Financial Accounting AN INTRODUCTION TO CONCEPTS, METHODS, AND USES Clyde P. Stickney Dartmouth College Roman L. Weil University of Chicago Katherine Schipper Duke University Jennifer Francis Duke University Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States Financial Accounting, An Introduction © 2010, 2007 South-Western, Cengage Learning to Concepts, Methods, and Uses, 13e ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be Clyde P. Stickney, Roman L. Weil, Katherine Schipper, reproduced or used in any form or by any means—graphic, electronic, or mechanical, Jennifer Francis including photocopying, recording, taping, Web distribution, information storage and retrieval systems, or in any other manner—except as may be permitted by the license Vice President of Editorial, Business: Jack W. Calhoun terms herein. 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The really useful training yields a comprehension of a few general principles with a thorough grounding in the way they apply to a variety of concrete details. In subsequent practice the students will have forgotten your particular details; but they will remember by an unconscious common sense how to apply principles to immediate circumstances. Alfred North Whitehead The Aims of Education and Other Essays WARNING: Study of this book is known to cause thinking, occasionally deep thinking. Typical side effects include mild temporary anxiety followed by profound long-term understanding and satisfaction. iii This page intentionally left blank P R E F A C E Our perspective in this textbook derives from our belief that effective finan- cial reporting, starting with financial statement preparation and ending with financial statement analysis and use, requires ruthless objectivity and extreme expertise. For the financial reporting process to have its intended effects, preparers of financial statements must make unbiased and informed measurements—in particular, fair value measurements—and users of finan- cial statements must comprehend and analyze those measurements with skill and objectivity. Over the years, we have come to refer to our book’s title by the acronym FACMU—Finan- cial Accounting: An Introduction to Concepts, Methods, and Uses. We take concepts, meth- ods, and uses to be the central elements in learning and teaching about financial accounting. The 13th Edition of FACMU has the same objectives as the previous editions: ◾ To help students develop a sufficient understanding of the basic concepts underlying financial reports so that they can apply the concepts to new and different situations. ◾ To train students in accounting terminology and methods so that they can interpret, analyze, and evaluate financial statements and notes currently published in corporate annual reports. Most introductory financial accounting textbooks state these, or similar, objectives. Text- books differ in their relative emphases on concepts, methods, and uses. 1. Concepts This book emphasizes the rationale for, and implications of, accounting con- cepts. To learn accounting, students must develop the ability to conceptualize the trans- actions that accounting summarizes and the process of summarization. Without such concepts, students will have difficulty focusing on the relevant issues in new and different situations. Accordingly, each chapter identifies important accounting concepts, and includes numerical examples illustrating their application. The end-of-chapter material includes numerous short exercises and longer problems to check students’ ability to apply the concepts to different situations. 2. Methods We place enough emphasis on accounting procedures to enable students to interpret, analyze, and evaluate published financial statements. The text does not empha- size procedures to such an extent that students bog down in detail. All writers of account- ing textbooks must decide just how much accounting procedure to include. We believe students learn most effectively by working exercises and problems. Too much emphasis on accounting procedures, however, lulls students into the security of thinking they under- stand accounting concepts when they do not. We have for many years used the mixture of concepts and procedures in this book and have found it effective in the classroom. Understanding the accounting implications of an event requires that students con- struct the journal entry for that event. Throughout this book we use journal entries in describing the nature of accounting events. Moreover, most chapters contain exercises and problems that require the analysis of transactions with debits and credits. Do not conclude by a glance at this text, however, that it is primarily procedural. We want students to learn concepts; the procedures enhance the learning of concepts. 3. Uses This book attempts to bridge the gap between the preparation of financial reports and their use in various decision situations. The chapters consider the effects of alternative accounting principles on the measurement of earnings and financial position and the appropriate interpretations of them. Numerous problems based on financial statement data of actual companies appear at the end of most chapters. v vi Preface OVERVIEW OF CHANGES IN THE 13TH EDITION New authors. We have added Jennifer Francis and Katherine Schipper to the team. They bring teaching excellence and the experience of a standard setter to the collaboration. That they have had outstanding careers as accounting scholars enables them to contribute beyond their roles as outstanding teachers. We four authors have made the following changes in the 13th Edition: 1. Integration of International Financial Reporting Standards (IFRS). As this book goes to press, the SEC has announced a decision process that, within seven years, may result in IFRS replacing U.S. GAAP as the body of accounting principles that U.S. companies must follow. We have integrated IFRS into the text. We start from the premise that U.S. GAAP and IFRS use the same concepts, but sometimes require or permit different methods. At the FACMU level, for MBA students and upperclass undergraduates, the methods are often identical or similar; where they are not, we describe and illustrate the differences. You can easily see the scope of the U.S. GAAP/IFRS details in this book by examining the chart in the front endpapers, inside the front cover. That chart shows you the chapters and topics where the discussion includes IFRS as well as U.S. GAAP. 2. New emphasis on fair values and components of other comprehensive income. As U.S. GAAP and IFRS incorporate more required or permitted fair value measurements, we have broadened our coverage. The fair value option in U.S. GAAP and IFRS affects accounting for some debt securities and some investments. We discuss these in Chapters 10, 12, and 13, both concepts and methods. Insofar as changes in fair values affect other comprehensive income, we’ve expanded that discussion as well. We refer to the Decem- ber 2008 report by the SEC on its “Study on Mark-to-Market Accounting” at the several places where this report affects the material we discuss. 3. Codification of U.S. GAAP. In its Accounting Standards Codification™ system, the Financial Accounting Standards Board (FASB) has issued a compilation of U.S. GAAP, including Statements of Financial Accounting Standards, Accounting Principles Board Opinions, Accounting Research Bulletins, Staff Accounting Bulletins, EITF Consensuses, FASB Interpretations, and several other sorts of pronouncements. This compilation, which organizes the material by topic, brings together into one place the various account- ing methods and procedures that treat that topic. If you see SFAS No. 2, you likely think about research and development costs, not Codification Topic 730. In the future, how- ever, students will need to think in terms of topic numbers, not pronouncement names and numbers, in order to participate in accounting conversations during their profes- sional careers. We provide both conventional citations and Codification Topic numbers in all citations to U.S. GAAP (except for Statements of Financial Accounting Concepts, which are not part of the Codification). The Codification topic numbers within citations will look like this: (Codification Topic 730). 4. Increased use of actual financial statements. We have increased the use of actual financial statement excerpts in the chapters and in end-of-chapter assignment materials. You will see that Chapter 1, for example, reprints the actual financial statements of both Nord- strom and Scania, while Chapter 6 uses most of the financial statements of Wal-Mart. The preceding changes affect more than one chapter of the book. The following affect individual chapters. 5. Addition of an early chapter treating the record-keeping cycle. Given the success our new Duke University authors have had with the record-keeping material they give to their MBA students before the financial accounting course begins, we have reorganized the balance sheet and income statement record-keeping material into a single chapter. Chapter 2 introduces assets, liabilities, shareholders’ equity, journal entries, T-accounts, recording of operating transactions, elementary adjusting entries, closing entries, and preparation of financial statements. Chapter 2 accomplishes all this without overwhelm- ing the student with advanced accounting and economic concepts. The problem material includes the “working backward” problems that have distinguished this text from many of its competitors. The basic record-keeping cycle gives students transactions, then asks for recording entries and adjusting entries, then asks for preparation of the income state- Preface vii ment, then closing entries, and finally the ending balance sheet and statement of cash flows. In the working backward problems, we give students some of the later items and ask them to derive earlier items. We say one doesn’t understand accounting until one can work through the record-keeping cycle backward as well as forward. The typical accounting problem gives facts and asks the students to derive the financial statements. The working backward problems start with some subset of the financial statements and ask the students to derive the underlying transaction. 6. Enhanced focus on balance sheet and income statement measurements, formats, and con- ventions. Chapter 3 (balance sheet) introduces the asset and liability recognition criteria and measurement bases, including fair value measurement. Chapter 4 (income statement) continues by describing basic revenue and expense recognition criteria and measurement and timing issues; Chapter 7 contains a more detailed discussion of revenue recognition. Both chapters highlight classification and display differences that exist across firms, as well as between firms that follow U.S. GAAP and IFRS. 7. Increased emphasis on the direct method of computing cash flow from operations. Both the FASB and the IASB have expressed a preference for the direct method of comput- ing cash flow from operations. Students are likely to increasingly encounter the direct method during their professional careers. Thus, we place increased emphasis on the direct method in the 13th Edition. Our students encounter difficulty with the indirect method of computing cash flow from operations when they initially study the statement of cash flows in Chapter 5. We have found that introducing the direct method initially helps them to understand the adjustments required to convert net income to cash flow from opera- tions under the indirect method. Chapter 5 therefore places increased emphasis on the direct method, without deleting material on the indirect method commonly found in practice. Chapter 15 revisits the statement of cash flows, integrating material on more advanced topics into discussions of both the direct and indirect methods for presenting cash flow from operations. For example, we now include transactions for, and income tax effects of, stock option compensation expense, impairment loss, and employees’ exercise of their stock options. 8. Reorganization of topics involving revenue recognition and working capital. Chapter 7 treats revenue recognition, receivables, and advances from customers. Chapter 8 treats other current assets and current liabilities, including inventories, payables, and restruc- turing liabilities, whose treatment is new in this edition. The decision to bring all the working capital account issues together results from our view that the accounting for current liabilities has more in common with the accounting for current assets than with the accounting for noncurrent liabilities. Think, for example, about the allowance method applied both to uncollectibles and to warranty costs. 9. IFRS differences from U.S. GAAP for noncurrent assets. Chapter 9 contrasts the U.S. GAAP and IFRS treatments of noncurrent assets. At the elementary level of this book, the major differences between U.S. GAAP and IFRS in the accounting for noncurrent assets occur in the accounting for development costs and impairments. 10. Reorganization of noncurrent liability topics. Chapter 10 treats mortgages, bonds, install- ment notes, and lease liabilities, this last moved here from the following chapter. Chapter 11 treats income taxes with the same coverage as in preceding editions and adds addi- tional material on off-balance sheet financing and defined benefit pension arrangements. Leases are so common in business that we now treat them as a basic, not an advanced, topic in liabilities. We have structured the presentation of the advanced topics in liabili- ties so that the instructor can omit any of the three without loss of continuity to the others. For example, you can easily skip the pension material and assign the material on income taxes. We do. We don’t expect students to master all this material during their first term in accounting, but many will not take more accounting and find later in their careers that they need to understand the basics of accounting for these more advanced topics. We have included this material, in the FACMU style of concepts, methods, and uses, so that this book can serve as a reference on these topics for our alumni. 11. Separation of investments in marketable securities and derivatives from treatment of the equity method and consolidated statements. Chapter 12 expands our coverage of account- ing for derivatives, while Chapter 13 adds material on joint ventures and variable inter- est entities (U.S. GAAP) and special purpose entities (IFRS). We have expanded this material into two chapters so that we can provide more coverage on derivatives without viii Preface having a single enormous chapter. As in Chapter 11, we have provided a significant amount of advanced materials to support instructor choice as to which advanced top- ics to cover and to ensure that our alumni will have this material at the ready when they encounter these issues on the job or in more advanced courses in the MBA curriculum. 12. Summary of the FASB’s and IASB’s joint projects on the conceptual framework and finan- cial statement presentation. Chapter 16 discusses the current status of the joint FASB- IASB conceptual framework project and the likely changes under consideration. It also describes and illustrates the tentative conclusions of these standard setting bodies on the format of the financial statements. 13. More complex topics appear on the Web site. We have placed complex material on deferred taxes, foreign currency translation, and general price-level-adjusted accounting on the text’s Web site. ORGANIZATION This book comprises four major parts: ◾ Part One: “Overview of Financial Statements,” consisting of Chapters 1 and 2. ◾ Part Two: “Accounting Concepts and Methods,” Chapters 3 through 6. ◾ Part Three: “Measuring and Reporting Assets and Equities Using U.S. GAAP and IFRS,” Chapters 7 through 14. ◾ Part Four: “Synthesis,” Chapters 15 and 16. In our view, the four parts are tiers, or steps, in the learning process. Part One presents a general overview of the principal financial statements and basic transactions recording and financial statement preparation. Part Two discusses the basic accounting model accountants use to generate the principal financial statements. Part Three considers the specific account- ing principles or methods used in preparing the financial statements. Part Four summarizes and integrates the material from the first three parts. This organization reflects the view that learning takes place most effectively when students begin with a broad picture, then break up that broad picture into smaller pieces until achieving the desired depth, and finally synthesize so that the relation between the parts and the whole retains its perspective. Chapter 1 presents a brief description of the principal activities of a business firm (goal setting and strategy formulation, investing, financing, and operating) and shows how the principal financial statements—the balance sheet, the income statement, and the statement of cash flows—report the results of these activities. We use the business activities and the financial statements of Nordstrom and Scania to illustrate the important concepts. Chapter 1 also provides an overview of the financial reporting environment. Many students feel del- uged with the multitude of new terms and concepts after reading Chapter 1. However, most of these same students admit later that the broad overview helped piece material together as they later explored individual topics at greater length and in greater depth. The new Chap- ter 2 focuses on record-keeping vocabulary and processes. Chapter 2 uses T-accounts and journal entries as tools for recording transactions. The appendix to Chapter 2 describes and illustrates the use of a Microsoft Excel® spreadsheet for recording transactions for instructors who prefer this approach. Chapter 2, unlike treatments in other texts, integrates the account- ing entries for transactions during a period with the related adjusting entries at the end of the period. When textbooks discuss these two types of entries in separate chapters, students often lose sight of the fact that measurement of net income and financial position requires both kinds of entries. Chapters 3 through 5 present the basic accounting model that generates the financial statements. Chapters 3 and 4 discuss the elements of financial statements: assets, liabilities, sharehold- ers’ equity, revenue, and expenses. The conceptual frameworks of the FASB and the IASB provide the basis for these discussions, which include fair value measurements for assets and liabilities. Chapter 5 discusses cash flows. We continue to put coverage of the statement of cash flows early in the text. This placement serves two purposes. First, it elevates the statement Preface ix to its rightful place among the principal financial statements. Students can thereby integrate the concepts of profitability and cash flow more effectively and begin to understand that one does not necessarily accompany the other. Covering this statement at the end of the course can lead students to think the cash flow statement less important. Placing this chapter early in the book forces the student to cement understanding of the basic accounting model from Chapters 2, 3, and 4. Preparing the statement of cash flows requires the student to work backward from the balance sheet and income statement to reconstruct the transactions that took place. As the previous section discussed, we place increased emphasis on the direct method of computing cash flow from operations, without detracting from the importance of understanding the indirect method. The FASB, for more than a decade, and the IASB have expressed a preference for the direct method. Few U.S. companies currently use it, but we think this will change during the careers of your students. Chapters 2 to 5 use the balance sheet equation or changes in the balance sheet equation to motivate understanding. Each of these chapters includes one or more simple problems that students can work using the balance sheet approach to prepare the principal financial state- ments. Although these chapters emphasize debit/credit procedures, instructors can use the balance sheet equation approach to communicate the basics of statement preparation. Chapters 3, 4, and 5 each contain a section on analyzing and interpreting the financial statement introduced in the chapter. This presages the integrated analysis of profitability and risk in Chapter 6. Chapter 6 describes and illustrates tools for analyzing the financial statements, using the financial statements of Wal-Mart. The discussion structures the various financial statement ratios in a multi-level format that, students have found, reduces the need to memorize formu- las. Instructors who incorporate annual reports of actual companies throughout their course, as we do with Nordstrom and Scania, will find that analysis of the financial statements of such companies provides an effective synthesis at this point. An appendix to Chapter 6 illustrates procedures for preparing pro forma financial statements. This topic helps cement understanding of the relations among the principal financial statements. Chapters 7 through 14 discuss the guidance in U.S. GAAP and IFRS for generating the financial statements. Each chapter not only describes and illustrates the application of the guidance, but also considers how accounting principles affect the financial statements. This approach reflects the view that students should be able to interpret and analyze published financial statements and to understand the effect of alternative accounting methods on such assessments. Chapter 15 deepens the exploration of the statement of cash flows by presenting a compre- hensive illustration using the transactions in Chapters 7 to 14. Chapter 16 reviews the account- ing principles discussed in Chapters 7 to 14 and discusses reporting issues that s tandard-setting bodies are currently addressing, particularly those where U.S. GAAP and IFRS diverge. Prob- lems 3 and 4 at the end of Chapter 16 provide a review for the entire book. An appendix to the book describes compound interest and present value computations for students not previously exposed to this topic. The end of the book includes a comprehensive glossary of accounting terms. It serves as a reference tool for accounting and other business terms and provides additional descriptions of a few topics, such as accounting changes and inventory profit, considered only briefly in the text. RELATED MATERIALS ACCOMPANYING THE TEXTBOOK Contact the publisher to receive the following supplementary materials that augment the textbook: Instructor’s Resource CD-ROM (ISBN 0-324-78801-0) The Instructor’s Resource CD-ROM includes the following supplements: ◾ Solutions Manual The Solutions Manual, written by the authors, provides full solutions for all end-of-chapter assignment items, including questions, exercises, and problems. We give computations, allowing the instructor to show how to reach a particular answer. The Solutions Manual also appears as a printed item. ◾ Solutions Transparency Masters Transparency masters, available to adopting instruc- tors, accompany all numerical end-of-chapter exercises and problems.