Introduction to Financial Accounting Second Edition Based on International Financial Reporting Standards Henry Dauderis David Annand Copyright © 2014 Henry Dauderis Published by Valley Educational Services Ltd. 4910C – 58 St., Athabasca AB T9S 1L5 ISBN 978-0-9936701-2-1 Printed and bound in Canada by Athabasca University Library and Archives Canada Cataloguing in Publication Dauderis, Henry, 1941– Annand, David, 1954– This textbook is licensed under a Creative Commons License, Attribution–Non- commercial–Share Alike 4.0 Canada: see www.creativecommons.org. This material may be reproduced for non-commercial purposes and changes may be used by others provided that credit is given to the original authors. To obtain permission for uses beyond those outlined in the Creative Commons license, please contact David Annand at [email protected]. Latest version available at http://business.athabascau.ca/faculty/david-annand-edd/ Please forward suggested changes to [email protected]. December 8, 2014 Table of Contents 1. Introduction to Financial Accounting 1 A. Introduction 2 B. Accounting Defined 2 C. Business Organizations 2 D. Generally Accepted Accounting Principles 4 E. Financial Statements 7 F. Transactions Analysis and Double-entry Accounting 7 Summary of Chapter 1 Learning Objectives 18 Concept Self-check 21 Comprehension Problems 22 Problems 29 Alternate Problems 35 2. The Accounting Process 41 A. Accounts 42 B. Transactions Analysis Using Accounts 47 C. The Trial Balance 54 D. Using Formal Accounting Records 57 E. The Accounting Cycle 61 Summary of Chapter 2 Learning Objectives 63 Concept Self-check 65 Comprehension Problems 66 Problems 78 Alternate Problems 85 Decision Problem 93 3. Financial Accounting and the Use of Adjusting Entries 95 A. The Operating Cycle 96 B. Adjusting Entries 101 C. The Adjusted Trial Balance 112 D. Using the Adjusted Trial Balance to Prepare Financial Statements 113 E. The Accounting Cycle 115 F. The Closing Process 116 Summary of Chapter 3 Learning Objectives 121 Concept Self-check 125 Comprehension Problems 126 Problems 134 Alternate Problems 143 Review Problem 151 Decision Problem 153 4. The Classified Balance Sheet and Related Disclosures 155 A. Financial Statement Disclosure Decisions 156 B. Classified Balance Sheet 158 C. Notes to Financial Statements 164 D. The Auditor’s Report 168 E. Management’s Responsibility for Financial Statements 170 Summary of Chapter 4 Learning Objectives 172 Concept Self-check 175 Problems 175 Alternate Problems 183 5. Accounting for the Sale of Goods 191 A. The Basics of Merchandizing 192 B. The Purchase and Payment Cycle of Merchandizing Using the Perpetual Inventory Method 194 C. Merchandize Inventory: Sales and Collections Using the Perpetual Inventory Method 198 D. Adjusting Merchandize Inventory Using the Perpetual Inventory Method 202 E. Merchandizing Income Statement 209 F. Closing Entries for a Merchandizer Using the Perpetual Inventory Method 211 Appendix: The Periodic Inventory System 214 Summary of Chapter 5 Learning Objectives 226 Concept Self-check 229 Comprehension Problems 230 Problems 236 Alternate Problems 248 Decision Problem 260 6. Assigning Costs to Merchandize 263 A. Inventory Cost Flow Assumptions 264 B. Financial Statement Impact of Different Inventory Cost Flows 275 C. Lower of Cost and Net Realizable Value (LCNRV) 278 D. Estimating the Balance in Merchandize Inventory 279 Appendix: Inventory Cost Flow Assumptions Under the Periodic System 282 Summary of Chapter 6 Learning Objectives 286 Concept Self-check 288 Comprehension Problems 290 Problems 300 Alternate Problems 312 Supplementary Problems 324 7. Cash and Receivables 331 A. Internal Control 332 B. Petty Cash 333 C. Cash Collections and Payments 336 D. Accounts Receivable 353 E. Notes Receivable 362 Summary of Chapter 7 Learning Objectives 363 Concept Self-check 365 Comprehension Problems 366 Problems 371 Alternate Problems 381 Decision Problem 391 8. Long-lived Assets 393 A. Establishing Cost of Property, Plant, and Equipment (PPE) 394 B. Depreciation 397 C. Partial Year Depreciation 403 D. Revision Depreciation 404 E. Impairment of Long-lived Assets 408 F. Derecognition of Property, Plant, and Equipment 409 G. Intangible Assets 413 H. Goodwill 415 I. Disclosure 416 Summary of Chapter 8 Learning Objectives 417 Concept Self-check 421 Comprehension Problems 423 Problems 431 Alternate Problems 438 9. Debt Financing: Current and Non-current Liabilities 447 A. Current versus Non-current Liabilities 448 B. Known Current Liabilities 448 C. Estimated Current Liabilities 456 D. Non-current Liabilities 459 E. Demonstration Problem 464 Summary of Chapter 9 Learning Objectives 474 Concept Self-check 477 Comprehension Problems 477 Problems 482 Alternate Problems 487 10. Debt Financing: Bonds 493 A. The Nature of Bonds and the Rights of Bondholders 494 B. The Bond Accounting Process 498 C. Bond Amortization and Interest 502 Appendix 1: Present Value Calculations 512 Appendix 2: The Effective Interest Method of Amortisation 519 Summary of Chapter 10 Learning Objectives 525 Concept Self-check 527 Comprehension Problems 528 Problems 533 Alternate Problems 539 11. Equity Financing 545 A. The Corporate Structure 546 B. The Debt versus Equity Financing Decision 551 C. Recording Share Capital Transactions 553 D. Cash Dividends 558 E. Book Value 564 Appendix 1: Share Dividends 566 Appendix 2: Retained Earnings 569 Summary of Chapter 11 Learning Objectives 573 Concept Self-check 577 Comprehension Problems 579 Problems 587 Alternate Problems 594 12. Proprietorships and Partnerships 601 A. Proprietorships 602 B. Partnerships 606 C. Allocation of Partnership Profits and Losses 610 D. Admission and Withdrawal of Partners 615 E. Liquidation of a Partnership 622 Summary of Chapter 12 Learning Objectives 629 Concept Self-check 651 Comprehension Problems 651 Problems 635 Alternate Problems 640 Decision Problems 644 13. Financial Statement Analysis 647 A. Introduction to Ratio Analysis 648 B. Liquidity Ratios: Analyzing Short-term Cash Needs 652 C. Profitability Ratios: Analyzing Returns on Business Activity 661 D. Leverage Ratios: Analyzing Financial Statements 665 E. Market Ratios: Analysis of Financial Returns to Investors 668 F. Overall Analysis of Big Dog’s Financial Statements 671 G. Horizontal and Vertical Trend Analysis 672 H. Summary of Financial Ratios 674 Appendix: The Scott Formula 677 Summary of Chapter 13 Learning Objectives 688 Concept Self-check 691 Discussion Cases 692 Comprehension Problems 696 Problems 704 Alternate Problems 709 Supplementary Problems 714 Decision Problems 719 14. The Statement of Cash Flows 729 A. Financial Statement Reporting 730 B. Preparing the Statement of Cash Flows 732 C. Interpreting the Statement of Cash Flows 751 Summary of Chapter 14 Learning Objectives 753 Concept Self-check 755 Comprehension Problems 756 Problems 763 Alternate Problems 768 Decision Problems 774 Index 777 CHAPTER ONE Introduction to Financial Accounting Chapter 1 Learning Objectives LO1 – Define accounting. LO2 – Identify and describe the forms of business organizations. LO3 – Identify and explain generally accepted accounting principles (GAAP). LO4 – Identify and explain the uses of the four financial statements. LO5 – Analyze transactions using the accounting equation. CHAPTER ONE / Introduction to Financial Accounting 1 A. Introduction Accounting is often called the language of business because it uses a unique vocabulary to communicate information to decision makers. In this chapter, we will discuss what financial accounting is and briefly introduce how financial information is communicated through financial statements. Then we will study how financial transactions are analyzed and reported on financial statements. B. Accounting Defined Accounting is the process of identifying, measuring, recording, and LO1 – Define communicating an organization’s economic activities to users. Users accounting. need information for decision making. Internal users of accounting information work for the organization and are responsible for planning, organizing, and operating the entity. The area of accounting known as managerial accounting serves the decision-making needs of internal users. External users do not work for the organization and include investors, creditors, labour unions, and customers. Financial accounting is the area of accounting that presents financial information of interest to external users. This book deals with financial accounting. C. Business Organizations An organization is a group of individuals who come together to pursue a LO2 – Identify and common set of goals and objectives. There are typically two types of describe the forms organizations: business and non-business. A business organization sells of business products or services for profit. A non-business organization, such as a organizations. charity or hospital, exists to meet various societal needs and does not have profit as a goal. All organizations record, report, and, most importantly, use accounting information for making decisions. This book focuses on business organizations. There are three common forms of business organizations—a proprietorship, a partnership, and a corporation. Proprietorship A proprietorship is a business owned by one person. It is not a separate legal entity, which means that the business and the owner are considered to be the same. For example, the profits of a proprietorship 2 CHAPTER ONE / Introduction to Financial Accounting