CURRENT STANDARD SETTING. .................................................................................... 16

The Establishment of Accounting Standards—A Political Process ....................................... 18

FASB’s Standard-Setting Process .......................................................................................... 19

Toward Global Accounting Standards .................................................................................... 20

Role of the Auditor ................................................................................................................. 21

Financial Reporting Reform ................................................................................................... 21

A Move Away from Rules-Based Standards? ........................................................................ 22

Ethics in Accounting............................................................................................................... 22

Analytical Model for Ethical Decisions.................................................................................. 22

THE CONCEPTUAL FRAMEWORK .................................................................................. 22

FASB and IASB Joint Conceptual Framework Project .......................................................... 23

Qualitative Characteristics of Accounting Information .......................................................... 25

Practical Boundaries (Constraints) to Achieving Desired Qualitative Characteristics ........... 26

Elements of Financial Statements ........................................................................................... 26

Recognition and Measurement Concepts ............................................................................... 27

Underlying Assumptions and Accounting Principles ............................................................. 28

Evolution of Accounting Principles the Asset/Liability Approach ........................................ 28

Evolution of Accounting Principles the Move toward Fair Value ......................................... 29

Chapter 02: Review of the Accounting Process ........................................................................ 31

The Accounting Equation ....................................................................................................... 32

Accounting Equation for a Corporation.................................................................................. 32

General Ledger ....................................................................................................................... 34

Posting Journal Entries ........................................................................................................... 35


Adjusting Entries .................................................................................................................... 36

The Statement of Cash Flows ................................................................................................. 39

The Statement of Shareholders’ Equity .................................................................................. 40

The Closing Process ............................................................................................................... 40

Post-Closing Trial Balance ..................................................................................................... 41

Chapter 3: The Balance Sheet and Financial Disclosures .......................................................... 42

The Balance Sheet .................................................................................................................. 43

Current Assets ......................................................................................................................... 43

Noncurrent Assets ................................................................................................................... 43

Liabilities ................................................................................................................................ 44

Current Liabilities ................................................................................................................... 44

Long-term Liabilities .............................................................................................................. 44

Disclosure Notes ..................................................................................................................... 45

The Balance Sheet .................................................................................................................. 45

Management Discussion and Analysis ................................................................................... 46

Management’s Responsibilities .............................................................................................. 46

Auditors’ Report ..................................................................................................................... 46

Using Financial Statement Information .................................................................................. 47

Liquidity Ratios ...................................................................................................................... 47

Financing Ratios ..................................................................................................................... 48

Reporting by Operating Segment ........................................................................................... 48

Chapter 4: The Income Statement and Statement of Cash Flows ............................................. 50

Operating versus Nonoperating Income ................................................................................. 52

Income Statement (Single-Step) ............................................................................................. 53

Income Statement (Multiple-Step) ......................................................................................... 54

U. S. GAAP vs. IFRS ............................................................................................................. 54

Earnings Quality ..................................................................................................................... 55

Manipulating Income and Income Smoothing ........................................................................ 55

Operating Income and Earnings Quality ................................................................................ 56

Nonoperating Income and Earnings Quality .......................................................................... 56

Separately Reported Items ...................................................................................................... 57

Intraperiod Income Tax Allocation ........................................................................................ 57

Reporting Discontinued Operations........................................................................................ 58

Reporting Discontinued Operations........................................................................................ 59


Extraordinary Items ................................................................................................................ 59

U. S. GAAP vs. IFRS ............................................................................................................. 60

Unusual or Infrequent Items ................................................................................................... 60

Accounting Changes ............................................................................................................... 60

Change in Accounting Principle ............................................................................................. 61

Change in Depreciation, Amortization, or Depletion Method ................................................ 61

Change in Accounting Estimate ............................................................................................. 62

Change in Reporting Entity .................................................................................................... 62

Correction of Accounting Errors ............................................................................................ 63

Earnings per Share Disclosure ................................................................................................ 64

Comprehensive Income .......................................................................................................... 65

Other Comprehensive Income ................................................................................................ 65

U. S. GAAP vs. IFRS ............................................................................................................. 65

Accumulated Other Comprehensive Income .......................................................................... 66

The Statement of Cash Flows ................................................................................................. 67

Direct and Indirect Methods of Reporting .............................................................................. 69

Format of the Statement of Cash Flows ................................................................................. 69

ANALYZING THE STATEMT OF CASH FLOWS .................................................................. 71

Direct Method ......................................................................................................................... 73

Indirect Method ...................................................................................................................... 73

ALC’s Statement of Cash Flows ............................................................................................ 74

Noncash Investing and Financing Activities .......................................................................... 75

U. S. GAAP vs. IFRS ............................................................................................................. 76

U. S. GAAP vs. IFRS ............................................................................................................. 76

Glossary ...................................................................................................................................... 78


Chapter 01: Environment and Theoretical Structure of Financial Accounting

OVERVIEW The primary function of financial accounting is to provide useful financial information to users external to the business enterprise. The focus of financial accounting is on the information needs of investors and creditors. These users make critical resource allocation decisions that affect the nation’s economy. The primary means of conveying financial information to external users is through financial statements and related notes. In this chapter you explore important topics such as the FASB’s conceptual framework that serve as a foundation for a more detailed study of financial statements, the way the statement elements are measured, and the concepts underlying these measurements and related disclosures.

LEARNING OBJECTIVES


FINANCIAL ACCOUNTING ENVIRONMENT In 1984 an undergraduate student at the University of Texas used $1,000 of his own funds to found a company called PC’s Limited. The student’s vision was to capitalize on the emerging personal computer (PC) business by selling directly to customers rather than through traditional retail outlets. The customer’s PC would not be manufactured until it was ordered. This just-in-time (JIT) approach to production combined with the direct sales model would allow the company to better understand customer needs and more efficiently provide the most effective computing solutions. In 1985, the first full year of company operations, the student’s family contributed $300,000 in expansion capital, and revenue topped $73 million. 1 These were the humble beginnings for a visionary student named Michael Dell and a company eventually renamed Dell Inc. that has become the world’s largest PC manufacturer. Company profits for the year ended January 30, 2009, exceeded $2.4 billion and revenue topped $61 billion. Many factors have contributed to the success of Dell Inc. The company’s founder was visionary in terms of his approach to marketing and production. Importantly, too, the ability to raise external capital from investors and creditors at various times in the company’s history was critical to its growth. Funding began with Michael Dell’s initial $1,000 outlay and his family’s $300,000 investment. In 1988, an initial public offering of the company’s stock provided $30 million in equity financing. 2 Investors and creditors use many different kinds of information before supplying capital to business enterprises like Dell. The information is used to assess the future risk and return of their potential investments in the enterprise. 3 For example, information about the enterprise’s products and its management is of vital importance to this assessment. In addition, various kinds of financial information are extremely important to investors and creditors. You might think of accounting as a special “language” used to communicate financial information about a business to those who wish to use the information to make decisions. Financial accounting, in particular, is concerned with providing relevant financial information to various external users. The chart in Graphic 1–1 illustrates a number of financial information supplier groups as well as several external user groups. Of these groups, the primary focus of financial accounting is on the financial information provided by profit oriented companies to their present and potential investors and creditors. The reason for this focus is discussed in a later section of this chapter. One external user group, often referred to as financial intermediaries, includes financial analysts, stockbrokers, mutual fund managers, and credit rating organizations. These users provide advice to investors and creditors and/or make investment-credit decisions on their behalf. The collapse of Enron Corporation in 2001 and other high profile accounting failures made immensely clear the importance of reporting reliable financial information. On the other hand, managerial accounting deals with the concepts and methods used to provide information to an organization’s internal users, that is, its managers. You study managerial accounting elsewhere in your curriculum. The primary means of conveying financial information to investors, creditors, and other external users is through financial statements and related disclosure notes. The financial statements most frequently provided are (1) the balance sheet or statement of financial position, (2) the income statement or statement of operations, (3) the statement of cash flows, and (4) the statement of shareholders’ equity. As you progress through this text,


you will review and expand your knowledge of the information in these financial statements, the way the elements in these statements are measured, and the concepts underlying these measurements and related disclosures. We use the term financial reporting to refer to the process of providing this information to external users. Keep in mind, though, that external users receive important financial information in a variety of other formats as well, including news releases and management forecasts, prospectuses, and reports filed with regulatory agencies. Dell Inc.’s 2009 financial statements and related disclosure notes are provided in Appendix B located at the back of the text. You also can locate the 2009 statements and notes online at www.dell.com. To provide context for our discussions throughout the text, we occasionally refer to these statements and notes. Also, as new topics are introduced in later chapters, you might want to refer to the information to see how Dell reported the items being discussed.

The Economic Environment and Financial Reporting In the United States, we have a highly developed free-enterprise economy with the majority of productive resources privately owned rather than government owned. It’s important in this type of system that a mechanism exists to allocate the scarce resources of our society, both natural resources and labor, in an efficient manner. Resources should be allocated to private enterprises that will use them best to provide goods and services desired by society and not to enterprises that will waste them. The mechanisms that foster this efficient allocation of resources are the capital markets. We can think of the capital markets simply as a composite of all investors and creditors. The three primary forms of business organization are the sole proprietorship, the partnership, and the corporation. In the United States, sole proprietorships and partnerships outnumber corporations. However, the dominant form of business organization, in terms of the ownership of productive resources, is the corporation. The corporate form makes it easier for an enterprise to acquire resources through the capital markets. Investors provide resources, usually cash, to a corporation in exchange for evidence of ownership interest, that is, shares of stock. Creditors such as banks lend


cash to the corporation. Also, creditors can lend the corporation cash through the medium of bonds. Stocks and bonds usually are traded on organized security markets such as the New York Stock Exchange and the NASDAQ. The advantages and disadvantages of the corporate form are discussed at greater length in Chapter 18. The transfers of these stocks and bonds among individuals and institutions are referred to as secondary market transactions. Corporations receive no new cash from secondary market transactions. New cash is provided in primary market transactions in which the shares or bonds are sold by the corporation to the initial owners. Nevertheless, secondary market transactions are extremely important to the efficient allocation of resources in our economy. These transactions help establish market prices for additional shares and for bonds that corporations may wish to issue in the future to acquire additional capital. Also, many shareholders and bondholders might be unwilling to initially provide resources to corporations if there were no available mechanism for the future sale of their stocks and bonds to others. What information do investors and creditors need to decide which companies will be provided capital? We explore that question next.

Cash versus Accrual Accounting Even though predicting future cash flows is the primary objective, the model best able to achieve that objective is the accrual accounting model. A competing model is cash basis accounting. Each model produces a periodic measure of performance that could be used by investors and creditors for predicting future cash flows.

CASH BASIS ACCOUNTING Cash basis accounting produces a measure called net operating cash flow. This measure is the difference between cash receipts and cash disbursements during a reporting period from transactions related to providing goods and services to customers. Net operating cash flow is very easy to understand and all information required to measure it is factual. Also, it certainly relates to a variable of critical interest to investors and creditors. What could be better in helping to predict future cash flows from selling products and services than current cash flows from these activities? Remember, a company will be able to provide a return to investors and creditors only if it can use the capital provided to generate a positive net operating cash flow. However, there is a major drawback to using the current period’s operating cash flow to predict future operating cash flows. Over the life of the company, net operating cash flow definitely is the variable of concern. However, over short periods of time, operating cash flows may not be indicative of the company’s long-run cash-generating ability (that is, its ability to generate positive net operating cash flows in the future). To demonstrate this, consider the following example. In Illustration 1–1 net operating cash flows are determined for the Carter Company during its first three years of operations. Over the three-year period, Carter generated a positive net operating cash flow of $60,000. At the end of this three-year period, Carter has no outstanding debts. Because total sales and cash receipts over the three-year period were each $300,000, nothing is owed to Carter by customers. Also, at the beginning of the first year, Carter prepaid $60,000 for three years’ rent on the facilities. There are no uncompleted transactions at the end of the three-year period. In that sense, we can view this three-year period as a micro version of the entire life of a company.


The company incurred utility costs of $10,000 per year over the period. However, during the first year only $5,000 actually was paid, with the remainder being paid the second year. Employee salary costs of $50,000 were paid in full each year. Is net operating cash flow for year 1 (negative $65,000) an accurate indicator of future cash-generating ability? 4 Obviously, it is not a good predictor of the positive net cash flows that occur in the next two years. Is the three-year pattern of net operating cash flows indicative of the company’s year-by-year performance? No. But, if we measure the same activities by the accrual accounting model, we get a more accurate prediction of future operating cash flows and a more reasonable portrayal of the balanced operating performance of the company over the three years.

ACCRUAL ACCOUNTING. The accrual accounting model measures the entity’s accomplishments and resource sacrifices during the period, regardless of when cash is received or paid. The accrual accounting model’s measure of periodic accomplishments is called revenues, and the periodic measure of resource sacrifices is called expenses. The difference between revenues and expenses is net income or net loss if expenses are greater than revenues. 5 How would we measure revenues and expenses in this very simplistic situation? Illustration 1–2 offers a possible solution.

Net income of $20,000 for year 1 appears to be a reasonable predictor of the company’s cash-generating ability as total net operating cash flow for the three-year period is a positive $60,000. Also, compare the three-year pattern of net operating cash flows in Illustration 1–1 to the three-year pattern of net income in Illustration 1–2. The net income pattern is more representative of the steady operating performance over the three-year period. 6


While this example is somewhat simplistic, it allows us to see the motivation for using the accrual accounting model. Accrual income attempts to measure the accomplishments and sacrifices that occurred during the year, which may not correspond to cash inflows and outflows. For example, revenue for year 1 is the $100,000 in sales. This is a better measure of the company’s accomplishments during year 1 than the $50,000 cash collected from customers. Does this mean that information about cash flows from operating activities is not useful? No. Indeed, when combined with information about cash flows from investing and financing activities, this information provides valuable input into decisions made by investors and creditors. In fact, collectively, this cash flow information constitutes the statement of cash flows—one of the basic financial statements.

The Development of Financial Accounting and Reporting Standards Accrual accounting is the financial reporting model used by the majority of profit-oriented companies and by many not-for-profit companies. The fact that companies use the same model is important to financial statement users. Investors and creditors use financial information to make their resource allocation decisions. It’s critical that they be able to compare financial information among companies. To facilitate these comparisons, financial accounting employs a body of standards known as generally accepted accounting principles, often abbreviated as GAAP (and pronounced gap ). GAAP is a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting the information in their financial statements and related notes. The more important broad principles underlying GAAP are discussed in a subsequent section of this chapter and revisited throughout the text in the context of accounting applications for which they provide conceptual support. 8 Specific standards, such as how to measure and report a lease transaction, receive more focused attention in subsequent chapters.

Historical Perspective and Standards Pressures on the accounting profession to establish uniform accounting standards began to surface after the stock market crash of 1929. Some feel that insufficient and misleading financial statement information led to inflated stock prices and that this contributed to the stock market crash and the subsequent depression. The 1933 Securities Act and the 1934 Securities Exchange Act were designed to restore investor confidence. The 1933 act sets forth accounting and disclosure requirements for initial offerings of securities (stocks and bonds). The 1934 act applies to secondary market transactions and mandates reporting requirements for companies whose securities are publicly traded on either organized stock exchanges or in over-the-counter markets. 9 The 1934 act also created the Securities and Exchange Commission (SEC). In the 1934 act, Congress gave the SEC the authority to set accounting and reporting standards for companies whose securities are publicly traded. However, the SEC, a government appointed body, has delegated the task of setting accounting standards to the private sector. It is important to understand that the power still lies with the SEC. If


the SEC does not agree with a particular standard issued by the private sector, it can force a change in the standard. In fact, it has done so in the past. The SEC does issue its own accounting standards in the form of Financial Reporting Releases (FRRs), which regulate what information companies must report to it. The SEC also issues Staff Accounting Bulletins as authoritative supplements for reporting issues. These standards usually agree with those previously issued by the private sector. To learn more about the SEC, consult its Internet site at www.sec.gov

EARLY STANDARD SETTING The first private sector body to assume the task of setting accounting standards was the Committee on Accounting Procedure (CAP). The CAP was a committee of the American Institute of Accountants (AIA). The AIA, which was renamed the American Institute of Certified Public Accountants (AICPA) in 1957, is the national professional organization for certified professional public accountants. From 1938 to 1959, the CAP issued 51 Accounting Research Bulletins (ARBs) which dealt with specific accounting and reporting problems. No theoretical framework for financial accounting was established. This approach of dealing with individual issues without a framework led to stern criticism of the accounting profession. In 1959 the Accounting Principles Board (APB) replaced the CAP. Members of the APB also belonged to the AICPA. The APB operated from 1959 through 1973 and issued 31 Accounting Principles Board Opinions (APBOs), various Interpretations, and four Statements. The Opinions also dealt with specific accounting and reporting problems. Many ARBs and APBOs have not been superseded and still represent authoritative GAAP. The APB’s main effort to establish a theoretical framework for financial accounting and reporting was APB Statement No. 4, “Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises.” Unfortunately, the effort was not successful. The APB was composed of members of the accounting profession and was supported by their professional organization. Members participated in the activities of the board on a voluntary, part-time basis. The APB was criticized by industry and government for its inability to establish an underlying framework for financial accounting and reporting and for its inability to act quickly enough to keep up with financial reporting issues as they developed. Perhaps the most important flaw of the APB was a perceived lack of independence. Composed almost entirely of certified public accountants, the board was subject to the criticism that the clients of the represented public accounting firms were exerting self-interested pressure on the board and influencing decisions. Another complaint was the absence of varied interest groups in the standard-setting process.

CURRENT STANDARD SETTING. Criticism of the APB led to the creation in 1973 of the Financial Accounting Standards Board (FASB) and its supporting structure. The FASB differs from its predecessor in many ways. There are five full-time members of the FASB, compared to 18–21 part-time members of the APB. While all of the APB members belonged to the AICPA, FASB members represent various constituencies concerned with accounting standards. Members have included representatives from the


accounting profession, profit-oriented companies, accounting educators, and government. The APB was supported financially by the AICPA, while the FASB is supported by its parent organization, the Financial Accounting Foundation (FAF). The FAF is responsible for selecting the members of the FASB and its Advisory Council, ensuring adequate funding of FASB activities, and exercising general oversight of the FASB’s activities. The FASB is, therefore, an independent, private sector body whose members represent a broad constituency of interest groups. In 1984, the FASB’s Emerging Issues Task Force (EITF) was formed to provide more timely responses to emerging financial reporting issues. The EITF membership includes 15 individuals from public accounting and private industry, along with a representative from the FASB and an SEC observer. The membership of the task force is designed to include individuals who are in a position to be aware of emerging financial reporting issues. The task force considers these emerging issues and attempts to reach a consensus on how to account for them. If consensus can be reached, generally no FASB action is required. The task force disseminates its rulings in the form of EITF Issues. These pronouncements are considered part of generally accepted accounting principles. If a consensus can’t be reached, FASB involvement may be necessary. The EITF plays an important role in the standard-setting process by identifying potential problem areas and then acting as a filter for the FASB. This speeds up the standard-setting process and allows the FASB to focus on pervasive long-term problems. One of the FASB’s most important activities has been the formulation of a conceptual framework. The conceptual framework discussed in more depth later in this chapter, deals with theoretical and conceptual issues and provides an underlying structure for current and future accounting and reporting standards. The Board also has issued over 160 specific accounting standards, called Statements of Financial Accounting Standards (SFASs), as well as numerous FASB Interpretations, Staff Positions and Technical Bulletins.

HIERARCHY OF STANDARD-SETTING AUTHORITY

Graphic 1–2 summarizes this discussion on accounting standards. The graphic shows then hierarchy of accounting standard setting in order of authority. Congress gave the SEC the authority to set accounting standards, specifically for companies whose securities are publicly traded. However, the SEC has delegated the task to various private sector bodies (currently the FASB) while retaining its legislated authority. From the above discussion, we can see that multiple sources comprise the body of literature referred to as GAAP, including pronouncements and interpretations of the


SEC, CAP, APB, and FASB, as well as AICPA industry guides, bulletins, and interpretations. Determining the appropriate accounting treatment for a particular event or transaction might require an accountant to research several of these sources. To simplify the task of researching an accounting topic, in 2007 the FASB launched its FASB Accounting Standards Codification project. The objective of the project was to integrate and topically organize all relevant accounting pronouncements comprising GAAP in a searchable, online database.14 The codification became effective on July 1, 2009, and now represents the single source of authoritative nongovernmental U.S. GAAP, except for rules and interpretive releases of the SEC, which remain also as sources of authoritative GAAP. All other literature is now nonauthoritative. The codification is organized into nine main topics and approximately 90 subtopics. The main topics and related numbering system are illustrated in Graphic 1–3. The Codification can be located at www.fasb.org

Throughout the text, we use the new Accounting Standards Codification System (ASC) in footnotes when referencing generally accepted accounting principles (FASB ASC followed by the appropriate number). Each footnote also includes a reference to the original accounting standard that is codified in ASC. Your instructor may assign end-of-chapter exercises and cases that ask you to research the FASB’s Accounting Standards Codification.

The Establishment of Accounting Standards—A Political Process The Financial Accounting Standards Board must consider the potential economic consequences of accounting standards. Many times, financial accounting standards are a compromise between the Board’s position and the wishes of various special interest groups. Especially controversial in recent years has been the efforts to develop


accounting standards for employee stock options, business combinations, and the fair value standard. The FASB’s dilemma is to balance accounting considerations and political considerations resulting from perceived economic consequences.

FASB’s Standard-Setting Process The Financial Accounting Standards Board goes through an elaborate process before issuing standards. First, the Board receives requests/recommendations for possible projects and reconsideration of existing standards from various sources. Second, the FASB Chairman decides whether to add a project to the technical agenda, subject to oversight by the Foundation's Board of Trustees and after appropriate consultation with FASB Members and others. Third, the Board deliberates at one or more public meetings the various issues identified and analyzed by the staff. Fourth, the Board issues an Exposure Draft (ED). (In some projects, a Discussion Paper may be issued to obtain input at an early stage that is used to develop an Exposure Draft.) Fifth, the Board holds a public roundtable meeting on the Exposure Draft, if necessary. Sixth, the staff analyzes comment letters, public roundtable discussion, and any other information, and the Board re-deliberates the proposed provisions at public meetings. And lastly, the Board issues Board issues an Accounting Standards Update describing amendments to the Accounting Standards Codification.

� Board receives recommendations for projects.


� Board votes to add the project to its agenda. � Board deliberates the issues at a series of public meetings. � Board issues an Exposure Draft (ED). � Board holds a public roundtable meeting on the ED. � Staff analyzes feedback and the Board re-deliberates the proposed revisions at

public meetings. � Board issues a Standards Update describing amendments to the Codification.

Toward Global Accounting Standards The increase in international trade and the presence of large multinational companies in many countries in the world has led to problems where different accounting standards govern financial reporting in different countries. In response to this problem, the International Accounting Standards Committee (IASC) was formed in 1973. The IASC reorganized itself in 2001 and created a new standards setting body called the International Accounting Standards Board (IASB). The main objective of the IASB is to develop a single set of high quality, understandable and enforceable global accounting standards to help participants in the world’s capital markets and other users make economic decisions. The IASB issues standards called International Financial Reporting Standards or IFRSs which are gaining support around the globe. According to the SEC Roadmap, IFRS may be required by U.S. Companies in 2014. The main objective of the International Accounting Standards Board (IASB) is to develop a single set of high quality, understandable and enforceable global accounting standards to help participants in the world’s capital markets and other users make economic decisions.


Role of the Auditor Management prepares a company’s financial statements. Auditors serve as independent intermediaries to help insure that management has appropriately applied generally accepted accounting principles in preparing the company’s financial statements. Auditors express an opinion on the compliance of the financial statements with generally accepted accounting principles. The auditor’s opinion adds credibility to the financial statements. Audits are conducted by a Certified Public Accountants (CPAs) who are licensed by states to provide audit services. Auditors serve as independent intermediaries to help insure that management has appropriately applied GAAP in preparing the company’s financial statements.

Financial Reporting Reform The collapse of Enron in 2001, followed by other accounting scandals in companies like WorldCom, caused Congress to pass the Public Company Accounting Reform and Investor Protection Act of 2002. The Act is commonly referred to as the Sarbanes-Oxley Act named for the two congressmen who sponsored the bill. The goal was to restore credibility and investor confidence in the financial reporting process. This federal law provides for the regulation of auditors of public securities issuing entities and the types of services they furnish to clients, increases accountability of corporate executives, addresses conflicts of interest for securities analysts, and provides for stiff criminal penalties for violators. As a result of numerous financial scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, (Sarbanes-Oxley Act). The goal was to restore credibility and investor confidence in the financial reporting process.


A Move Away from Rules-Based Standards? Investors and creditors rely on financial accounting information to make resource allocation decisions. The information must be objective and reliable to be of maximum usefulness. A high standard of ethical behavior is expected of the accounting profession throughout the financial accounting and reporting process.

• Rules based accounting standards vs. objectives-oriented approach • Objectives oriented (principles-based) approach stressed professional judgment

Ethics in Accounting Investors and creditors rely on financial accounting information to make resource allocation decisions. The information must possess the fundamental decision-specific qualities of relevance and faithful representation to be of maximum usefulness. A high standard of ethical behavior is expected of the accounting profession throughout the financial accounting and reporting process.

• For financial information to be useful, it should possess the fundamental decision-specific qualities of relevance and faithful representation.

• Management may be under pressure to report desired results and ignore or bend existing rules.

Analytical Model for Ethical Decisions Here you see seven steps that provide a framework for analyzing ethical issues. Following these seven steps can help you apply your sense of right and wrong in the resolution of ethical issues.

� Determine the facts of the situation. � Identify the ethical issue and the stakeholders. � Identify the values related to the situation. � Specify the alternative courses of action. � Evaluate the courses of action. � Identify the consequences of each course of action. � Make your decision and take any indicated action.

THE CONCEPTUAL FRAMEWORK The Conceptual Framework has been described as a constitution, a coherent system of interrelated objectives and fundamental that lead to consistent accounting standards. The conceptual framework does not prescribe generally accepted accounting principles, but it provides an underlying foundation for the development of accounting standards. The Financial Accounting Standards Board issued Statements of Financial Accounting Concepts to disseminate their conceptual framework. Objectives of financial accounting and reporting were addressed in SFAC 1. SFAC outlined the qualitative characteristics of accounting information. The elements of financial statements were described in SFAC 3, and which was superseded by SFAC 6. SFAC 4 deals with the objectives of financial reporting for nonprofit organizations, which are not covered in this text. Recognition and measurement issues were addressed in SFAC 5 and SFAC 7. As part of the ongoing efforts to converge U.S. GAAP and International Financial Reporting Standards, the FASB and the IASB are now working on a joint conceptual framework project.


The Conceptual Framework has been described as a constitution, a coherent system of interrelated objectives and fundamental that lead to consistent accounting standards.

FASB Conceptual Framework (Statements of Financial Accounting Concepts) Objectives of Financial Reporting (SFAC No. 1) Qualitative Characteristics (SFAC No. 2) Elements of Financial Statements (SFAC No. 6) Recognition and Measurement (SFAC No. 5 and SFAC No. 7)

FASB and IASB Joint Conceptual Framework Project Eight Phases:

A. Objective and Qualitative Characteristics B. Elements and Recognition C. Measurement D. Reporting Entity E. Presentation and Disclosure F. Framework for a GAAP Hierarchy G. Applicability to the Not-For-Profit Sector H. Remaining Issues

The FASB and the IASB are now working to develop a common and improved conceptual framework which will provide the foundation of developing principles-based, common standards. The project consists of 8 phases. Phase A is complete and replaces SFAC 1 and SFAC 2. The Boards are currently working on the next three phases, but it will likely take years before the project is completed.


The primary objective of financial reporting is to provide useful information to capital providers. The joint boards stated that their mandate is to assist in the efficient allocation of resources in capital markets. In Phase A of the joint conceptual framework project the boards addressed the objective, fundamental and enhancing qualitative characteristics, and constraints. The broad objectives in Statement of Financial Accounting Concepts One feed into the more specific issues addressed in Statements Two, Five and Six. On your screen, you see a graphic summary of the conceptual framework with key points of Statements Two, Five and Six.


Qualitative Characteristics of Accounting Information Part I. To be useful, information must make a difference in the decision process. Thus, decision usefulness is identified as the overriding objective in this hierarchy. To be useful, information should possess the fundamental qualities of relevance and faithful representation. Both are critical. Part II. Relevance means that the information must possess predictive value and/or confirmatory value, and typically both. Faithful representation exists when there is agreement between a measure and a real-world phenomenon that the measure is supposed to represent. It requires that information be complete, neutral, and free from material error. Part III. There are also four enhancing qualitative characteristics, comparability (consistency), verifiability, timeliness, and understandability.


Practical Boundaries (Constraints) to Achieving Desired Qualitative Characteristics -Cost Effectiveness -Materiality The costs of providing financial information include those of gathering, processing, and disseminating information. There are also costs to the users when interpreting the information. Information is considered to be cost effective only if the perceived benefit of increased decision usefulness exceed the anticipated costs of providing that information. Materiality is another boundary or constraint. Information is material if it has an effect on decisions. Conservatism is a justification for some accounting practices, but it is NOT a desired qualitative characteristic of financial information.

Elements of Financial Statements Statements of Financial Accounting Concepts 6 defines 10 elements of financial statements. • Assets are probable future economic benefits obtained or controlled by a

particular entity as a result of past transactions or events. • Liabilities are probable future sacrifices of economic benefits arising from

present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

• Equity (net assets) is the residual interest in the assets of a business entity. It is also known as stockholders’ equity or shareholders’ equity for corporations.

• Investments by owners are increases in equity resulting from transfers of resources (usually cash) to a company in exchange for ownership interest.

• Distributions to owners are decreases in equity resulting from transfers to owners. A cash dividend is the most common form of distribution to owners.


Recognition and Measurement Concepts Now that various elements have been identified, the issues of recognition and measurement need to be addressed. Recognition is the process of admitting information into the basic financial statements. The four criteria for recognition are definition, measurability, relevance, and reliability. Phase A of the joint FASB and IASB conceptual framework project has replaced reliability with faithful representation. The other issue is measurement, which involves both the choice of a unit of measure and the choice of an attribute to be measured. SFAC No. 7 provides a framework for using the present value of future cash flows in accounting measurements.


Underlying Assumptions and Accounting Principles The four basic assumptions underlying generally accepted accounting principles are:

� All economic events can be identified with a particular economic entity. � In the absence of information to the contrary, it is assumed that the business entity will continue to operate indefinitely. � The life of a business is divided into time periods to provide timely information. � All measurements are in United States dollars.

There are four accounting principles that provide guidance for accounting practice: � Measurement is based on the original transaction amount. � Revenue is recognized when the earnings process is complete, and when there is reasonable certainty of collecting the asset to be received. � Expenses are recognized in the same period as the related revenue. � Financial statements should include any information that could affect the

decisions made by external users. Summary of Recognition and Measurement Concepts

Evolution of Accounting Principles the Asset/Liability Approach Under the asset/liability approach we first measure the assets and liabilities that exist at a balance sheet date and then recognize the revenues, expenses, gains and losses needed to account for the changes in these assets and liabilities from the previous balance sheet date. Using this approach, principles for asset and liability measurement are emphasized, and revenues, expenses, gains and losses are recognized as necessary to


make the balance sheet reconcile with the income statement. A focus on assets and liabilities has led standard-setters to lean more and more toward fair value measurement.

The focus on assets and liabilities has led to increased interest on fair value measurement.

Evolution of Accounting Principles the Move toward Fair Value GAAP defines fair value as the price that would be received to sell assets or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There are three types of valuation techniques that can be used to measure fair value.

� Market approaches base valuation on market information. � Income approaches estimate value by determining the present value of estimated future earnings or cash flows. � Cost approaches base valuation on estimates of amounts required to buy or construct an asset of similar quality and condition.

Fair value is the price that would be received to sell assets or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

� Market Approaches � Cost Approaches � Income Approaches

Fair Value Hierarchy To increase consistency and comparability, the FASB provides a hierarchy that prioritizes the inputs that companies should use when determining fair value. The priority is based on the three broad preference levels shown on your screen. The higher the level (Level 1 is the highest), the more preferable the input. GAAP gives companies the option to report some or all of their financial assets and liabilities at fair value. A description of the inputs used to measure fair value must be disclosed in the notes to the financial statements so that financial statement readers can understand how the fair value was determined. This makes the information more useful to them.


The end of Chapter 01


Chapter 02: Review of the Accounting Process Chapter 1 explained that the primary means of conveying financial information to investors, creditors, and other external users is through financial statements and related notes. The purpose of this chapter is to review the fundamental accounting process used to produce the financial statements. This review establishes a framework for the study of the concepts covered in intermediate accounting. Actual accounting systems differ significantly from company to company. This chapter focuses on the many features that tend to be common to any accounting system. LEARNING OBJECTIVES

LO1 Analyze routine economic events- transactions- and record their affects on a company’s financial position using the accounting equation format.

LO2 Record transactions using the general journal format. LO3 Post the effects of journal entries to T-accounts and prepare an

unadjusted trial balance. LO4 Identify and describe the different types of adjusting journal entries. LO5 Determine the required adjustments, record adjusting journal entries in

general journal format, and prepare adjusted trial balance. LO6 Describe the four basic financial statements. LO7 Explain the closing process. LO8 Convert from cash basis net income to accrual basis net income.


The Accounting Equation

The first objective of any accounting system is to identify the economic events that can be expressed in financial terms by the system. The accounting equation underlies the process used to capture the effects of economic events. Assets equal liabilities plus owners’ equity. This general expression portrays the equality between the total economic resources of an entity (assets) and the total claims to those resources (liabilities and equity). The equation also implies that each economic event affecting this equation will have a dual effect because resources must always equal claims to those resources. The accounting equation can be expanded to include a column for each type of change in owners’ equity, as illustrated here.

��

+ Owner Investment -Owner Withdrawals +Revenues +Gain

-Expenses -Losses

Accounting Equation for a Corporation Owners’ of a corporation are its shareholders, so owners’ equity for a corporation is referred to as shareholders’ equity. Shareholders’ equity for a corporation arises primarily from two sources: (1) amounts invested by shareholders in the corporation and (2) amounts earned by the corporation (on behalf of its shareholders). These are reported as (1) paid-in capital and (2) retained earnings. Retained earnings equals net income less distributions to shareholders (primarily dividends) since the inception of the corporation.

A = L + SE

+ Paid-in Capital + Retained Earnings

+ Revenues + Gains

-Expenses -Losses

-Dividends

Accounting Equation, Debits and Credits, Increases and Decreases The double-entry system is used to process transactions. In the double-entry system, debit means left side of an account and credit means right side of an account. Whether a debit or a credit represents an increase or decrease depends on the type of account. Accounts on the left side of the accounting equation (assets) are increased by debit entries and decreased by credit entries. Accounts on the right side of the equation (liabilities and shareholders’ equity) are increased by credit entries and decreased by debit entries. This arbitrary, but effective, procedure ensures that for each transaction the net impact on the left sides of the accounts always equals the net impact on the right sides of accounts. Notice that increases and decreases in retained earnings are recorded indirectly in revenue, gain, expense, and loss accounts. For example, an expense represents a decrease in retained earnings, which requires a debit. That debit, however, is recorded


in an appropriate expense account rather than in retained earnings itself. This allows the company to maintain a separate record of expenses incurred during an accounting period. The debit to retained earnings for the expense is recorded in a closing entry (reviewed later) at the end of the period, only after the expense total is reflected in the income statement. Similarly, an increase in retained earnings due to a revenue is recorded indirectly with a credit to a revenue account, which is later reflected as a credit to retained earnings. Permanent accounts (assets, liabilities, paid-in capital and retained earnings) represent the basic financial position elements of the accounting equation. Temporary accounts (revenues, gains, expenses and losses) keep track of the changes in the retained earnings component of shareholders’ equity.

Permanent Accounts—assets, liabilities, paid-in capital, retained earnings Temporary Accounts-revenues, gains, expenses, losses

This slide presents the ten steps in the accounting processing cycle. Steps 1-4 take place during the accounting period. Step one: Obtain information about external transactions from source documents. Step two: Analyze the transaction. Step three: Record the transaction in a journal. Step four: Post from the journal to the general ledger. Steps 5-8 occur at the end of the accounting period. Step five: Prepare an unadjusted trial balance. Step six: Record adjusting entries and post to the general ledger accounts. Step seven: Prepare an adjusted trial balance. Step eight: Prepare financial statements. Steps 9 and 10 are required only at the end of the year. Step nine: Close the temporary accounts to retained earnings (at year-end only). Step ten: Prepare a post-closing trial balance (at year-end only).


On July 1, two individuals each invested $30,000 in a new business, Dress Right Clothing Corporation. Each investor was issued 3,000 shares of common stock. Two accounts are affected: Cash, an asset account, increases and Common Stock, a shareholders’ equity account, increases. The journal entry to record this transaction is a debit to the Cash account and a credit to the Common Stock account for $60,000.

July 1 Cash…………………………. $60,000

Common stock…………………. $60,000

General Ledger The general ledger is a collection of accounts. Increases and decreases in each element of a company’s financial statements are recorded in these accounts. A separate account is maintained for individual assets, liabilities, retained earnings, paid-in capital, revenues, gains, expenses, and losses. An account includes the account title, an account number, and columns to record increases, decreases, the cumulative balance, and the date. For instructional purposes we use T-accounts instead of formal ledger accounts.


The “T” account is a shorthand format of an account used by accountants to analyze transactions. It is not part of the bookkeeping system.

Posting Journal Entries The General Journal on this slide summarizes several transactions for Dress Right as they would appear in a general journal. In addition to the date, account titles, debit and credit columns, the journal also has a column titled Post Ref. (Posting Reference). This usually is a number assigned to the general ledger account that is being debited or credited. for purposes of this illustration, all asset accounts have been assigned numbers in the 100s, all liabilities are 200s, permanent shareholders’ equity accounts are 300s, revenues are 400s, and expenses are 500s. Posting is the process of transferring (posting) the debit/credit information from the journal to the general ledger accounts. This slide illustrates the Cash ledger account (in T-account form) for Dress Right after all the general journal transactions for the month of July have been posted. The ledger accounts also contain a posting reference, usually the page number of the journal in which the journal entry was recorded. This allows for easy cross-referencing between the journal and the ledger. The reference GJ1 next to each of the posted amounts indicates that the source of the entry is page 1 of the general journal.


After recording all entries for the period, Dress Right’s Unadjusted Trial Balance would be as follows: Here is the Unadjusted Trial Balance after recording all the entries for the period for Dress Right. Before financial statements are prepared and before adjusting entries are recorded at the end of an accounting period, an unadjusted trial balance usuallyprepared. A trial balance is simply a list of the general ledger accounts, listed in the order that they appear in the ledger, along with their balances at a particular date. Its purpose is to allow us to check for completeness and to prove that the accounts with debit balances equals the sum of the accounts with credit balances, that is, the accounting equation is in balance.

Adjusting Entries At the end of the period, even when all transactions and events are analyzed, corrected, journalized, and posted to appropriate ledger accounts, some account balances will require updating. Adjusting entries are required to implement the accrual accounting model. More specifically, these entries are required to satisfy the realization principle

After recording all entries for the period, Dress Right’s Unadjusted Trial Balance

Here is the Unadjusted Trial Balance after recording all the entries for the period for Dress Right. Before financial statements are prepared and before adjusting entries are recorded at the end of an accounting period, an unadjusted trial balance usuallyprepared. A trial balance is simply a list of the general ledger accounts, listed in the order that they appear in the ledger, along with their balances at a particular date. Its purpose is to allow us to check for completeness and to prove that the accounts with debit balances equals the sum of the accounts with credit balances, that is, the accounting equation is in balance.

At the end of the period, even when all transactions and events are analyzed, corrected, nalized, and posted to appropriate ledger accounts, some account balances will

require updating. Adjusting entries are required to implement the accrual accounting model. More specifically, these entries are required to satisfy the realization principle

Page 36

After recording all entries for the period, Dress Right’s Unadjusted Trial Balance

Here is the Unadjusted Trial Balance after recording all the entries for the period for Dress Right. Before financial statements are prepared and before adjusting entries are recorded at the end of an accounting period, an unadjusted trial balance usually is prepared. A trial balance is simply a list of the general ledger accounts, listed in the order that they appear in the ledger, along with their balances at a particular date. Its purpose is to allow us to check for completeness and to prove that the sum of the accounts with debit balances equals the sum of the accounts with credit balances, that

At the end of the period, even when all transactions and events are analyzed, corrected, nalized, and posted to appropriate ledger accounts, some account balances will

require updating. Adjusting entries are required to implement the accrual accounting model. More specifically, these entries are required to satisfy the realization principle


and the matching principle. Adjusting entries help ensure that all revenues earned in a period are recognized in that period, regardless of when the cash is received. Also, they enable a company to recognize all expenses incurred during a period, regardless when cash payment is made. As a result, a period’s income statement provides a more complete measure of a company’s operating performance and a better measure for predicting future operating cash flows. The balance sheet also provides a more complete assessment of assets and liabilities as sources of future cash receipts and disbursements. You might think of adjusting entries as a method of bringing the company’s financial information up to date before preparing the financial statements.Adjusting entries are necessary for three situations: Prepayments, Accruals, and Estimates. Prepayments are transactions where cash is paid or received expense or revenue is recognized. Accruals are transactions where cash is paid or received after a related expense or revenue is recognized. Accountants must often make estimates in order to comply with the accrual accounting model.

d the matching principle. Adjusting entries help ensure that all revenues earned in a period are recognized in that period, regardless of when the cash is received. Also, they enable a company to recognize all expenses incurred during a period, regardless when cash payment is made. As a result, a period’s income statement provides a more complete measure of a company’s operating performance and a better measure for predicting future operating cash flows. The balance sheet also provides a more

sessment of assets and liabilities as sources of future cash receipts and disbursements. You might think of adjusting entries as a method of bringing the company’s financial information up to date before preparing the financial statements.

s are necessary for three situations: Prepayments, Accruals, and Estimates. Prepayments are transactions where cash is paid or received expense or revenue is recognized. Accruals are transactions where cash is paid or

a related expense or revenue is recognized. Accountants must often make estimates in order to comply with the accrual accounting model.

This is the Adjusted Trial Balance for Dress Right after all adjusting entries have been recorded and posted.Dresuse these balances to prepare the financial statements.

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d the matching principle. Adjusting entries help ensure that all revenues earned in a period are recognized in that period, regardless of when the cash is received. Also, they enable a company to recognize all expenses incurred during a period, regardless of when cash payment is made. As a result, a period’s income statement provides a more complete measure of a company’s operating performance and a better measure for predicting future operating cash flows. The balance sheet also provides a more

sessment of assets and liabilities as sources of future cash receipts and disbursements. You might think of adjusting entries as a method of bringing the company’s financial information up to date before preparing the financial statements.

s are necessary for three situations: Prepayments, Accruals, and Estimates. Prepayments are transactions where cash is paid or received before a related expense or revenue is recognized. Accruals are transactions where cash is paid or

a related expense or revenue is recognized. Accountants must often make

This is the Adjusted Trial Balance for Dress Right after all adjusting entries have been recorded and posted. Dress Right will use these balances to prepare the financial statements.


The purpose of the income statement is to summarize the profit-generating activities of a company that occurred during a particular period of time. It is a change statement in that it reports the changes in shareholders’ equity (retained earnings) that occurred during the period as a result of revenues, expenses, gains and losses. The income statement for Dress Right indicates a profit for the month of July of $2,417. During the month the company was able to increase its net assets (equity) from activities related to selling its product. A common classification scheme is shown here operating items are separated from nonoperating items. Operating items include revenues and expenses directly related to the principal revenue-generating activities of the company. Nonoperating items include gains and losses and revenues and expenses from peripheral activities.

The purpose of the balance sheet is to present the financial position of the company on a particular date. The balance sheet is a statement that presents an organized list of assets, liabilities, and shareholders’ equity at a point in time. The asset section of Dress Right’s balance sheet is illustrated on this slide. As we do on the income statement, we group the balance sheet elements into meaningful categories. For example, most balance sheets include the classifications of current assets, as shown here. Current assets are those assets that are cash, will be converted into cash, or will be used up within one year or the operating cycle, whichever is longer. Examples of assets not classified as current include property and equipment and long-term receivables and investments. The only noncurrent asset Dress Right has is Furniture and Fixtures. The liabilities and shareholders’ equity section of Dress Right’s balance sheet is illustrated on this slide. The liabilities are grouped into current liabilities and long-term liabilities. Current liabilities are debts that will be satisfied within one year or the operating cycle, whichever is longer. All liabilities not classified as current are classified as long-term. Dress Right has several debts classified as current and only one classified as long-term. Shareholders’ equity lists the paid-in capital portion of equity—common stock—and retained earnings. Notice that the income statement ties to the balance sheet through retained earnings. Specifically, the revenue, expense, gain, and loss transactions that make up net income in the income statement ($2,417) become the major components of retained earnings. Later in the chapter we discuss the closing process we use to


transfer, or close, these temporary income statement accounts to the permanent retained earnings account. Notice that the basic accounting equation was in balance: assets equal liabilities plus shareholders’ equity.

The Statement of Cash Flows Similar to the income statement, the statement of cash flows also is a change statement, disclosing the events that caused cash to change during the period. The statement classifies all transactions affecting cash into one of three categories: (1) Operating Activities, (2) Investing Activities, and (3) Financing Activities. Operating activities are inflows and outflows of cash related to transactions entering the determination of net income. Investing activities involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets. Financing activities involve cash inflows and outflows from transactions with creditors and owners. During its first month of operation, Dress Right’s cash account increased $68,500, primarily with cash provided through financing activities.


The Statement of Shareholders’ Equity The statement of shareholders’ equity is also a change statement. It discloses the sources of changes in the various permanent shareholders’ equity accounts that occurred during the period. Looking at Dress Right’s statement of shareholders’ equity, we can see the net effect, $2,417, of the profit-generating transactions that caused retained earnings to change. In addition, the company paid its shareholders a $1,000 dividend that reduced retained earnings. The statement of shareholders’ equity also includes a summary of the changes in Dress Right’s common stock account.

The Closing Process Recall that step 9 of the accounting processing cycle is to close temporary accounts to retained earnings. The closing process serves a dual purpose. First, the temporary accounts are reduced to zero balances, ready to measure activity in the upcoming accounting period. Second, these temporary account balances are closed (transferred)

Cash flows from Operating Activities:Cash inflows: From customers 36,500$ From rent 1,000 Cash outflows: For rent (24,000) For supplies (2,000) To suppliers for merchandise (25,000) To employees (5,000) Net cash used by operating activities (18,500)$ Cash flows from Investing Activities: Purchase of furniture and fixtures (12,000) Cash flows from Financing Activities: Issue of capital stock 60,000$ Increase in notes payable 40,000 Payment of cash dividend (1,000) Net cash provided by financing activities 99,000 Net increase in cash 68,500$

Dress Right Clothing CorporationStatement of Cash Flows

For the Month of July 2011

Common Stock

Retained Earnings

Total Shareholders'

EquityBalance at July 1, 2011 -$ -$ -$ Issue of capital stock 60,000 60,000 Net income for July 2011 2,417 2,417 Less: Dividends (1,000) (1,000) Balance at July 31, 2011 60,000$ 1,417$ 61,417$

Dress Right Clothing CorporationStatement of Shareholders' Equity

For the Month of July 2011


to retained earnings to reflect the changes that have occurred in that account during the period. The closing process applies only to temporary accounts. First, close revenues and expenses to income summary; then income summary is closed to retained earnings. The use of the income summary account is just a bookkeeping convenience that provides a check that all temporary accounts have been properly closed (that is, the balance in income summary equals net income or loss). Next, close dividends to retained earnings.

Post-Closing Trial Balance After the closing entries are posted to the ledger accounts, a post-closing trial balance is prepared. The purpose of this trial balance is to verify that the closing entries were prepared and posted correctly and that the accounts are now ready for next year’s transactions.

DRESS RIGHT CLOTHING CORPORATIONPost-Closing Trial Balance

July 31, 2011Account Title Debits CreditsCash 68,500$ Accounts receivable 2,000 Allowance for uncollectible accounts 500$ Supplies 1,200 Prepaid rent 22,000 Inventory 38,000 Furniture and fixtures 12,000 Accumulated depr.-furniture & fixtures 200 Accounts payable 35,000 Note payable 40,000 Unearned rent revenue 750 Salaries payable 5,500 Interest payable 333 Common stock 60,000 Retained earnings 1,417 Totals 143,700$ 143,700$


Chapter 3: The Balance Sheet and Financial Disclosures

OVERVIEW Chapter 1 stressed the importance of the financial statements in helping investors and creditors predict future cash flows. The balance sheet, along with accompanying disclosures, provides relevant information useful in helping investors and creditors not only to predict future cash flows, but also to make the related assessments of liquidity and long-term solvency. The purpose of this chapter is to provide an overview of the balance sheet and financial disclosures and to explore how this information is used by decision makers. LEARNING OBJECTIVES After studying this chapter, you should be able to:

• LO1 Describe the purpose of the balance sheet and understand its usefulness and limitations.

• LO2 Distinguish among current and noncurrent assets and liabilities. • LO3 Identify and describe the various balance sheet asset classifications. • LO4 Identify and describe the two balance sheet liability classifications. • LO5 Explain the purpose of financial statement disclosures. • LO6 Explain the purpose of the management discussion and analysis

disclosure. • LO7 Explain the purpose of an audit and describe the content of the audit

report. • LO8 Describe the techniques used by financial analysts to transform financial

information into forms more useful analysis. • LO9 Identify and calculate the common liquidity and financing ratios used to

assess risk.


The Balance Sheet The three primary elements of the balance sheet are assets, liabilities and owners’ equity. Let’s look at each of these elements in more detail.

�� Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Current Assets Part I Current assets include cash and all other assets expected to become cash or consumed within one year or the operating cycle, whichever is longer. Current assets includes cash, cash equivalents, short-term investments, receivables, inventories, and prepaid expenses. Part II Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. Cash that is restricted for a special purpose and not available for current operations should not be classified as a current asset.

Noncurrent Assets Noncurrent assets include investments, property, plant and equipment, intangibles, and other long-term assets. Noncurrent assets are not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.

(In thousands) 2006 2007Assets:Current assets: Cash and cash equivalents 3,544,671$ 6,081,593$ Marketable securities 7,699,243 8,137,020 Accounts receivables, net of allowance 1,322,340 2,162,521 Deferred income taxes, net 29,713 68,538 Income taxes receivable - 145,253 Prepaid revenue share, expenses and other assets 443,880 694,213 Total current assets 13,039,847 17,289,138 Noncurrent assets: Prepaid revenue share, expenses and other assets, noncurrent 114,455 168,530 Deferred income taxes, net., non-current - 33,219 Non-marketable equity securities 1,031,850 1,059,694 Property and equipment, net 2,395,239 4,039,261 Intangible assets, net 346,841 446,596 Goodwill 1,545,119 2,299,368 Total noncurrent assets 5,433,504 8,046,668 Total Assets 18,473,351$ 25,335,806$

Google Inc.Balance SheetDecember 31


Liabilities Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events.

Current Liabilities Current liabilities are expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer. Current liabilities include accounts payable, notes payable, accrued liabilities, and current maturities of long-term debt.

Long-term Liabilities Long-term liabilities are not expected to be satisfied through current assets or creation of current liabilities within one year or the operating cycle, whichever is longer. Long-term liabilities include long-term notes, mortgages, long-term bonds, pension obligations, and lease obligations. Shareholders’ Equity is the residual interest in the assets of an entity that remains after deducting liabilities.

(In milions) 2006 2007Liabilities:Current liabilities: Accounts payable 211,169$ 282,106$ Accrued compensation & benefits 351,671 588,390

266,247 465,032 Accrued revenue share 370,364 522,001 Deferred revenue 105,136 178,073 Total current liabilities 1,304,587 2,035,602 Long-term liabilities: Deferred revenue, long-term 20,006 30,249 Deferred income taxes, net 40,421 - Income taxes payable, long-term - 478,372

68,497 101,904 Total long-term liabilities 128,924 610,525 Total liabilities 1,433,511$ 2,646,127$


Other long-term liabilities

Accrued expenses and other current liabilities

(In thousands, except par value per share) 2006 2007Stockholders' equityClass A and Class B common stock, $0.001 par value per share: 9,000,000 shares authorized; 293,027 (Class A 201,268, Class B 91,759) and par value of $293 (Class A $201, Class B $92) and 308,997 (Class A 277,670, Class B 81,327) and par value of $309 (Class A $228, Class B $81) shares issued and outstanding 309$ 313$ Additional paid-in capital 11,882,906 13,241,221 Accumulated other comprehensive income 23,311 113,373 Retained earnings 5,133,314 9,334,772 Total stockholders' equity 17,039,840$ 22,689,679$



Disclosure Notes Part I The full-disclosure principle requires that financial statements provide all material, relevant information concerning the reporting entity. Disclosure notes typically span several pages and either explain or elaborate upon the data presented in the financial statements themselves, or provide information not directly related to any specific item in the statements. Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions. The summary of significant accounting policies conveys valuable information about the company’s choices from among various alternative accounting methods. For example, management chooses whether to use accelerated or straight-line depreciation and whether to use first-in, first-out; last-in, first-out; or weighted average to measure inventories. Typically, this first disclosure note consists of a summary of significant accounting polices that discloses the choices the company makes. Part II A subsequent event is a significant development that takes place after the company’s fiscal year-end but before the financial statements are issued. Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having a material effect on operations. Part III Some transactions and events occur only occasionally, but when they do occur are potentially important to evaluating a company’s financial statements. In this category are related party transactions, errors and irregularities, and illegal acts.

The Balance Sheet The purpose of the balance sheet is to report a company’s financial position on a particular date. The purpose of the balance sheet is to report a company’s financial position on a particular date. It is a freeze frame or snapshot of financial position at the end of a particular day marking the end of an accounting period. A limitation of the balance sheet is that assets minus liabilities, measured according to generally accepted accounting principles, is not likely to be representative of the market value of the entity. Many assets, like land and buildings, are measured at their historical costs rather than their market values. Relatedly, many company resources including its trained employees, its experienced management team, and its reputation are not recorded as assets at all. However, despite these limitations, the balance sheet does have significant value. The balance sheet provides information useful for assessing future cash flows, liquidity, and long-term solvency.


Management Discussion and Analysis The management discussion and analysis (MDA) provides a biased but informed perspective of a company’s operations, liquidity, and capital resources. The MDA section of an annual report relates management’s biased perspective, however, it can offer an informed insight that might not be available elsewhere.

Management’s Responsibilities � Preparing the financial statements and other information in the annual report. � Maintaining and assessing the company’s internal control procedures.

Auditors’ Report Part I There are four types of audit opinions. An unqualified opinion is issued when the financial statements present fairly the financial position, results of operations, and cash flows are in conformity with generally accepted accounting principles. Part II A qualified opinion is issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole. Examples of exceptions are nonconformity with generally accepted accounting principles, inadequate disclosures, and a limitation or restriction of the scope of the examination. Part III

Limitations:

� The balance sheet does not portray the market value of the entity as a going concern nor its liquidation value.

� Resources such as employee skills and reputation are not recorded in the balance sheet.

Usefulness:

� The balance sheet describes many of the resources a company has available for generating future cash flows.

� It provides liquidity information useful in assessing a company’s ability to pay its current obligations.

� It provides long-term solvency information relating to the riskiness of a company with regard to the amount of liabilities in its capital structure.


An adverse opinion is issued when the exceptions are so serious that a qualified opinion is not justified. Adverse opinions are rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report. Part IV A disclaimer opinion is issued when insufficient information has been gathered to express an opinion.

Using Financial Statement Information Part I Investors, creditors, and others use information that companies provide in corporate financial reports to make decisions. Comparative financial statements allow financial statement users to compare year-to-year financial position, results of operations, and cash flows. Part II Some analysts enhance their comparison by using horizontal analysis. Horizontal analysis expresses each item in the financial statements as a percentage of that same item in the financial statements of another year (base amount). Part III Similarly, vertical analysis involves expressing each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, but within the same year. For example, cash inventory, and other assets can be restated as a percentage of total assets; net income and each expense can be restated as a percentage of revenues. Part IV No accounting numbers are meaningful in and of themselves. Ratio analysis allows analysts to control for size differences over time and among firms.

Liquidity Ratios Liquidity refers to the readiness of assets to be converted to cash. Liquidity ratios compare a company’s obligations that will shortly become due with the company’s cash and other current assets that, by definition, are expected to be used to pay for the obligations that will be due in the short term. The current ratio is calculated as current assets divided by current liabilities and measures a company’s ability to satisfy its short-term liabilities. A current ratio of 2 indicates that the company has twice as many current assets available as current liabilities. A company could have difficulty paying its liabilities even with a current ratio significantly greater than 1.o. For example, a large portion of the current assets could include inventory. If the inventory is not able to be converted into cash for several months, obligations may come due that could not be paid out of current assets. The acid-test ratio is calculated as quick assets divided by current liabilities. Quick assets are current assets excluding inventories and prepaid items. By eliminating current assets less readily convertible into cash, this ratio provides a more stringent indication of a company’s ability to pay its current liabilities.

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Financing Ratios Investors and creditors, particularly long-term creditors, are vitally interested in a company’s long-term solvency and stability. The debt to equity ratio is calculated as total liabilities divided by shareholders’ equity. This ratio indicates the extent of reliance on creditors, rather than owners, in providing resources. The higher this ratio, the greater the creditor claims on assets, so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations. The times interest earned ratio is a way to gauge the ability of a company to satisfy its fixed debt obligations by comparing interest charges with the income available to pay those charges. This ratio is calculated as net income plus interest expense plus taxes divided by interest expense. The times interest earned ratio indicates the margin of safety provided to creditors.

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Reporting by Operating Segment Many companies operate in several business segments as a strategy to achieve growth and to reduce operating risk through diversification. Segment reporting facilitates the financial statement analysis of diversified companies. The following characteristics define an operating segment: An operating segment is a component of an enterprise:

• That engages in business activities from which it may earn revenues and incur expenses.

• Whose operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance.

• For which discrete financial information is available. For areas determined to be reportable operating segments, the following disclosures are required:

• General information about the operating segment. • Information about reported segment profit or loss, segment assets,

and the basis of measurement. • Reconciliations of the totals of segment revenues, reported profit or

loss, assets, and other significant items. • Interim period information.

Statement of Financial Accounting Standards Number one hundred thirty one requires an enterprise to report certain geographic information unless it is impracticable to do so. This information includes revenues from external customers attributed to the enterprise’s country of domicile and attributed to all foreign countries in total from which the enterprise derives revenues, and long-lived assets other than financial instruments, long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets located in the enterprise’s country of domicile and located in all foreign countries in total in which the enterprise holds assets.

• Revenues from major customers must also be disclosed. If ten percent or more of the revenue of an enterprise is derived from transactions with a single customer, the enterprise must disclose that fact, the total amount of revenue from each such customer, and the identity of the operating segment or segments


earning the revenue. This information provides insight concerning the extent to which a company’s prosperity depends on one or more major customers.

End of Chapter 3.


Chapter 4: The Income Statement and Statement of Cash Flows The purpose of the income statement is to summarize the profit-generating activities that occurred during a particular reporting period. The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during the period. This chapter has a twofold purpose: (1) to consider important issues dealing with income statement content, presentation, and disclosure and (2) to provide an overview of the statement of cash flows, which is covered in depth in Chapter 21. After studying this chapter, you should be able to:

LO1 Discuss the importance of income from continuing operations and describe its components. (page 170)

LO2 Describe earnings quality and how it is impacted by management practices to manipulate earnings. (page 175)

LO3 Discuss the components of operating and nonoperating income and their relationship to earnings quality. (page 176)

LO4 Define what constitutes discontinued operations and describe the appropriate income statement presentation for these transactions. (page 182)

LO5 Define extraordinary items and describe the appropriate income statement presentation for these transactions. (page 186)

LO6 Describe the measurement and reporting requirements for a change in accounting principle. (page 188)

LO7 Explain the accounting treatments of changes in estimates and correction of errors. (page 190)

LO8 Define earnings per share (EPS) and explain required disclosures of EPS for certain income statement components. (page 192)

LO9 Explain the difference between net income and comprehensive income and how we report components of the difference. (page 194)

LO10 Describe the purpose of the statement of cash flows. (page 198)

LO11 Identify and describe the various classifications of cash flows presented in a statement of cash flows. (page 199)

LO12 Discuss the primary differences between U.S. GAAP and IFRS with respect to the income statement and statement of cash flows. (pages 174, 182, 187, 195, 199, and 204)


Before we discuss the specific components of an income statement in much depth, let’s take a quick look at the general makeup of the statement. The graphic on this slide illustrates an income statement for a hypothetical manufacturing company that you can refer to as we proceed through the chapter. At this point, our objective is only to gain a general perspective of the items reported and classifications contained in corporate income statements. Notice the three general areas include income from continuing operations, separately reported items, and earnings per share.


The need to provide information to help analysts predict future cash flows emphasizes the importance of properly reporting the amount of income from the entity’s continuing operations. Clearly, it is the operating transactions that probably will continue into the future that are the best predictors of future cash flows. The components of income from continuing operations are revenues, expenses (including income taxes), gains, and losses, excluding those related to discontinued operations and extraordinary items. Revenues are inflows of resources resulting from providing goods or services to customers, such as sales revenue. Expenses are outflows of resources incurred in generating revenues, such as cost of goods sold and operating expenses. Gains and losses are increases or decreases in equity from peripheral or incidental transactions of an entity. In general, these gains and losses are those changes in equity that do not result directly from operations but nonetheless are related to those activities. For example, gains and losses from the routine sale of equipment, buildings, or other operating assets and from the sale of investment assets normally would be included in income from continuing operations. Income tax expense is reported separately because of its importance and size.

Operating versus Nonoperating Income Many corporate income statements distinguish between operating income and nonoperating income. Operating income includes revenues and expenses directly related to the primary revenue-generating activities of the company. For example, operating income for a manufacturing company includes sales revenues from selling the products it manufactures as well as all expenses related to this activity. Similarly, operating income might also include gains and losses from selling equipment and other assets used in the manufacturing process. On the other hand, nonoperating income relates to peripheral or incidental activities of the company. For example, a manufacturer would include interest and dividend revenue, gains and losses from selling investments, and interest expense in nonoperating income. Other income (expense) often is the classification heading


companies use in the income statement for nonoperating items. On the other hand, a financial institution like a bank would consider those items to be a part of operating income because they relate to the principal revenue generating activities for that type of business.

Income Statement (Single-Step) No specific standards dictate how income from continuing operations must be displayed, so companies have considerable latitude in how they present the components of income from continuing operations. This flexibility has resulted in a variety of income statement presentations. However, we can identify two general approaches, the single-step and the multiple-step. This slide illustrates an example of a single step income statement for a hypothetical manufacturing company, Maxwell Gear Corporation. The single-step format first lists all the revenues and gains included in income from continuing operations. Then, expenses and losses are grouped, subtotaled, and subtracted—in a single step—from revenues and gains to derive income from continuing operations. Operating and nonoperating items are not separately classified.


Income Statement (Multiple-Step) The multiple-step income statement format includes a number of intermediate subtotals before arriving at income from operations. However, notice that the net income is the same no matter which format is used. A primary advantage of the multiple-step format is that, by separately classifying operating and nonoperating items, it provides information that might be useful in analyzing trends. Similarly, the classification of expenses by function also provides useful information.

U. S. GAAP vs. IFRS There are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying international standards. Some of the differences are:

1. International standards require certain minimum information to be reported on the face of the income statement. U.S. GAAP has no minimum requirements.

2. International standards allow expenses to be classified either by function (e.g., cost of goods sold, general and administrative, etc.), or by natural description (e.g., salaries, rent, etc.). SEC regulations require that expenses be classified by function.

3. In the United States, the “bottom line” of the income statement usually is called either net income or net loss. The descriptive term for the bottom line of the income statement prepared according to international standards is either profit or loss.

4. As we discuss later in the chapter, we report “extraordinary items” separately in an income statement prepared according to U.S. GAAP. International standards prohibit reporting “extraordinary items.”


There are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying IFRS. Some differences are highlighted below.

Earnings Quality Financial analysts are concerned with more than just the bottom line of the income statement—net income. The presentation of the components of net income and the related supplemental disclosures provide clues to the user of the statement in an assessment of earnings quality. Earnings quality is used as a framework for more in-depth discussions of operating and nonoperating income. Earnings quality refers to the ability of reported earnings to predict a company’s future. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts try to separate a company’s transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future.

Manipulating Income and Income Smoothing “Most executives prefer to report earnings that follow a smooth, regular, upward path.” ~Ford S. Worthy, “Manipulating Profits: How It’s Done”, Fortune An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. In a Fortune article titled “Manipulating Profits: How It’s Done” Ford S. Worthy states that “Most executives prefer to report earnings that follow a smooth, regular, upward path. They hate to report declines, but they also want to avoid increases that vary wildly from year to year; it’s better to have two years of 15% earnings increases than a 30% gain one year and none the next. As a result, some companies ‘bank’ earnings by understating them in particularly good years and use the banked profits to polish results in bad years.” How do managers manipulate income? Two major methods are (1) income shifting and (2) income statement classification. Income shifting is achieved by accelerating or delaying the recognition of revenues or expenses. For example, a practice called “channel stuffing”


accelerates revenue recognition by persuading distributors to purchase more of your product than necessary near the end of a reporting period. The most common income statement classification manipulation involves the inclusion of recurring operating expenses in “special charge” categories such as restructuring costs. This practice sometimes is referred to as “big bath” accounting, a reference to cleaning up company balance sheets. Asset reductions, or the incurrence of liabilities, for these restructuring costs result in large reductions in income that might otherwise appear as normal operating expenses either in the current or future years. Two ways to manipulate income:

1. Income shifting 2. Income statement classification

Operating Income and Earnings Quality Should all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? No. Operating expenses may include unusual items that may or may not continue in the future. Restructuring costs are recognized in the period the exit or disposal cost obligation actually is incurred. As an example, suppose terminated employees are to receive termination benefits, but only after they remain with the employer beyond a minimum retention period. In that case, a liability for termination benefits, and corresponding expense, should be accrued in the period(s) the employees render their service. On the other hand, if future service beyond a minimum retention period is not required, the liability and corresponding expense for benefits are recognized at the time the company communicates the arrangement to employees. In both cases, the liability and expense are recorded at the point they are deemed incurred. Similarly, costs associated with closing facilities and relocating employees are recognized when goods or services associated with those activities are received. GAAP also establishes that fair value is the objective for initial measurement of the liability, and that a liability’s fair value often will be measured by determining the present value of future estimated cash outflows. Goodwill Impairment and Long-lived Asset Impairment involves asset impairment losses or charges. Any long-lived asset, whether tangible or intangible, should have its balance reduced if there has been a significant impairment of value. We explore property, plant, and equipment and intangible assets in Chapters 10 and 11. After discussing this topic in more depth in those chapters, we revisit the concept of earnings quality as it relates to asset impairment.

Nonoperating Income and Earnings Quality Most of the components of earnings in an income statement relate directly to the ordinary, continuing operations of the company. Some, though, such as interest and gains or losses are only tangentially related to normal operations. These we refer to as nonoperating items. Some nonoperating items have generated considerable discussion with respect to earnings quality, notably gains and losses generated from the sale of investments. For example, as the stock market boom reached its height late in the year 2000, many companies recorded large gains from sale of investments that had appreciated significantly in value. How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent?


Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings. Supposedly, these pro forma earnings numbers are management’s view of “permanent earnings,” in the sense of being a better long-run performance measure. These pro forma earnings numbers are controversial because determining which items to exclude is at the discretion of management. Therefore, management could mislead investors. Nevertheless, these disclosures do represent management’s perception of what its permanent earnings are and provides additional information to the financial community.

Separately Reported Items Generally accepted accounting principles require that certain transactions be reported separately in the income statement, below income from continuing operations. There are two types of events that, if they have a material effect on the income statement, require separate reporting below income from continuing operations as well as separate disclosure: (1) discontinued operations and (2) extraordinary items. In fact, these are the only two events that are allowed to be reported below continuing operations. The presentation order is as shown on the slide. The objective is to separately report all the income effects of each of these items. The process of associating income tax effects with the income statement components that create them is referred to as intraperiod tax allocation, which we will address in the next section. A third separately reported item, the cumulative effect of a change in accounting principle, might be included for certain mandated changes in accounting principles. Before 2005, most voluntary changes in accounting principles also were treated this way, by including the cumulative effect on the income of previous years from having used the old method rather than the new method in the income statement of the year of change as a separately reported item below extraordinary items. Now, most voluntary changes in accounting principles require retrospective treatment. We no longer report the entire effect in the year of the change. Instead, we retrospectively recast prior years’ financial statements when we report those statements again (in comparative statements, for example) so that they appear as if the newly adopted accounting method had been used in those years presented. We discuss the retrospective approach later in this chapter and in subsequent chapters.

Intraperiod Income Tax Allocation Part I


Intraperiod tax allocation associates (or allocates) income tax expense (or income tax benefits if there is a loss) with each major component of income that causes it. As a result, the two items reported separately below income from continuing operations are presented net of the related income tax effect. For example, assume a company experienced an extraordinary gain during the year. The amount of income tax expense deducted from income from continuing operations is the amount of income tax expense that the company would have incurred if there were no extraordinary gain. The effect on income taxes caused by the extraordinary item is deducted from the extraordinary gain in the income statement. Part II Assume that the Maxwell Gear Corporation had income from continuing operations before income tax expense of $200,000 and an extraordinary gain of $60,000 in 2011. The income tax rate is 40% on all items of income or loss. Therefore, the company’s total income tax expense is $104,000 (40% × $260,000). However, as illustrated on this slide, the total tax expense of $104,000 must be allocated, $80,000 to continuing operations and $24,000 (40% × $60,000) to the extraordinary gain.

Reporting Discontinued Operations As part of the continuing process to converge U.S. GAAP and international standards, the FASB and IASB worked together to develop a common definition of discontinued operations and a common set of disclosures for disposals of components of an entity. The FASB issued an exposure draft (ED) that outlined the Boards’ preliminary position. At the time this text was published, a final pronouncement had not been issued. The ED defines a “component” of an entity for this purpose as either:

1. An operating segment that has either been disposed of or is classified as “held for sale”; or

2. A business that meets the criteria to be classified as held for sale on acquisition. An operating segment is a part of an enterprise:


1. That may earn revenues and incur expenses. 2. Whose operating results are regularly reviewed to make decisions about

resources to be allocated to the segment and assess its performance. 3. For which discrete financial information is available.

A business that might be considered discontinued is defined the same as when accounting for business combinations, specifically:

1. An integrated set of activities and assets. 2. Capable of being conducted and managed to provide a return in the form of

dividends, lower costs, or other economic benefits. Many were critical of prior U.S. GAAP for its broad definition of a component of the entity. In addition to achieving convergence with international standards, the new guidance, if finalized as outlined in the exposure draft, is expected to reduce the number of business segments that are considered to be components of the entity requiring separate income statement presentation.

Reporting Discontinued Operations When a component has been sold, the reported income effects of a discontinued operation will include two elements: (1) Operating income or loss of the component from the beginning of the reporting period to the disposal date and (2) Gain or loss on the disposal of the component. When the component is considered held for sale, the reported income effects of a discontinued operation will include two elements: (1) Operating income or loss of the component from the beginning of the reporting period to the end of the reporting period and (2) An “impairment loss” if the carrying value of the assets of the component is more than the fair value minus cost to sell.

Extraordinary Items Extraordinary items are material events and transactions that are both unusual in nature and infrequent in occurrence and are reported net of related tax effects. These criteria must be considered in light of the environment in which the entity operates. There is obviously a considerable degree of subjectivity involved in the determination. A key


point in the definition of an extraordinary item is that determining whether an event satisfies both criteria depends on the environment in which the firm operates. The environment includes factors such as the type of products or services sold and the geographical location of the firm’s operations. What is extraordinary for one firm may not be extraordinary for another firm. For example, a loss caused by a hurricane in Florida may not be judged to be extraordinary. However, hurricane damage in New York may indeed be unusual and infrequent. An extraordinary item is a material event or transaction that is both:

1. Unusual in nature, and 2. Infrequent in occurrence

Extraordinary items are reported net of related taxes

U. S. GAAP vs. IFRS U.S. GAAP provides for the separate reporting, as an extraordinary item, of a material gain or loss that is unusual in nature and infrequent in occurrence. In 2003, the IASB revised IAS No. 1. The revision states that neither the income statement nor any notes may contain any items called “extraordinary.” A recent survey of 500 large public companies reported that only four of the companies disclosed an extraordinary gain or loss in their 2007 income statements. Losses from two 21st century “extraordinary” events, the September 11, 2001, terrorist attacks and Hurricane Katrina in 2005, did not qualify for extraordinary treatment. The treatment of these two events, the scarcity of extraordinary gains and losses reported in corporate income statements, and the desire to converge U.S. and international accounting standards could guide the FASB to the elimination of the extraordinary item classification. The scarcity of extraordinary gains and losses reported in corporate income statements and the desire to converge U.S. and international accounting standards could guide the FASB to the elimination of the extraordinary item classification.

Unusual or Infrequent Items Items that are material and are either unusual or infrequent—but not both—are included as a separate item in continuing operations

Accounting Changes Accounting changes fall into one of three categories: (1) a change in an accounting principle, (2) a change in an accounting estimate, or (3) a change in reporting entity. The correction of an error is another adjustment that is accounted for in the same way as certain accounting changes.


Change in Accounting Principle A change in accounting principle refers to a change from one acceptable accounting method to another. There are many situations that allow alternative treatments for similar transactions. Common examples of these situations include the choice among FIFO, LIFO, and average cost for the measurement of inventory and among alternative revenue recognition methods. New standards issued by the FASB also require companies to change their accounting methods. GAAP requires that voluntary accounting changes be accounted for retrospectively. For each year in the comparative statements reported, we revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along. Then, a journal entry is created to adjust all account balances affected to what those amounts would have been. An adjustment is made to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity to account for the cumulative income effect of changing to the new principle in periods prior to those reported. When a new FASB standard mandates a change in accounting principle, the board often allows companies to choose among multiple ways of accounting for the changes. One approach generally allowed is to account for the change retrospectively, exactly as we account for voluntary changes in principles. A second approach is to allow companies to report the cumulative effect on the income of previous years from having used the old method rather than the new method in the income statement of the year of change as a separately reported item below extraordinary items.

• Occurs when changing from one GAAP method to another GAAP method, for example, a change from LIFO to FIFO

• GAAP requires that most voluntary accounting changes be accounted for retrospectively by revising prior years’ financial statements.

• For mandated changes in accounting principles, the FASB often allows companies to choose to account for the change retrospectively or as a separately reported item below extraordinary items.

Change in Depreciation, Amortization, or Depletion Method A change in depreciation, amortization, or depletion method is considered to be a change in accounting estimate that is achieved by a change in accounting principle. We

Type of Accounting Change Definition

Change in Accounting Principle

Change from one GAAP method to another GAAP method

Change in Accounting Estimate

Revision of an estimate because of new information or new experience

Change in Reporting Entity

Preparation of financial statements for an accounting entity other than the entity that existed in the previous period


account for these changes prospectively, exactly as we would any other change in estimate.

Change in Accounting EstimateEstimates are a necessary aspect of accounting. A few of the more common accounting estimates are the amount of future bad debts on existing accounts receivable, the useful life and residual value of a depreciable asset, and future warranty expense. Because estimates require the prediction of future events, it’s not unusual for them to turn out to be wrong. When an estimate is modified as new information comes to light, accounting for the change in estimate is quite straightforward. We do not revise prior years’ financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from that point on, that is, prospectively. Remember that a change in depreciation, amortization, or depletion metconsidered a change in estimate resulting from a change in principle. For that reason, we account for such a change prospectively, similar to the way we account for other changes in estimate. One difference is that most changes in estimate do not rcompany to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justifimethod is preferable.

Change in Reporting EntityPart I A third type of change—financial statements for an accounting entity other than the entity that existed in the previous period. Some changes in reporting entity are a result of changes in accountiexample, GAAP requires companies like Ford, General Motors and General Electric to consolidate their manufacturing operations with their financial subsidiaries, creating a new entity that includes them both. For those changes in entity, the p

account for these changes prospectively, exactly as we would any other change in

Change in Accounting Estimate tes are a necessary aspect of accounting. A few of the more common accounting

estimates are the amount of future bad debts on existing accounts receivable, the useful life and residual value of a depreciable asset, and future warranty expense.

timates require the prediction of future events, it’s not unusual for them to turn out to be wrong. When an estimate is modified as new information comes to light, accounting for the change in estimate is quite straightforward. We do not revise prior

’ financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from that point on, that is,

Remember that a change in depreciation, amortization, or depletion metconsidered a change in estimate resulting from a change in principle. For that reason, we account for such a change prospectively, similar to the way we account for other changes in estimate. One difference is that most changes in estimate do not rcompany to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new

Change in Reporting Entity

—the change in reporting entity —involves the preparation of financial statements for an accounting entity other than the entity that existed in the

Some changes in reporting entity are a result of changes in accountiexample, GAAP requires companies like Ford, General Motors and General Electric to consolidate their manufacturing operations with their financial subsidiaries, creating a new entity that includes them both. For those changes in entity, the p

Page 62

account for these changes prospectively, exactly as we would any other change in

tes are a necessary aspect of accounting. A few of the more common accounting estimates are the amount of future bad debts on existing accounts receivable, the useful life and residual value of a depreciable asset, and future warranty expense.

timates require the prediction of future events, it’s not unusual for them to turn out to be wrong. When an estimate is modified as new information comes to light, accounting for the change in estimate is quite straightforward. We do not revise prior

’ financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from that point on, that is,

Remember that a change in depreciation, amortization, or depletion method is considered a change in estimate resulting from a change in principle. For that reason, we account for such a change prospectively, similar to the way we account for other changes in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing

cation as to why the new

involves the preparation of financial statements for an accounting entity other than the entity that existed in the

Some changes in reporting entity are a result of changes in accounting rules. For example, GAAP requires companies like Ford, General Motors and General Electric to consolidate their manufacturing operations with their financial subsidiaries, creating a new entity that includes them both. For those changes in entity, the prior-period


financial statements that are presented for comparative purposes should be restated to appear as if the new entity existed in those periods. Part II However, the more frequent change in entity occurs when one company acquires another one. In those circumstances, the financial statements of the acquirer include the acquiree as of the date of acquisition, and the acquirer’s prior-period financial statements that are presented for comparative purposes are not restated. This makes it difficult to make year-to-year comparisons for a company that frequently acquires other companies. Acquiring companies are required to provide a disclosure note that presents key financial statement information as if the acquisition had occurred before the beginning of the previous year. At a minimum, the supplemental pro forma information should display revenue, income before extraordinary items, net income, and earnings per share.

Correction of Accounting Errors Errors occur when transactions are either recorded incorrectly or not recorded at all. Accountants employ various control mechanisms to ensure that transactions are accounted for correctly. In spite of this, errors occur. When errors do occur, they can affect any one or several of the financial statement elements on any of the financial statements a company prepares. In fact, many kinds of errors simultaneously affect more than one financial statement. When errors are discovered, they should be corrected. Most errors are discovered in the same year that they are made. These errors are simple to correct. The original erroneous journal entry is reversed and the appropriate entry is recorded. The correction of material errors discovered in a subsequent year is considered to be a prior period adjustment. A prior period adjustment refers to an addition to or reduction in the beginning retained earnings balance in a statement of shareholders’ equity (or statement of retained earnings if that’s presented instead). When it’s discovered that the ending balance of retained earnings in the period prior to the discovery of an error was


incorrect as a result of that error, the balance is corrected. However, simply reporting a corrected amount might cause misunderstanding for someone familiar with the previously reported amount. Explicitly reporting a prior period adjustment on the statement of shareholders’ equity (or statement of retained earnings) avoids this confusion. In addition to reporting the prior period adjustment to retained earnings, previous years’ financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction. Also, a disclosure note communicates the impact of the error on income.

Earnings per Share Disclosure One of the most widely used ratios is earnings per share, which shows the amount of income earned by a company expressed on a per share basis. Companies report both basic and diluted earnings per share. Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Diluted earnings per share reflects the potential for dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised


Companies must disclose per share amounts for (1) income or loss before any separately reported items, (2) each separately reported item, and (3) net income or loss. Report EPS data separately for:

1. Income or Loss from Continuing Operations 2. Separately Reported Items

a) discontinued operations b) extraordinary Items

3. Net Income or Loss

Comprehensive Income Comprehensive income is the total change in equity for a reporting period other than from transactions with owners. Comprehensive income includes net income as well as other gains and losses that change shareholders’ equity but are not included in traditional net income. An expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements.

Other Comprehensive Income Comprehensive income includes traditional net income as well as four additional gains and losses that change shareholders’ equity. The calculation of net income omits certain types of gains and losses that are included in comprehensive income. Companies must report both net income and comprehensive income and reconcile the difference between the two. The following items are part of comprehensive income:

1. net unrealized holding gains (losses) from investments (net of tax). 2. gains and losses due to revising assumptions or market returns differing from

expectations and prior service cost from amending the postretirement benefit plan.

3. when a derivative is designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction.

4. gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum)

U. S. GAAP vs. IFRS As part of a joint project with the FASB, the International Accounting Standards Board (IASB) in 2007 issued a new version of IAS No. 146 that revised the standard to bring international reporting of comprehensive income largely in line with U.S. standards. It provides the option of presenting revenue and expense items and components of OCI either in (a) a single statement of comprehensive income or (b) in a separate income statement followed by a statement of comprehensive income. U.S. GAAP also allows the reporting of other comprehensive income in the statement of shareholders’ equity. Earlier we listed four possible OCI items according to U.S. GAAP. There is an additional possible item, changes in revaluation surplus, under IFRS. In Chapter 10 you will learn that IAS No. 16 permits companies to value property, plant, and equipment at (1) cost less accumulated depreciation or (2) fair value (revaluation). IAS No. 38 provides a similar option for the valuation of intangible assets. U.S. GAAP prohibits revaluation. If the revaluation option is chosen and fair value is higher than book value,


the difference, changes in revaluation surplus, is reported as other comprehensive income and then accumulates in a revaluation surplus account in equity.

Accumulated Other Comprehensive Income In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as an additional component of shareholders’ equity. In addition to reporting OCI that occurs in the current reporting period, we must also report these amounts on a cumulative basis in the balance sheet. This is consistent with the way we report net income that occurs in the current reporting period in the income statement and also report accumulated net income (that hasn’t been distributed as dividends) in the balance sheet as retained earnings. Similarly, we report OCI as it occurs in the current reporting period and also report accumulated other comprehensive income (AOCI) in the balance sheet. This is demonstrated on this slide for Astro-Med Inc.


The Statement of Cash Flows The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during a period. The statement of cash flows helps investors and creditors assess future net cash flows, liquidity, and long-term solvency. A statement of cash flows is required for each income statement period reported.

Classification of Cash Flows (Cash inflows and cash outflows.)

1. Operating Activities Cash flow activities that include the cash effects of transaction that creates revenues and expenses and thus enter into the determination of net income. Operating activities are inflows and outflows of cash related to the transactions entering into the determination of net operating income. A few examples of cash inflows and outflows from operating activities are listed on this slide. The difference between the inflows and the outflows is called net cash flows from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.

2. Investing Activities Cash flow activities that include the acquiring and selling of long-term assets, the acquiring and selling of marketable securities other than cash equivalents and the making and collecting of loans. Investing activities involve the acquisition and sale of (1) long-lived assets used in the business and (2) nonoperating investment assets. A few examples of cash inflows and outflows from investing activities are listed on this slide.

3. Financing Activities: Business activities that involve obtaining resources from or returning resources to owners and providing them with a return on their investment, and obtaining resources from creditors and repaying the amounts borrowed or otherwise settling the obligations. Financing activities involve cash inflows and outflows from transactions with creditors and owners. A few examples of cash inflows and outflows from financing activities are listed on this slide.



Direct and Indirect Methods of Reporting Two generally accepted formats can be used to report operating activities, the direct method and the indirect method. By the direct method, the cash effect of each operating activity is reported directly in the statement of cash flows. By the indirect method, cash flow from operating activities is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis.

Format of the Statement of Cash Flows The three activities discussed above operating, investing, and financing plus the significant noncash investing and financing activities constitute the general format of the statement of cash flows.


COMPANY NAME

Statement of Cash Flows Period Covered

Cash flows from operating activities (List of individual items) xx Net Cash provided (used) by operating activities xxx Cash flows from investing activities (List of individual inflows and outflows) xx Net Cash provided (used) by investing activities xxx Cash flows from financing activities (List of individual inflows and outflows) xx Net Cash provided (used) by financing activities xxx Net increase (decrease) in cash xxx Cash at beginning of period xxx Cash end of period xxx Noncash investing and financing activities (List individual noncash transactions) xxx

Schedule of Cash Flows from Operating Activities ( Indirect Method)

Summary of Adjustments The effects of items on the income statement that do not affect cash flows may be summarized as follows: Add to or Deduct From Net Income Depreciation Expense Add Amortization Expense Add Depletion Expense Add Losses Add Gains Deduct The adjustments for increases and decreases in current assets and current liabilities may be summarized as follows: Add to Deduct from Net Income Net Income Current Assets Accounts Receivable (net) Decrease Increase Inventory Decrease Increase Prepaid Expense Decrease Increase Current Liabilities Accounts Payable Increase Decrease Accrued Liabilities Increase Decrease Income Taxes Payable Increase Decrease


ANALYZING THE STATEMT OF CASH FLOWS

Cash flow yield incomenet

activitiesoperatingfromflowscashnet=

Cash flows to sales salesnet

activitiesoperatingfromflowscashnet=

Free Cash Flow

assetsplantofsalesassetsplant

ofpurchasesdividendsactivitiesoperatingfromflowscashnet

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o THE DIRECT METHOD OF PREPARING THE STATEMENT OF CASH FLOWS Determining Cash Flows from Operating Activities

Cash Receipts from Sales { ceivableAccountsinDecrease

ceivableAccountsinIncreaseSales

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Cash Payments for purchases

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PayableAccountsinDecrease

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InventoryinIncrease

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COGS

Cash Payments

From Operating

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Expenses

Noncash

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To contrast the direct and indirect methods further, consider the example for Arlington Lawn Care (ALC), which began operations at the beginning of 2011. ALC’s 2011 income statement and its year-end balance sheet are shown on this slide. Notice that retained earnings consists of the net income of $35,000 less cash dividends paid of $5,000. While the net income is $35,000, the cash flow from these same activities is not necessarily the same amount. From the income statement, we see that ALC’s net income has four components. Three of those—service revenue, general and administrative expenses, and income tax expense—affect cash flows, but not by the accrual amounts reported in the income statement. One component—depreciation—reduces net income but not cash; it’s simply an allocation over time of a prior year’s expenditure for a depreciable asset. On the next slide we will see how ALC’s operating section of the statement of cash flows uses this information under both the direct and indirect methods.


Direct Method Under the direct method, the cash effect of each operating activity is reported directly in the statement. Under the direct method, the cash effect of each operating activity is reported directly in the statement. For example, cash received from customers is reported as the cash effect of sales activities. Income statement transactions that have no cash flow effect, such as depreciation, are simply not reported. You will recall from the previous slide that ALC’s service revenue is $90,000, but ALC did not collect that much cash from its customers. We know that because accounts receivable increased from $0 to $12,000, so ALC must have collected to date only $78,000 of the amount earned. Similarly, general and administrative expenses of $32,000 were incurred, but $7,000 of that hasn’t yet been paid. We know that because accounts payable increased by $7,000. Also, prepaid insurance increased by $4,000 so ALC must have paid $4,000 more cash for insurance coverage than the amount that expired and was reported as insurance expense. That means cash paid thus far for general and administrative expenses was only $29,000 ($32,000 less the $7,000 increase in accounts payable plus the $4,000 increase in prepaid insurance). The other expense, income tax, was $15,000, but that’s the amount by which income taxes payable increased so no cash has yet been paid for income taxes.

Indirect Method By the indirect method, we arrive at net cash flow from operating activities indirectly by starting with reported net income and working backwards to convert that amount to a cash basis. To report operating cash flows using the indirect method, we take a different approach. We start with ALC’s net income but realize that the $35,000 includes both cash and noncash components. We need to adjust net income, then, to eliminate the noncash effects so that we’re left with only the cash flows. We start by eliminating the only noncash component of net income in our illustration—depreciation expense. Depreciation of $8,000 was subtracted in the income statement, so we simply add it back in to eliminate it. That leaves us with the three components that do affect cash but not by the amounts reported. For those, we need to make adjustments to net income to cause it to reflect cash flows rather than accrual amounts. For instance, we saw earlier that only $78,000 cash was received from customers even though $90,000 in revenue is reflected in net


income. That means we need to include an adjustment to reduce net income by $12,000, the increase in accounts receivable. In a similar manner, we include adjustments for the changes in accounts payable, income taxes payable, and prepaid insurance to cause net income to reflect cash payments rather than expenses incurred. For accounts payable and taxes payable, because more was subtracted in the income statement than cash paid for the expenses related to these two liabilities, we need to add back the differences. Note that if these liabilities had decreased, we would have subtracted, rather than added, the changes. For prepaid insurance, because less was subtracted in the income statement than cash paid, we need to subtract the difference—the increase in prepaid insurance. If this asset had decreased, we would have added, rather than subtracted, the change.

ALC’s Statement of Cash Flows This slide illustrates ALC’s statement of cash flows. Earlier we showed how to arrive at net cash flows from operating activities using either the direct or indirect method. Net cash flows from investing activities represents the difference between the inflows and outflows of the investing activities. The only investing activity for ALC is the investment of $40,000 cash for equipment. We know $40,000 was paid to buy equipment because that balance sheet account increased from no balance to $40,000. Net cash flows from financing activities is the difference between the inflows and outflows of the financing activities. ACL has two financing activities. First, a review of the balance sheet indicates that common stock increased from $0 to $50,000, so we include that amount as a cash inflow from financing activities. Second, information provided with ACL’s financial statements on an earlier slide told us that $5,000 was paid as a cash dividend, which is also a financing activity.


Noncash Investing and Financing Activities As we just discussed, the statement of cash flows provides useful information about the investing and financing activities in which a company is engaged. Even though these primarily result in cash inflows and cash outflows, there may be significant investing and financing activities occurring during the period that do not involve cash flows at all. In order to provide complete information about these activities, any significant noncash investing and financing activities (that is, noncash exchanges) are reported either on the face of the statement of cash flow or in a disclosure note. An example of a significant noncash investing and financing activity is the acquisition of equipment (an investing activity) by issuing either a long-term note payable or equity securities (a financing activity).


U. S. GAAP vs. IFRS Like U.S. GAAP, international standards also require a statement of cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing. However, the U.S. standard designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. IAS No. 7, on the other hand, allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities.

U. S. GAAP vs. IFRS The FASB and IASB are working together on a project, Financial Statement Presentation, to establish a common standard for presenting information in the financial statements, including classifying and displaying line items and aggregating line items into subtotals and totals. This standard will have a dramatic impact on the format of financial statements. An important part of the proposal involves the organization of elements of the balance sheet (statement of financial position), statement of comprehensive income (including the income statement), and statement of cash flows (SCF) into a common set of classifications. The income statement (statement of comprehensive income) and the statement of cash flows are slated to change in several ways. First, though, we should note that the SCF retains the three major classifications of cash flows. The income statement (and balance sheet as well) also will include classifications by operating, investing, and financing activities, providing a “cohesive” financial picture that stresses the relationships among the financial statements. For each statement, though, operating and investing activities will be included within a new category, “business” activities. Each statement also will include three additional groupings: discontinued operations, income taxes, and equity (if needed). The new look for the statement of comprehensive income and the statement of cash flows will be as shown on this slide.


The end of Chapter 04


Glossary

Accounting equation

the process used to capture the effect of economic events; Assets = Liabilities + Owner's Equity.

Accounting Principles Board (APB)

the second private sector body delegated the task of setting accounting standards.

Accounts storage areas to keep track of the increases and decreases in financial position elements.

Accounts payable obligations to suppliers of merchandise or of services purchased on open account.

Accounts receivable

receivables resulting from the sale of goods or services on account.

Accounts receivable aging schedule

applying different percentages to accounts receivable balances depending on the length of time outstanding.

Accrual accounting

measurement of the entity's accomplishments and resource sacrifices during the period, regardless of when cash is received or paid.

Accruals when the cash flow comes after either expense or revenue recognition.

Accrued interest interest that has accrued since the last interest date.

Accrued liabilities expenses already incurred but not yet paid (accrued expenses).

Accrued receivables

the recognition of revenue earned before cash is received.

Accumulated benefit obligation (ABO)

the discounted present value of estimated retirement benefits earned so far by employees, applying the plan's pension formula using existing compensation levels.

Accumulated other comprehensive income

amount of other comprehensive income (nonowner changes in equity other than net income) accumulated over the current and prior periods.

Accumulated postretirement benefit obligation (APBO)

portion of the EPBO attributed to employee service up to a particular date.

Acid-test ratio current assets, excluding inventories and prepaid items, divided by current liabilities.

Acquisition costs the amounts paid to acquire the rights to explore for undiscovered natural resources or to extract proven natural resources.

Activity-based allocation of an asset's cost base using a measure of the asset's


method input or output.

Actuary a professional trained in a particular branch of statistics and mathematics to assess the various uncertainties and to estimate the company's obligation to employees in connection with its pension plan.

Additions the adding of a new major component to an existing asset.

Adjusted trial balance

trial balance after adjusting entries have been recorded.

Adjusting entries internal transactions recorded at the end of any period when financial statements are prepared.

Allocation base the value of the usefulness that is expected to be consumed.

Allocation method the pattern in which the usefulness is expected to be consumed.

Allowance method

recording bad debt expense and reducing accounts receivable indirectly by crediting a contra account (allowance for uncollectible accounts) to accounts receivable for an estimate of the amount that eventually will prove uncollectible.

American Institute of Accountants (AIA)/American Institute of Certified Public Accountants (AICPA)

national organization of professional public accountants.

Amortization cost allocation for intangibles.

Amortization schedule

schedule that reflects the changes in the debt over its term to maturity.

Annuity cash flows received or paid in the same amount each period.

Annuity due cash flows occurring at the beginning of each period.

Antidilutive securities

the effect of the conversion or exercise of potential common shares would be to increase rather than decrease, EPS.

Articles of incorporation

statement of the nature of the firm's business activities, the shares to be issued, and the composition of the initial board of directors.

Asset retirement obligations (AROs)

obligations associated with the disposition of an operational asset.

Assets probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Asset turnover ratio

measure of a company's efficiency in using assets to generate revenue.

Assigning using receivables as collateral for loans; nonpayment of a debt will


require the proceeds from collecting the assigned receivables to go directly toward repayment of the debt.

Attribution process of assigning the cost of benefits to the years during which those benefits are assumed to be earned by employees.

Auditors independent intermediaries who help ensure that management has appropriately applied GAAP in preparing the company's financial statements.

Auditor's report report issued by CPAs who audit the financial statements that informs users of the audit findings.

Average collection period

indication of the average age of accounts receivable.

Average cost method

assumes cost of goods sold and ending inventory consist of a mixture of all the goods available for sale.

Average days in inventory

indicates the average number of days it normally takes to sell inventory.

Bad debt expense an operating expense incurred to boost sales; inherent cost of granting credit.

Balance sheet a position statement that presents an organized list of assets, liabilities, and equity at a particular point in time.

Balance sheet approach

determination of bad debt expense by estimating the net realizable value of accounts receivable to be reported in the balance sheet.

Bank reconciliation

comparison of the bank balance with the balance in the company's own records.

Bargain purchase option (BPO)

provision in the lease contract that gives the lessee the option of purchasing the leased property at a bargain price.

Bargain renewal option

gives the lessee the option to renew the lease at a bargain rate.

Basic EPS computed by dividing income available to common stockholders (net income less any preferred stock dividends) by the weighted-average number of common shares outstanding for the period.

Billings of construction contract

contra account to the asset construction in progress; subtracted from construction in progress to determine balance sheet presentation.

Board of directors establishes corporate policies and appoints officers who manage the corporation.

Bond indenture document that describes specific promises made to bondholders.

Bonds A form of debt consisting of separable units (bonds) that obligates the issuing corporation to repay a stated amount at a specified maturity date and to pay interest to bondholders between the issue date and maturity.


Book value assets minus liabilities as shown in the balance sheet.

Callable allows the issuing company to buy back, or call, outstanding bonds from the bondholders before their scheduled maturity date.

Capital budgeting The process of evaluating the purchase of operational assets.

Capital leases installment purchases/sales that are formulated outwardly as leases.

Capital markets mechanisms that foster the allocation of resources efficiently.

Cash currency and coins, balances in checking accounts, and items acceptable for deposit in these accounts, such as checks and money orders received from customers.

Cash basis accounting/net operating cash flow

difference between cash receipts and cash disbursements during a reporting period from transactions related to providing goods and services to customers.

Cash disbursements journal

record of cash disbursements.

Cash discounts sales discounts; represent reductions not in the selling price of a good or service but in the amount to be paid by a credit customer if paid within a specific period of time.

Cash equivalents certain negotiable items such as commercial paper, money market funds, and U.S. Treasury bills that are highly liquid investments quickly convertible to cash.

Cash equivalents short-term, highly liquid investments that can be readily converted to cash with little risk of loss.

Cash flow hedge a derivative used to hedge against the exposure to changes in cash inflows or cash outflows of an asset or liability or a forecasted transaction (like a future purchase or sale).

Cash flows from financing activities

both inflows and outflows of cash resulting from the external financing of a business.

Cash flows from investing activities

both outflows and inflows of cash caused by the acquisition and disposition of assets.

Cash flows from operating activities

both inflows and outflows of cash that result from activities reported on the income statement.

Cash receipts journal

record of cash receipts.

Certified Public Accountants (CPAs)

licensed individuals who can represent that the financial statements have been audited in accordance with generally accepted auditing standards.


Change in accounting estimate

a change in an estimate when new information comes to light.

Change in accounting principle

switch by a company from one accounting method to another.

Change in reporting entity

presentation of consolidated financial statements in place of statements of individual companies, or a change in the specific companies that constitute the group for which consolidated or combined statements are prepared.

Closing process the temporary accounts are reduced to zero balances, and these temporary account balances are closed (transferred) to retained earnings to reflect the changes that have occurred in that account during the period.

Commercial paper

unsecured notes sold in minimum denominations of $25,000 with maturities ranging from 30 to 270 days.

Committee on Accounting Procedure (CAP)

the first private sector body that was delegated the task of setting accounting standards.

Comparability the ability to help users see similarities and differences among events and conditions.

Comparative financial statements

corresponding financial statements from the previous years accompanying the issued financial statements.

Compensating balance

a specified balance (usually some percentage of the committee amount) a borrower of a loan is asked to maintain in a lowinterest or noninterest-bearing account at the bank.

Completed contract method

recognition of revenue for a long-term contract when the project is complete.

Complex capital structure

potential common shares are outstanding.

Composite depreciation method

physically dissimilar assets are aggregated to gain the convenience of group depreciation.

Compound interest

interest computed not only on the initial investment but also on the accumulated interest in previous periods.

Comprehensive income

traditional net income plus other nonowner changes in equity.

Conceptual framework

deals with theoretical and conceptual issues and provides an underlying structure for current and future accounting and reporting standards.


Conservatism practice followed in an attempt to ensure that uncertainties and risks inherent in business situations are adequately considered.

Consignment the consignor physically transfers the goods to the other company (the consignee), but the consignor retains legal title.

Consistency permits valid comparisons between different periods.

Consolidated financial statements

combination of the separate financial statements of the parent and subsidiary each period into a single aggregate set of financial statements as if there were only one company.

Construction in progress

asset account equivalent to the asset work-inprogress inventory in a manufacturing company.

Contingently issuable shares

additional shares of common stock to be issued, contingent on the occurrence of some future circumstance.

Conventional retail method

applying the retail inventory method in such a way that LCM is approximated.

Convertible bonds bonds for which bondholders have the option to convert the bonds into shares of stock.

Copyright exclusive right of protection given to a creator of a published work, such as a song, painting, photograph, or book.

Corporation the dominant form of business organization that acquires capital from investors in exchange for ownership interest and from creditors by borrowing.

Correction of an error

an adjustment a company makes due to an error made.

Cost effectiveness the perceived benefit of increased decision usefulness exceeds the anticipated cost of providing that information.

Cost of goods sold cost of the inventory sold during the period.

Cost recovery method

deferral of all gross profit recognition until the cost of the item sold has been recovered.

Cost-to-retail percentage

ratio found by dividing goods available for sale at cost by goods available for sale at retail.

Coupons bonds name of the owner was not registered; the holder actually clipped an attached coupon and redeemed it in accordance with instructions on the indenture.

Credits represent the right side of the account.

Cumulative if the specified dividend is not paid in a given year, the unpaid dividends accumulate and must be made up in a later dividend year before any dividends are paid on common shares.

Current assets includes assets that are cash, will be converted into cash, or will be used up within one year or the operating cycle, whichever is longer.


Current liabilities expected to require current assets and usually are payable within one year.

Current maturities of long-term debt

the current installment due on long-term debt, reported as a current liability.

Current ratio current assets divided by current liabilities.

Date of record specific date stated as to when the determination will be made of the recipient of the dividend.

Debenture bond secured only by the "full faith and credit" of the issuing corporation.

Debits represent the left side of the account.

Debt issue cost with either publicly or privately sold debt, the issuing company will incur costs in connection with issuing bonds or notes, such as legal and accounting fees and printing costs, in addition to registration and underwriting fees.

Debt to equity ratio

compares resources provided by creditors with resources provided by owners.

Decision usefulness

the quality of being useful to decision making.

Default risk a company's ability to pay its obligations when they come due.

Deferred annuity the first cash flow occurs more than the one period after the date the agreement begins.

Deferred tax asset taxes to be saved in the future when future deductible amounts reduce taxable income (when the temporary differences reverse).

Deferred tax liability

taxes to be paid in the future when future taxable amounts become taxable (when the temporary differences reverse).

Deficit debit balance in retained earnings.

Defined benefit pension plans

fixed retirement benefits defined by a designated formula, based on employees' years of service and annual compensation.

Defined contribution pension plans

fixed annual contributions to a pension fund; employees choose where funds are invested—usually stocks or fixed-income securities.

Depletion allocation of the cost of natural resources.

Depreciation cost allocation for plant and equipment.

Derivatives financial instruments usually created to hedge against risks created by other financial instruments or by transactions that have yet to occur but are anticipated and that "derive" their values or contractually required cash flows from some other security or index.

Detachable stock the investor has the option to purchase a stated number of shares


purchase warrants

of common stock at a specified option price, within a given period of time.

Development costs

for natural resources, costs incurred after the resource has been discovered but before production begins.

Diluted EPS incorporates the dilutive effect of all potential common shares.

Direct financing lease

lease in which the lessor finances the asset for the lessee and earns interest revenue over the lease term.

Direct method the cash effect of each operating activity (i.e., income statement item) is reported directly on the statement of cash flows.

Direct write-off method

an allowance for uncollectible accounts is not used; instead bad debts that do arise are written off as bad debt expense.

Disclosure notes additional insights about company operations, accounting principles, contractual agreements, and pending litigation.

Discontinued operations

The discontinuance of a component of an entity whose operations and cash flows can be clearly distinguished from the rest of the entity.

Discount Arises when bonds are sold for less than face amount.

Discounting the transfer of a note receivable to a financial institution.

Distributions to owners

decreases in equity resulting from transfers to owners.

Dividend distribution to shareholders of a portion of assets earned.

Dollar-value LIFO (DVL)

Inventory is viewed as a quantity of value instead of a physical quantity of goods. Instead of layers of units from different purchases, the DVL inventory pool is viewed as comprising layers of dollar value from different years.

Dollar-value LIFO retail method

LIFO retail method combined with dollar-value LIFO.

Double-declining-balance (DDB) method

200% of the straight-line rate is multiplied by book value.

Double-entry system

dual effect that each transaction has on the accounting equation when recorded.

Early extinguishment of debt

debt is retired prior to its scheduled maturity date.

Earnings per share (EPS)

the amount of income earned by a company expressed on a per share basis.

Earnings quality refers to the ability of reported earnings (income) to predict a company's future earnings.


Economic events any event that directly affects the financial position of the company.

Effective interest method

recording interest each period as the effective rate of interest multiplied by the outstanding balance of the debt.

Effective rate the actual rate at which money grows per year.

Emerging Issues Task Force (EITF)

responsible for providing more timely responses to emerging financial reporting issues.

Employee share purchase plans

permit all employees to buy shares directly from their company, often at favorable terms.

Equity method used when an investor can't control, but can significantly influence, the investee.

Equity/net assets called shareholders' equity or stockholders' equity for a corporation; the residual interest in the assets of an entity that remains after deducting liabilities.

Estimates prediction of future events.

Ethics a code or moral system that provides criteria for evaluating right and wrong.

Ex-dividend date date usually two business days before the date of the record and is the first day the stock trades without the right to receive the declared dividend.

Executory costs maintenance, insurance, taxes, and any other costs usually associated with ownership.

Expected cash flow approach

adjusts the cash flows, not the discount rate, for the uncertainty or risk of those cash flows.

Expected economic life

useful life of an asset.

Expected postretirement benefit obligation (EPBO)

discounted present value of the total net cost to the employer of postretirement benefits.

Expected return on plan assets

estimated long-term return on invested assets.

Expenses outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing good, rendering services, or other activities that constitute the entity's ongoing major, or central, operations.

Exploration costs for natural resources, expenditures such as drilling a well, or excavating a mine, or any other costs of searching for natural resources.


External events exchange between the company and a separate economic entity.

Extraordinary items

material events and transactions that are both unusual in nature and infrequent in occurrence.

F.O.B. (free on board) shipping point

legal title to the goods changes hands at the point of shipment when the seller delivers the goods to the common carrier, and the purchaser is responsible for shipping costs and transit insurance.

F.O.B. destination the seller is responsible for shipping and the legal title does not pass until the goods arrive at their destination.

Factor financial institution that buys receivables for cash, handles the billing and collection of the receivables, and charges a fee for this service.

Fair value hedge a derivative is used to hedge against the exposure to changes in the fair value of an asset or liability or a firm commitment.

Financial accounting

provides relevant financial information to various external users.

Financial Accounting Foundation (FAF)

responsible for selecting the members of the FASB and its Advisory Council, ensuring adequate funding of FASB activities, and exercising general oversight of the FASB's activities.

Financial Accounting Standards Board (FASB)

the current private sector body that has been delegated the task of setting accounting standards.

Financial activities

cash inflows and outflows from transactions with creditors and owners.

Financial instrument

cash; evidence of an ownership interest in an entity; a contract that imposes on one entity an obligation to deliver cash or another financial instrument, and conveys to the second entity a right to receive cash or another financial instrument; and a contract that imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and conveys to a second entity a right to exchange other financial instruments on potentially favorable terms.

Financial leverage by earning a return on borrowed funds that exceeds the cost of borrowing the funds, a company can provide its shareholders with a total return higher than it could achieve by employing equity funds alone.

Financial reporting

process of providing financial statement information to external users.

Financial statements

primary means of communicating financial information to external parties.

Finished goods costs that have accumulated in work in process are transferred to finished goods once the manufacturing process is completed.


Fiscal year the annual time period used to report to external users.

Fixed-asset turnover ratio

used to measure how effectively managers used PP&E;

Foreign currency futures contract

agreement that requires the seller to deliver a specific foreign currency at a designated future date at a specific price.

Foreign currency hedge

if a derivative is used to hedge the risk that some transactions require settlement in a currency other than the entities' functional currency or that foreign operations will require translation adjustments to reported amounts.

Forward contract calls for delivery on a specific date; is not traded on a market exchange; does not call for a daily cash settlement for price changes in the underlying contract.

Fractional shares a stock dividend or stock split results in some shareholders being entitled to fractions of whole shares.

Franchise contractual arrangement under which the franchisor grants the franchisee the exclusive right to use the franchisor's trademark or tradename within a geographical area, usually for specified period of time.

Franchisee individual or corporation given the right to sell the franchisor's products and use its name for a specified period of time.

Franchisor grants to the franchisee the right to sell the franchisor's products and use its name for a specific period of time.

Freight-in transportation-in; in a periodic system, freight costs generally are added to this temporary account, which is added to purchases in determining net purchases.

Full -cost method allows costs incurred in searching for oil and gas within a large geographical area to be capitalized as assets and expensed in the future as oil and gas from the successful wells are removed from that area.

Full-disclosure principle

the financial reports should include any information that could affect the decisions made by external users.

Funded status difference between the employer's obligation (PBO) and the resources available to satisfy that obligation (plan assets).

Future deductible amounts

the future tax consequence of a temporary difference will be to decrease taxable income relative to accounting income.

Futures contract agreement that requires the seller to deliver a particular commodity at a designated future date at a specified price.

Future taxable amounts

the future tax consequence of temporary difference will be to increase taxable income relative to accounting income.

Future value amount of money that a dollar will grow to at some point in the future.


Gain or loss on the PBO

the decrease or increase in the PBO when one or more estimates used in determining the PBO require revision.

Gains increases in equity from peripheral, or incidental, transactions of an entity.

General journal used to record any type of transaction.

General ledger collection of accounts.

Generally Accepted Accounting Principles (GAAP)

set of both broad and specific guidelines that companies should follow when measuring and reporting the information in their financial statements and related notes.

Going concern assumption

in the absence of information to the contrary, it is anticipated that a business entity will continue to operate indefinitely.

Goodwill unique intangible asset in that its cost can't be directly associated with any specifically identifiable right and it is not separable from the company itself.

Government Accounting Standards Board (GASB)

responsible for developing accounting standards for governmental units such as states and cities.

Gross investment in the lease

total of periodic rental payments and residual value.

Gross method For the buyer, views a discount not taken as part of the cost of inventory. For the seller, views a discount not taken by the customer as part of sales of revenue.

Gross profit method (gross margin method)

estimates cost of goods sold which is then subtracted from cost of goods available for sale to estimate ending inventory.

Gross profit/ratio highlights the important relationship between net sales revenue

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Group depreciation method

collection of assets defined as depreciable assets that share similar service lives and other attributes.

Half-year convention

record one-half of a full year's depreciation in the year of acquisition and another half year in the year of disposal.

Hedging taking an action that is expected to produce exposure to a particular type of risk that is precisely the opposite of an actual


risk to which the company already is exposed.

Historical costs original transaction value.

Horizontal analysis

comparison by expressing each item as a percentage of that same item in the financial statements of another year (base amount) in order to more easily see year-to-year changes.

Illegal acts violations of the law, such as bribes, kickbacks, and illegal contributions to political candidates.

Impairment of value

operational assets should be written down if there has been a significant impairment (fair value less than book value) of value.

Implicit rate of interest

rate implicit in the agreement.

Improvements replacement of a major component of an operational asset.

Income from continuing operations

revenues, expenses (including income taxes), gain, and losses, excluding those related to discontinued operations and extraordinary items.

Income statement statement of operations or statement of earnings is used to summarize the profit-generating activities that occurred during a particular reporting period.

Income statement approach

estimating bad debt expense as a percentage of each period's net credit sales; usually determined by reviewing the company's recent history of the relationship between credit sales and actual bad debts.

Income summary account that is a bookkeeping convenience used in the closing process that provides a check that all temporary accounts have been properly closed.

Income tax expense

provision for income taxes; reported as a separate expense in corporate income statements.

Indirect method the net cash increase or decrease from operating activities is derived indirectly by starting with reported net income and working backwards to convert that amount to a cash basis.

Initial direct costs costs incurred by the lessor that are associated directly with originating a lease and are essential to acquire the lease.

In-process research and development

the amount of the purchase price in a business acquisition that is allocated to projects that have not yet reached technological feasibility.

Installment notes Notes payable for which equal installment payments include both an amount that represents interest and an amount that represents a reduction of the outstanding balance so that at maturity the note is completely paid.

Installment sales method

recognizes revenue and costs only when cash payments are received.


Institute of Internal Auditors

national organization of accountants providing internal auditing services for their own organizations.

Institute of Management Accountants (IMA)

primary national organization of accountants working in industry and government.

Intangible assets operational assets that lack physical substance; examples include patents, copyrights, franchises, and goodwill.

Interest "rent" paid for the use of money for some period of time.

Interest cost interest accrued on the projected benefit obligation calculated as the discount rate multiplied by the projected benefit obligation at the beginning of the year.

Interest rate swap agreement to exchange fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying principal amounts.

Internal control a company's plan to encourage adherence to company policies and procedures, promote operational efficiency, minimize errors and theft, and enhance the reliability and accuracy of accounting data.

Internal events events that directly affect the financial position of the company but don't involve an exchange transaction with another entity.

International Accounting Standards Board (IASB)

objectives are to develop a single set of high-quality, understandable global accounting standards, to promote the use of those standards, and to bring about the convergence of national accounting standards and International Accounting Standards.

International Accounting Standards Committee (IASC)

umbrella organization formed to develop global accounting standards.

International Financial Reporting Standards

voluntary IASB standards.

Intraperiod tax allocation

associates (allocates) income tax expense (or income tax Gross profit Net sales benefit if there is a loss) with each major component of income that causes it.

Intrinsic value the difference between the market price of the shares and the option price at which they can be acquired.

Inventories goods awaiting sale (finished goods), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials).

Inventory goods acquired, manufactured, or in the process of being


manufactured for sale.

Inventory turnover ratio

measures a company's efficiency in managing its investment in inventory.

Investing activities

involve the acquisition and sale of long-term assets used in the business and non-operating investment assets.

Investments by owners

increases in equity resulting from transfers of resources (usually cash) to a company in exchange for ownership interest.

Irregularities intentional distortions of financial statements.

Journal a chronological record of all economic events affecting financial position.

Journal entry captures the effect of a transaction on financial position in debit/credit form.

Just-in-time (JIT) system

a system used by a manufacturer to coordinate production with suppliers so that raw materials or components arrive just as they are needed in the production process.

Land improvements

the cost of parking lots, driveways, and private roads and the costs of fences and lawn and garden sprinkler systems.

Last-in, first-out (LIFO) method

assumes units sold are the most recent units purchased.

Leasehold improvements

account title when a lessee makes improvements to leased property that reverts back to the lessor at the end of the lease.

Lessee user of a leased asset.

Lessor owner of a leased asset.

Leveraged lease a third-party, long-term creditor provides nonrecourse financing for a lease agreement between a lessor and a lessee.

Liabilities probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

LIFO conformity rule

if a company uses LIFO to measure taxable income, the company also must use LIFO for external financial reporting.

LIFO inventory pools

simplifies recordkeeping and reduces the risk of LIFO liquidation by grouping inventory units into pools based on physical similarities of the individual units.

LIFO liquidation the decline in inventory quantity during the period.

Limited liability company

owners are not liable for the debts of the business, except to the extent of their investment; all members can be involved with managing the business without losing liability protection; no limitations on the number of owners.


Limited liability partnership

similar to a limited liability company, except it doesn't offer all the liability protection available in the limited liability company structure.

Line of credit allows a company to borrow cash without having to follow formal loan procedures and paperwork.

Liquidating dividend

when a dividend exceeds the balance in retained earnings.

Liquidity period of time before an asset is converted to cash or until a liability is paid.

Long-term solvency

the riskiness of a company with regard to the amount of liabilities in its capital structure.

Loss contingency existing, uncertain situation involving potential loss depending on whether some future event occurs.

Losses decreases in equity arising from peripheral, or incidental, transactions of the entity.

Lower-of-cost-or-market (LCM)

recognizes losses in the period that the value of inventory declines below its cost.

Management discussion and analysis (MDA)

provides a biased but informed perspective of a company's operations, liquidity, and capital resources.

Managerial accounting

deals with the concepts and methods used to provide information to an organization's internal users (i.e., its managers).

Matching principle

expenses are recognized in the same period as the related revenues.

Materiality if a more costly way of providing information is not expected to have a material effect on decisions made by those using the information, the less costly method may be acceptable.

Measurement process of associating numerical amounts to the elements.

Minimum lease payments

payments the lessee is required to make in connection with the lease.

Minimum pension liability

an employer must report a pension liability at least equal to the amount by which its ABO exceeds its plan assets.

Model Business Corporation Act

designed to serve as a guide to states in the development of their corporation statutes.

Modified accelerated cost recovery system (MACRS)

The federal income tax code allows taxpayers to compute depreciation for their tax returns using this method.

Monetary assets money and claims to receive money, the amount of which is fixed or determinable.


Monetary liabilities

obligations to pay amounts of cash, the amount of which is fixed or determinable.

Mortgage bond backed by a lien on specified real estate owned by the issuer.

Multiple -step income statement format that includes a number of intermediate subtotals before arriving at income from continuing operations.

Natural resources oil and gas deposits, timber tracts, and mineral deposits.

Net income/net loss revenue + gains − (expenses and losses for a period)

income statement bottom line.

Net markdown net effect of the change in selling price (increase, decrease, increase).

Net markup net effect of the change in selling price (increase, increase, decrease).

Net method For the buyer, considers the cost of inventory to include the net, after-discount amount, and any discounts not taken are reported as interest expense. For the seller, considers sales revenue to be the net amount, after discount, and any discounts not taken by the customer as interest revenue.

Net operating loss negative taxable income because tax-deductible expenses exceed taxable revenues.

Net realizable less a normal profit margin (NRV − NP)

lower limit of market.

Net realizable value:

the amount of cash the company expects to actually collect from customers.

Net realizable value (NRV)

upper limit of market.

Neutrality neutral with respect to parties potentially affected.

Noncash investing and financing activities

transactions that do not increase or decrease cash but that result in significant investing and financing activities.

Noninterest-bearing note

notes that bear interest, but the interest is deducted (or discounted) from the face amount to determine the cash proceeds made available to the borrower at the outset.

Nonoperating income

includes gains and losses and revenues and expenses related to peripheral or incidental activities of the company.

Nontemporary difference

difference between pretax accounting income and taxable income and, consequently, between the reported amount of an asset or


liability in the financial statements and its tax basis that will not "reverse" resulting from transactions and events that under existing tax law will never affect taxable income or taxes payable.

Note payable A promissory note (essentially an IOU) that obligates the issuing corporation to repay a stated amount at or by a specified maturity date and to pay interest to the lender between the issue date and maturity.

Notes receivable receivables supported by a formal agreement or note that specifies payment terms.

Objectives-oriented/principles-based accounting standards

approach to standard setting stresses professional judgment, as opposed to following a list of rules.

Operating activities

inflows and outflows of cash related to transactions entering into the determination of net income.

Operating cycle period of time necessary to convert cash to raw materials, raw materials to finished product, the finished product to receivables, and then finally receivables back to cash.

Operating income includes revenues and expenses directly related to the principal revenue-generating activities of the company.

Operating leases fundamental rights and responsibilities of ownership are retained by the lessor and that the lessee merely is using the asset temporarily.

Operating loss carryback

reduction of prior (up to two) years' taxable income by a current net operating loss.

Operating loss forward

reduction of future (up to 20) years' taxable income by a current net operating loss.

Operating segment

a component of an enterprise that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other companies of the same enterprise); whose operating results are regularly reviewed by the enterprise's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance; for which discrete financial information is available.

Operational assets property, plant, and equipment, along with intangible assets.

Operational risk how adept a company is at withstanding various events and circumstances that might impair its ability to earn profits.

Option gives the holder the right either to buy or sell a financial instrument at a specified price.

Option pricing models

statistical models that incorporate information about a company's stock and the terms of the stock option to estimate the option's fair


value.

Ordinary annuity cash flows occur at the end of each period.

Other comprehensive income

certain gains and losses that are excluded from the calculation of net income, but included in the calculation of comprehensive income.

Paid-in capital invested capital consisting primarily of amounts invested by shareholders when they purchase shares of stock from the corporation.

Parenthetical comments/modifying comments

supplemental information disclosed on the face of financial statements.

Participating preferred shareholders are allowed to receive additional dividends beyond the stated amount.

Patent exclusive right to manufacture a product or to use a process.

Pension plan assets

employer contributions and accumulated earnings on the investment of those contributions to be used to pay retirement benefits to retired employees.

Percentage-of-completion method

allocation of a share of a project's revenues and expenses to each reporting period during the contract period.

Periodic inventory system

the merchandise inventory account balance is not adjusted as purchases and sales are made but only periodically at the end of a reporting period when a physical count of the period's ending inventory is made and costs are assigned to the quantities determined.

Periodicity assumption

allows the life of a company to be divided into artificial time periods to provide timely information.

Permanent accounts

represent assets, liabilities, and shareholders' equity at a point in time.

Perpetual inventory system

account inventory is continually adjusted for each change in inventory, whether it's caused by a purchase, a sale, or a return of merchandise by the company to its supplier.

Pledging trade receivables in general rather than specific receivables are pledged as collateral; the responsibility for collection of the receivables remains solely with the company.

Point-of-sale the goods or services sold to the buyer are delivered (the title is transferred).

Post-closing trial balance

verifies that the closing entries were prepared and posted correctly and that the accounts are now ready for next year's transactions.

Posting transferring debits and credits recorded in individual journal entries to the specific accounts affected.


Postretirement benefits

all types of retiree benefits; may include medical coverage, dental coverage, life insurance, group legal services, and other benefits.

Potential common shares

Securities that, while not being common stock may become common stock through their exercise, conversion, or issuance and therefore dilute (reduce) earnings per share.

Predictive value/feedback value

confirmation of investor expectations about future cash-generating ability.

Preferred stock typically has a preference (a) to specified amount of dividends (stated dollar amount per share or percentage of par value per share) and (b) to distribution of assets in the event the corporation is dissolved.

Premium arises when bonds are sold for more than face amount.

Prepaid expense represents an asset recorded when an expense is paid in advance, creating benefits beyond the current period.

Prepayments/deferrals

the cash flow precedes either expense or revenue recognition.

Present value today's equivalent to a particular amount in the future.

Prior period adjustment

addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity due to a correction of an error.

Prior service cost the cost of credit given for an amendment to a pension plan to employee service rendered in prior years.

Product costs costs associated with products and expensed as cost of goods sold only when the related products are sold.

Profit margin on sales

net income divided by net sales; measures the amount of net income achieved per sales dollar.

Pro forma earnings

actual (GAAP) earnings reduced by any expenses the reporting company feels are unusual and should be excluded.

Projected benefit obligation (PBO)

the discounted present value of estimated retirement benefits earned so far by employees, applying the plan's pension formula using projected future compensation levels.

Property dividend when a noncash asset is distributed.

Property, plant, and equipment

land, buildings, equipment, machinery, autos, and trucks.

Prospective approach

the accounting change is implemented in the present, and its effects are reflected in the financial statements of the current and future years only.

Proxy statement contains disclosures on compensation to directors and executives; sent to all shareholders each year.


Purchase commitments

contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates.

Purchase discounts

reductions in the amount to be paid if remittance is made within a designated period of time.

Purchase return a reduction in both inventory and accounts payable (if the account has not yet been paid) at the time of the return.

Purchases journal records the purchase of merchandise on account.

Quasi reorganization

a firm undergoing financial difficulties, but with favorable future prospects, may use a quasi reorganization to write down inflated asset values and eliminate an accumulated deficit.

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Ratio analysis comparison of accounting numbers to evaluate the performance and risk of a firm.

Raw materials cost of components purchased from other manufacturers that will become part of the finished product.

Real estate lease involves land—exclusively or in part.

Realization principle

requires that the earnings process is judged to be complete or virtually complete, and there is reasonable certainty as to the collectibility of the asset to be received (usually cash) before revenue can be recognized.

Rearrangements expenditures made to restructure an asset without addition, replacement, or improvement.

Receivables a company's claims to the future collection of cash, other assets, or services.

Receivables turnover ratio

indicates how quickly a company is able to collect its accounts receivable.

Recognition process of admitting information into the basic financial statements.

Redemption privilege

might allow preferred shareholders the option, under specified conditions, to return their shares for a predetermined redemption price.

Related-party transactions

transactions with owners, management, families of owners or management, affiliated companies, and other parties that can significantly influence or be influenced by the company.

Relevance one of the primary decision-specific qualities that make


accounting information useful; made up of predictive value and/or feedback value, and timeliness.

Reliability the extent to which information is verifiable, representationally faithful, and neutral.

Rent abatement lease agreements may call for uneven rent payments during the term of the lease, e.g., when the initial payment (or maybe several payments) is waived.

Replacement cost (RC)

the cost to replace the item by purchase or manufacture.

Replacement depreciation method

depreciation is recorded when assets are replaced.

Representational faithfulness

agreement between a measure or description and the phenomenon it purports to represent.

Residual value or salvage value, the amount the company expects to receive for the asset at the end of its service life less any anticipated disposal costs.

Restoration costs costs to restore land or other property to its original condition after extraction of the natural resource ends.

Restricted stock shares subject to forfeiture by the employee if employment is terminated within some specified number of years from the date of grant.

Retail inventory method

relies on the relationship between cost and selling price to estimate ending inventory and cost of goods sold; provides a more accurate estimate than the gross profit method.

Retained earnings amounts earned by the corporation on behalf of its shareholders and not (yet) distributed to them as dividends.

Retired stock shares repurchased and not designated as treasury stock.

Retirement depreciation method

Records depreciation when assets are disposed of and measures depreciation as the difference between the proceeds received and cost.

Retrospective approach

financial statements issued in previous years are revised to reflect the impact of an accounting change whenever those statements are presented again for comparative purpose.

Return on assets (ROA)

Indicates a company's overall profitability.

Return on shareholders' equity:

Amount of profit management can generate from the assets that owners provide.

Revenues inflows or other enhancements of assets or settlements of liabilities from delivering or producing goods, rendering services,


or other activities that constitute the entity's ongoing major, or central, operations.

Reverse stock split

when a company decreases, rather than increases, its outstanding shares.

Reversing entries optional entries that remove the effects of some of the adjusting entries made at the end of the previous reporting period for the sole purpose of simplifying journal entries made during the new period.

Right of conversion

shareholders' right to exchange shares of preferred stock for common stock at specified conversion ratio.

Right of return customers' right to return merchandise to retailers if they are not satisfied.

Rules-based accounting standards

a list of rules for choosing the appropriate accounting treatment for a transaction.

S corporation characteristics of both regular corporations and partnerships.

SAB No. 101 Staff Accounting Bulletin 101 summarizes the SEC's views on revenue recognition.

Sale-leaseback transaction

the owner of an asset sells it and immediately leases it back from the new owner.

Sales journal records credit sales.

Sales return the return of merchandise for a refund or for credit to be applied to other purchases.

Sales-type lease in addition to interest revenue earned over the lease term, the lessor receives a manufacturer's or dealer's profit on the sale of the asset.

Sarbanes-Oxley Act

law provides for the regulation of the key players in the financial reporting process.

Secondary market transactions

provide for the transfer of stocks and bonds among individuals and institutions.

Securities and Exchange Commission (SEC)

responsible for setting accounting and reporting standards for companies whose securities are publicly traded.

Securities available-for-sale

equity or debt securities the investor acquires, not for an active trading account or to be held to maturity.

Securities to be held-to-maturity

debt securities for which the investor has the "positive intent and ability" to hold the securities to maturity.

Securitization the company creates a special purpose entity (SPE), usually a trust or a subsidiary; the SPE buys a pool of trade receivables, credit


card receivables, or loans from the company and then sells related securities.

Serial bonds more structured (and less popular) way to retire bonds on a piecemeal basis.

Service cost increase in the projected benefit obligation attributable to employee service performed during the period.

Service life (useful life)

the estimated use that the company expects to receive from the asset.

Service method allocation approach that reflects the declining service pattern of the prior service cost.

Share purchase contract

shares ordinarily are sold in exchange for a promissory note from the subscriber—in essence, shares are sold on credit.

Short-term investments

investments not classified as cash equivalents that will be liquidated in the coming year or operating cycle, whichever is longer.

Significant influence

effective control is absent but the investor is able to exercise significant influence over the operating and financial policies of the investee (usually between 20% and 50% of the investee's voting shares are held).

Simple capital structure

a firm that has no potential common shares (outstanding securities that could potentially dilute earnings per share).

Simple interest computed by multiplying an initial investment times both the applicable interest rate and the period of time for which the money is used.

Single-step income statement format that groups all revenues and gains together and all expenses and losses together.

Sinking fund debentures

bonds that must be redeemed on a prespecified year-by-year basis; administered by a trustee who repurchases bonds in the open market.

Source documents relay essential information about each transaction to the accountant, e.g., sales invoices, bills from suppliers, cash register tapes.

Special journal record of a repetitive type of transaction, e.g., a sales journal.

Specific identification method

each unit sold during the period or each unit on hand at the end of the period to be matched with its actual cost.

Specific interest method

for interest capitalization, rates from specific construction loans to the extent of specific borrowings are used before using the average rate of other debt.

Start-up costs whenever a company introduces a new product or service, or commences business in a new territory or with a new customer, it


incurs one-time costs that are expensed in the period incurred.

Statement of cash flows

change statement summarizing the transactions that caused cash to change during the period.

Statement of shareholders' equity

statement disclosing the source of changes in the shareholders' equity accounts.

Stock appreciation rights (SARs)

awards that enable an employee to benefit by the amount that the market price of the company's stock rises above a specified amount without having to buy shares.

Stock dividend distribution of additional shares of stock to current shareholders of the corporation.

Stock options employees aren't actually awarded shares, but rather are given the option to buy shares at a specified exercise price within some specified number of years from the date of grant.

Stock split stock distribution of 25% or higher, sometimes call a large stock dividend.

Straight line an equal amount of depreciable base is allocated to each year of the asset's service life.

Straight-line method

recording interest each period at the same dollar amount.

Subordinated debenture

the holder is not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied.

Subsequent event a significant development that takes place after the company's fiscal year-end but before the financial statements are issued.

Subsidiary ledger record of a group of subsidiary accounts associated with a particular general ledger control account.

Successful efforts method

requires that exploration costs that are known not to have resulted in the discovery of oil or gas be included as expense in the period the expenditures are made.

Sum-of-the-years'-digits (SYD) method

systematic acceleration of depreciation by multiplying the depreciable base by a fraction that declines each year.

Supplemental financial statements

reports containing more detailed information than is shown in the primary financial statements.

T-account account with space at the top for the account title and two sides for recording increases and decreases.

Taxable income comprises revenues, expenses, gains, and losses as measured according to the regulations of the appropriate taxing authority.

Technological established when the enterprise has completed all planning,


feasibility designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements.

Temporary accounts

represent changes in the retained earnings component of shareholders' equity for a corporation caused by revenue, expense, gain, and loss transactions.

Temporary difference

difference between pretax accounting income and taxable income and, consequently, between the reported amount of an asset or liability in the financial statements and its tax basis which will "reverse" in later years.

Time-based methods

allocates the cost base according to the passage of time.

Timeliness information that is available to users early enough to allow its use in the decision process.

Times interest earned ratio

a way to gauge the ability of a company to satisfy its fixed debt obligations by comparing interest charges with the income available to pay those charges.

Time value of money

money can be invested today to earn interest and grow to a larger dollar amount in the future.

Trade discounts percentage reduction from the list price.

Trademark (tradename)

exclusive right to display a word, a slogan, a symbol, or an emblem that distinctively identifies a company, a product, or a service.

Trade notes payable

formally recognized by a written promissory note.

Trading securities equity or debt securities the investor (usually a financial institution) acquires principally for the purpose of selling in the near term.

Transaction analysis

process of reviewing the source documents to determine the dual effect on the accounting equation and the specific elements involved.

Transaction obligation

the unfunded accumulated postretirement benefit obligation existing when SFAS 106 was adopted.

Transactions economic events.

Treasury stock shares repurchased and not retired.

Troubled debt restructuring

the original terms of a debt agreement are changed as a result of financial difficulties experienced by the debtor (borrower).

Trustee person who accepts employer contributions, invests the contributions, accumulates the earnings on the investments, and pays benefits from the plan assets to retired employees or their


beneficiaries.

Unadjusted trial balance

a list of the general ledger accounts and their balances at a particular date.

Understandability users must understand the information within the context of the decision being made.

Unearned revenues

cash received from a customer in one period for goods or services that are to be provided in a future period.

Units-of-production method

computes a depreciation rate per measure of activity and then multiplies this rate by actual activity to determine periodic depreciation.

Unqualified opinion

auditors are satisfied that the financial statements present fairly the company's financial position, results of operations, and cash flows and are in conformity with generally accepted accounting principles.

Valuation allowance

indirect reduction (contra account) in a deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized.

Verifiability implies a consensus among different measurers.

Vertical analysis expression of each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, but within the same year.

Vested benefits benefits that employees have the right to receive even if their employment were to cease today.

Weighted-average interest method

for interest capitalization, weighted-average rate on all interest-bearing debt, including all construction loans, is used.

Without recourse the buyer assumes the risk of uncollectibility.

With recourse the seller retains the risk of uncollectibility.

Working capital differences between current assets and current liabilities.

Work-in-process inventory

products that are not yet complete.

Worksheet used to organize the accounting information needed to prepare adjusting and closing entries and the financial statements.

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