This text was adapted by The Saylor Foundation under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work’s original creator or licensee. Saylor URL: http://www.saylor.org/books Saylor.org 1 Preface How to Use This Book: From the Authors to the Students If we have done our job properly during the creation of this textbook, it will be like no other educational material that you have ever experienced. We literally set out to rethink the nature, structure, and purpose of college textbooks. Every feature that you find here was designed to enhance student learning. We want this material to be presented in a manner that is both innovative and effective. The two of us have taught in college for over sixty years. Year in and year out, financial accounting has always seemed to us to be both interesting and relevant to everyday life. We believe it is knowledge well worth acquiring. From the day we started this project, we hoped to share our enthusiasm with you, to develop a book that you will find to be both readable and worth reading. Historically, textbooks have been presented as dry monologues, a one-way conversation that often seems to talk to the teacher more than to the student. “Boring” and “confusing” should never be synonymous with any aspect of education. Instead, we seek to promote an active dialogue. Authors, teachers, and students should work together to create an environment where education flourishes. We want you, the student, to understand the nature of our endeavor. After all, the only reason that this book exists is to aid you in learning financial accounting. If you do not read the chapters because you find them boring or if you do not understand the material that is included, no one benefits. We will have wasted our time. We view this textbook as a guide. In constructing these seventeen chapters, we have worked to guide you on a voyage through the world of business and financial reporting. We want to help you attain a usable knowledge of the principles of financial accounting as well as an appreciation for its importance and logic. By learning its theory, presentation, and procedures, individuals become capable of using financial accounting to make prudent business decisions. That is an important goal regardless of the direction of your career. We have relied on our experience as teachers to highlight the aspects of this material that make it interesting, logical, and relevant. Saylor URL: http://www.saylor.org/books Saylor.org 2 Talk, though, is cheap. Saying that this book is different and interesting does not make it so. Be a wise consumer. When someone tries to sell you something, force them to back up their claims. So How Does This Book Work? What Makes It Special? 1. Every chapter is introduced with a short video in which one of the authors provides an overview of the material and a discussion of its importance. Thus, students are never forced to begin reading blindly, struggling to put new subjects into an understandable context. Even before the first written word, each chapter is explained through the opening video. Simply put, this introduction makes the subject matter more understandable and your reading more interesting and efficient. We attempt to remove the mystery from every aspect of financial accounting because we want you to be an effective learner. 2. This textbook is written entirely in a question-and-answer format. The Socratic method has been used successfully for thousands of years to help students develop critical thinking skills. We do that here on every page of every chapter. A question is posed and the answer is explained. Then, the next logical question is put forth to lead you through the material in a carefully constructed sequential pattern. Topics are presented and analyzed as through a conversation. This format breaks each chapter down into easy- to-understand components. A chapter is not thirty pages of seemingly unending material. Instead, it is twenty to forty questions and answers that put the information into manageable segments with each new question logically following the previous one. 3. All college textbooks present challenging material. However, that is no excuse for allowing readers to become lost. Educational materials should be designed to enhance learning and not befuddle students. At key points throughout each chapter, we have placed embedded multiple-choice questions along with our own carefully constructed answers. These questions allow you to pause at regular intervals to verify that you understand the material that has been covered. Immediate feedback is always a key ingredient in successful learning. These questions and answers are strategically placed throughout every chapter to permit ongoing review and reinforcement of knowledge. 4. For a course such as financial accounting, each subject should relate in some manner to the real world of business. Therefore, every chapter includes a discussion with a successful investment analyst about the material that has been presented. This expert provides an honest and open assessment of financial accounting straight from the daily world of high finance and serious business decisions. Every question, Saylor URL: http://www.saylor.org/books Saylor.org 3 every answer, every topic need to connect directly to the world we all face. Students should always be curious about the relevance of every aspect of a textbook’s coverage. We believe that it is helpful to consider this material from the perspective of a person already working in the business environment of the twenty-first century. 5. In many chapters, we also talk about the current evolution occurring in financial accounting as the United States moves from following U.S. rules (U.S. GAAP) to international standards (IFRS). The world is getting smaller as companies and their operations become more global. At the same time, technology makes the amount of available information from around the world almost beyond comprehension. Consequently, throughout this textbook, we interview one of the partners of a large international accounting firm about the impact of possibly changing financial accounting in this country so that all reporting abides by international accounting rules rather than solely U.S. standards. 6. Each chapter ends with a final video. However, instead of merely reviewing the material one last time in a repetitive fashion, we challenge you to select the five most important elements of each chapter. Some coverage is simply more important than others. That is a reasonable expectation. Part of a successful education is gaining the insight to make such evaluations. Then, we provide you with our own top five. The lists do not need to match; in fact, it is unlikely that they will be the same. That is not the purpose. This exercise should encourage you to weigh the significance of the material. What really makes a difference based on your understanding of financial accounting? In what areas should you focus your attention? Is This Book Unique? We truly believe so. We believe that it has an educationally creative structure that will promote your learning and make the educational process more effective and more interesting:  Opening videos for the chapters  Socratic method  Embedded multiple-choice questions  Discussions with both an investment analyst and an international accounting expert  Closing videos establishing top-five lists for each chapter Saylor URL: http://www.saylor.org/books Saylor.org 4 Every page of this book, every word in fact, has been created to encourage and enhance your understanding. We want you to benefit from our coverage, but just as importantly, we want you to enjoy the process. When presented correctly, learning can be fun and, we believe, should be. Please feel free to contact us if you have any suggestions for improvement. We would love to hear from you. Finally, this book is dedicated to our wives and our families. It is also dedicated to the thousands of wonderful teachers across the world who walk into countless college classrooms each day and make learning happen for their students. You make the world better. Saylor URL: http://www.saylor.org/books Saylor.org 5 Chapter 1 Why Is Financial Accounting Important? 1.1 Making Good Financial Decisions about an Organization LEARNING OBJECTIVES At the end of this section, students should be able to meet the following objectives: 1. Define “financial accounting.” 2. Understand the connection between financial accounting and the communication of information. 3. Explain the importance of learning to understand financial accounting. 4. List decisions that an individual might make about an organization. 5. Differentiate between financial accounting and managerial accounting. 6. Provide reasons for individuals to be interested in the financial accounting information supplied by their employers. Question: This textbook professes to be an introduction to financial accounting. A logical place to begin such an exploration is to ask the obvious question: What is financial accounting? Answer: In simplest terms, financial accounting is the communication of information about a business or other type of organization (such as a charity or government) so that individuals can assess its financial health and prospects. Probably no single word is more relevant to financial accounting than “information.” Whether it is gathering financial information about a specific organization, putting that information into a structure designed to enhance communication, or working to understand the information being conveyed, financial accounting is intertwined with information. In today’s world, information is king. Financial accounting provides the rules and structure for the conveyance of financial information about businesses (and other organizations). At any point in time, some businesses are poised to prosper while others teeter on the verge of failure. Many people are seriously interested in evaluating the degree of success achieved by a particular organization as well as its Saylor URL: http://www.saylor.org/books Saylor.org 6 prospects for the future. They seek information. Financial accounting provides data that these individuals need and want. organization → reports information based on the principles of financial accounting → individual assesses financial health Question: Every semester, most college students are enrolled in several courses as well as participate in numerous outside activities. All of these compete for the hours in each person’s day. Why should a student invest valuable time to learn the principles of financial accounting? Why should anyone be concerned with the information communicated about an organization? More concisely, what makes financial accounting important? Answer: Many possible benefits can be gained from acquiring a strong knowledge of financial accounting and the means by which information is communicated about an organization. In this book, justification for the serious study that is required to master the subject matter is simple and straightforward: obtaining a working knowledge of financial accounting and its underlying principles enables a person to understand the information conveyed about an organization so that better decisions can be made. Around the world, millions of individuals make critical judgments each day about the businesses and other organizations they encounter. Developing the ability to analyze financial information and then using that knowledge to arrive at sound decisions can be critically important. Whether an organization is as gigantic as Wal-Mart or as tiny as a local convenience store, a person could have many, varied reasons for making an assessment. As just a single example, a recent college graduate looking at full-time employment opportunities might want to determine the probability that Company A will have a brighter economic future than Company B. Although such decisions can never be correct 100 percent of the time, knowledge of financial accounting and the information being communicated greatly increases the likelihood of success. As Kofi Annan, former secretary-general of the United Nations, has said, “Knowledge is power. Information is liberating.” [1] Saylor URL: http://www.saylor.org/books Saylor.org 7 Thus, the ultimate purpose of this book is to provide students with a rich understanding of the rules and nuances of financial accounting so they can evaluate available information and then make good choices about those organizations. In the world of business, most successful individuals have developed this talent and are able to use it to achieve their investing and career objectives. Question: Knowledge of financial accounting assists individuals in making informed decisions about businesses and other organizations. What kinds of evaluations are typically made? For example, assume that a former student—one who recently graduated from college—has been assigned the task of analyzing financial data provided by Company C. What real-life decisions could a person be facing where an understanding of financial accounting is beneficial? Answer: The number of possible judgments that an individual might need to make about a business or other organization is close to unlimited. However, many decisions deal with current financial health and the prospects for future success. In making assessments of available data, a working knowledge of financial accounting is invaluable. The more in-depth the understanding is of those principles, the more likely the person will be able to use the available information to arrive at the best possible choice. Common examples include the following:  The college graduate might be employed by a bank to work in its corporate lending department. Company C is a local business that has applied to the bank for a large loan. The graduate has been asked by bank management to prepare an assessment of Company C to determine if it is likely to be financially healthy in the future so that it will be able to repay the money when due. A correct decision to lend the money eventually earns the bank profit because Company C (the debtor) will be required to pay an extra amount (known as interest) on the money borrowed. Conversely, an incorrect analysis of the information could lead to a substantial loss if the loan is granted and Company C is unable to fulfill its obligation. Bank officials must weigh the potential for profit against the risk of loss. That is a daily challenge in virtually all businesses. The former student’s career with the bank might depend on the ability to analyze financial accounting data and then make appropriate choices about the actions to be taken. Should a loan be made to this company? Saylor URL: http://www.saylor.org/books Saylor.org 8  The college graduate might hold a job as a credit analyst for a manufacturing company that sells its products to retail stores. Company C is a relatively new retailer that wants to buy goods (inventory) for its stores on credit from this manufacturer. The former student must judge whether it is wise to permit Company C to buy goods now but wait until later to remit the money. If payments are received on a timely basis, the manufacturer will have found a new outlet for its merchandise. Profits will likely increase. Unfortunately, another possibility also exists. Company C could make expensive purchases but then be unable to make payment, creating significant losses for the manufacturer. Should credit be extended to this company?  The college graduate might be employed by an investment firm that provides financial advice to its clients. The firm is presently considering whether to recommend acquisition of the ownership shares of Company C as a good investment strategy. The former student has been assigned to gather and evaluate relevant financial information as a basis for this decision. If Company C is poised to become stronger and more profitable, its ownership shares will likely rise in value over time, earning money for the firm’s clients. Conversely, if the prospects for Company C appear to be less bright, the value of these shares might be expected to drop (possibly precipitously) so that the investment firm should avoid suggesting the purchase of an ownership interest in Company C. Should shares of this company be recommended for acquisition? Success in life—especially in business—frequently results from making appropriate decisions. Many economic choices, such as those described above, depend on the ability to understand and make use of the financial information that is produced and presented about an organization in accordance with the rules and principles underlying financial accounting. EXERCISE Link to multiple-choice question for practice purposes:http://www.quia.com/quiz/2092614.html Question: A great number of possible decisions could be addressed in connection with an organization. Is an understanding of financial accounting relevant to all business decisions? What about the following? Saylor URL: http://www.saylor.org/books Saylor.org 9  Should a business buy a building to serve as its new headquarters or rent a facility instead?  What price should a data processing company charge customers for its services?  Should advertisements to alert the public about a new product be carried on the Internet or on television? Answer: Organizational decisions such as these are extremely important for success. However, these examples are not made about the reporting organization. Rather, they are made within the organization in connection with some element of its operations. The general term “accounting” refers to the communication of financial information for decision-making purposes. Accounting is then further subdivided into (a) financial accounting and (b) managerial accounting. [2] Financial accounting is the subject explored in this textbook. It focuses on conveying relevant data (primarily to external parties) so that decisions can be made about an organization (such as Motorola or Starbucks) as a whole. Thus, questions such as the following all fall within the discussion of financial accounting:  Do we loan money to Company C?  Do we sell on credit to Company C?  Do we recommend that our clients buy the ownership shares of Company C? They relate to evaluating the financial health and prospects of Company C as a whole. Managerial accounting is the subject of other books and other courses. This second branch of accounting refers to the communication of information within an organization so that internal decisions (such as whether to buy or rent a building) can be made in an appropriate manner. Individuals studying an organization as a whole have different goals than do internal parties making operational decisions. Thus, many unique characteristics have developed in connection with each of these two branches of accounting. Financial accounting and managerial accounting have evolved independently over the decades to address Saylor URL: http://www.saylor.org/books Saylor.org 10