Intermediate Accounting: Principles and Analysis, 2nd Edition

Chapter 1 FINANCIAL ACCOUNTING AND ACCOUNTING STANDARDS 2

The Size of the New York Phone Book, if Necessary 2

Financial Statements and Financial Reporting 4

Accounting and Capital Allocation 4

The Challenges Facing Financial Accounting 5

Objectives of Financial Reporting 6

The Need to Develop Standards 7

Parties Involved in Standard Setting 7

Securities and Exchange Commission (SEC) 7

American Institute of Certified Public Accountants (AICPA) 9

Financial Accounting Standards Board (FASB) 9

Governmental Accounting Standards Board (GASB) 12

Changing Role of the AICPA 13

Generally Accepted Accounting Principles 14

Issues in Financial Reporting 15

Standard Setting in a Political Environment 15

The Expectations Gap 16

International Accounting Standards 18

Ethics in the Environment of Financial Accounting 19

Conclusion 19

Convergence Corner International Financial Reporting 20

Chapter 2 CONCEPTUAL FRAMEWORK UNDERLYINGFINANCIAL ACCOUNTING 34

Show Me the Earnings! 34

Conceptual Framework 36

The Need for a Conceptual Framework 36

Development of a Conceptual Framework 37

First Level: Basic Objectives 38

Second Level: Fundamental Concepts 39

Qualitative Characteristics of Accounting Information 39

Basic Elements 42

Third Level: Recognition and Measurement Concepts 44

Basic Assumptions 45

Basic Principles of Accounting 47

Constraints 53

Summary of the Structure 56

Convergence Corner The Conceptual Framework 57

Chapter 3 THE ACCOUNTING INFORMATION SYSTEM 76

Needed: A Reliable Information System 76

Accounting Information System 78

Basic Terminology 78

Debits and Credits 79

Basic Equation 80

Financial Statements and Ownership Structure 82

The Accounting Cycle 83

Identifying and Recording Transactions and Other Events 84

Journalizing 84

Posting 85

Trial Balance 89

Adjusting Entries 91

Adjusted Trial Balance 101

Preparing Financial Statements 103

Closing 104

Post-Closing Trial Balance 106

Reversing Entries 107

The Accounting Cycle Summarized 107

Financial Statements for a Merchandising Company 107

Convergence Corner Accounting Information Systems 113

Behind the Numbers: Appendix 3A 115

Using Reversing Entries 115

Example of Reversing Entries—Accruals 115

Example of Reversing Entries—Prepayments 116

Summary of Reversing Entries 117

Behind the Numbers: Appendix 3B 117

Using a Worksheet: The Accounting Cycle Revisited 117

Worksheet Columns 118

Adjustments Entered on the Worksheet 118

Preparing Financial Statements from a Worksheet 120

Chapter 4 BALANCE SHEET 144

“There Ought to Be a Law” 144

Use and Limitations 146

Usefulness of the Balance Sheet 146

Limitations of the Balance Sheet 147

Classification in the Balance Sheet 148

Current Assets 149

Noncurrent Assets 153

Liabilities 156

Owners’ (Stockholders’) Equity 158

Balance Sheet Format 160

Additional Information Reported 162

Contingencies 163

Accounting Policies 163

Contractual Situations 163

Post–Balance-Sheet Events (Subsequent Events) 164

Fair Values 166

Techniques of Disclosure 167

Parenthetical Explanations 167

Notes 167

Cross-Reference and Contra Items 169

Supporting Schedules 169

Terminology 170

Convergence Corner Balance Sheet 171

Chapter 5 INCOME STATEMENT AND RELATEDINFORMATION 198

Which Income Number? 198

Income Statement 200

Usefulness of the Income Statement 200

Limitations of the Income Statement 200

Quality of Earnings 201

Format of the Income Statement 202

Elements of the Income Statement 202

Single-Step Income Statements 203

Multiple-Step Income Statements 204

Condensed Income Statements 207

Reporting Irregular Items 208

Discontinued Operations 210

Extraordinary Items 211

Unusual Gains and Losses 213

Changes in Accounting Principle 215

Changes in Estimates 215

Corrections of Errors 216

Summary of Irregular Items 216

Special Reporting Issues 218

Intraperiod Tax Allocation 218

Earnings per Share 220

Retained Earnings Statement 221

Comprehensive Income 222

Convergence Corner Income Statement 225

Chapter 6 STATEMENT OF CASH FLOWS 250

Don’t Take Cash Flow for Granted 250

The Statement of Cash Flows: Purpose and Format 252

Purpose of the Statement of Cash Flows 252

Classification of Cash Flows 252

Significant Noncash Activities 254

Format of the Statement of Cash Flows 254

Preparing the Statement of Cash Flows 256

Indirect and Direct Methods 256

Preparation of the Statement of Cash Flows 257

First Year of Operations—2008 257

Second Year of Operations—2009 262

Summary of Conversion to Net Cash Provided by Operating Activities—Indirect Method 266

Using Cash Flows to Evaluate a Company 269

Free Cash Flow 269

Assessing Liquidity and Solvency Using Cash Flows 270

Limitations of the Statement of Cash Flows 272

Convergence Corner Statement of Cash Flows 273

Behind the Numbers: Appendix 6A 276

Ratio Analysis_A Reference 276

Using Ratios to Analyze Financial Performance 276

Chapter 7 REVENUE RECOGNITION 302

It’s Back 302

The Current Environment 304

Guidelines for Revenue Recognition 304

Departures from the Sale Basis 305

Revenue Recognition at Point of Sale (Delivery) 307

Sales with Buyback Agreements 307

Sales When Right of Return Exists 307

Trade Loading and Channel Stuffing 308

Revenue Recognition before Delivery 310

Percentage-of-Completion Method 311

Completed-Contract Method 314

Completion-of-Production Basis 315

Revenue Recognition after Delivery 316

Installment-Sales Method 317

Cost-Recovery Method 320

Deposit Method 320

Summary of Revenue Recognition Bases 321

Observations 322

Convergence Corner Revenue Recognition 323

Behind the Numbers: Appendix 7A 326

Revenue Recognition Procedures 326

Long-Term Contracts 326

Installment Sales 331

Chapter 8 CASH AND RECEIVABLES 356

No-Tell Nortel 356

Section 1 Cash 358

What Is Cash? 358

Management and Control of Cash 358

Reporting Cash 359

Restricted Cash 360

Bank Overdrafts 360

Cash Equivalents 361

Summary of Cash-Related Items 361

Section 2 Receivables 362

Recognition of Accounts Receivable 364

Trade Discounts 364

Cash Discounts (Sales Discounts) 364

Nonrecognition of Interest Element 365

Valuation of Accounts Receivable 365

Uncollectible Accounts Receivable 366

Recognition of Notes Receivable 371

Note Issued at Face Value 372

Note Not Issued at Face Value 373

Choice of Interest Rate 376

Valuation of Notes Receivable 376

Disposition of Accounts and Notes Receivable 377

Secured Borrowing 377

Sales of Receivables 378

Secured Borrowing versus Sale 381

Presentation and Analysis 382

Presentation of Receivables 382

Analysis of Receivables 383

Convergence Corner Cash and Receivables 384

Behind the Numbers: Appendix 8A 388

Cash Controls 388

Using Bank Accounts 388

The Imprest Petty Cash System 388

Physical Protection of Cash Balances 389

Reconciliation of Bank Balances 390

Chapter 9 ACCOUNTING FOR INVENTORIES 418

Inventories in the Crystal Ball 418

Inventory Classification and Systems 420

Classification 420

Inventory Systems 420

Basic Issues in Inventory Valuation 423

Physical Goods Included in Inventory 423

Costs Included in Inventory 424

Which Cost Flow Assumption to Adopt? 426

Special Issues Related to LIFO 432

LIFO Reserve 432

LIFO Liquidation 433

Dollar-Value LIFO 434

Comparison of LIFO Approaches 437

Basis for Selection of Inventory Method 438

Lower-of-Cost-or-Market 442

Lower-of-Cost-or-Market—Ceiling and Floor 442

How Lower-of-Cost-or-Market Works 443

Methods of Applying Lower-of-Cost-or-Market 445

Evaluation of the Lower-of-Cost-or-Market Rule 446

Presentation and Analysis 447

Presentation of Inventories 447

Analysis of Inventories 449

Convergence Corner Inventories 450

Behind the Numbers: Appendix 9A 454

Gross Profit Method 454

Computation of Gross Profit Percentage 455

Evaluation of Gross Profit Method 457

Chapter 10 ACCOUNTING FOR PROPERTY, PLANT, AND EQUIPMENT 486

Where Have All the Assets Gone? 486

Acquisition and Valuation of Property, Plant, and Equipment 488

Cost of Land 488

Cost of Buildings 489

Cost of Equipment 489

Self-Constructed Assets 490

Interest Costs During Construction 490

Other Valuation Issues 492

Costs Subsequent to Acquisition 496

Additions 497

Improvements and Replacements 498

Rearrangement and Reinstallation 499

Repairs 499

Summary of Costs Subsequent to Acquisition 499

Use of Property, Plant, and Equipment: Depreciation 500

Factors Involved in the Depreciation Process 500

Methods of Depreciation 502

Special Depreciation Issues 506

Dispositions of Plant Assets 509

Sale of Plant Assets 510

Involuntary Conversion 510

Exchanges 511

Presentation and Analysis 516

Presentation of Property, Plant, and Equipment 516

Analysis of Property, Plant, and Equipment 517

Convergence Corner Property, Plant, and Equipment 519

Behind the Numbers: Appendix 10A 522

Interest-Capitalization Procedures 522

Interest Capitalization 522

Chapter 11 INTANGIBLE ASSETS 554

Untouchable 554

Intangible Asset Issues 556

Characteristics 556

Valuation 556

Amortization of Intangibles 557

Types of Intangible Assets 558

Marketing-Related Intangible Assets 558

Customer-Related Intangible Assets 559

Artistic-Related Intangible Assets 560

Contract-Related Intangible Assets 560

Technology-Related Intangible Assets 561

Goodwill 564

Impairments 568

Impairment of Property, Plant, and Equipment 568

Impairment of Limited-Life Intangibles 570

Impairment of Indefinite-Life Intangibles Other Than Goodwill 570

Impairment of Goodwill 571

Restoration of Impairment Loss 573

Impairment of Assets to Be Disposed of 573

Research and Development Costs 574

Identifying R&D Activities 574

Accounting for R&D Activities 575

Other Costs Similar to R&D Costs 576

Conceptual Questions 577

Presentation of Intangibles and Related Items 578

Presentation of Intangible Assets 578

Presentation of Research and Development Costs 579

Convergence Corner Intangible Assets 582

Chapter 12 ACCOUNTING FOR LIABILITIES 604

Now You See It, Now You Don’t 604

Section 1 Current Liabilities 606

What Is a Liability? 606

What Is a Current Liability? 606

Accounts Payable 607

Notes Payable 607

Current Maturities of Long-Term Debt 609

Dividends Payable 609

Unearned Revenues 610

Section 2 Long-Term Debt 612

Issuing Bonds 612

Types of Bonds 613

Valuation of Bonds Payable_Discount and Premium 614

Bonds Issued at Par on Interest Date 617

Bonds Issued at Discount or Premium on Interest Date 617

Classification of Discount and Premium 617

Costs of Issuing Bonds 618

Extinguishment of Debt 618

Section 3 Special Issues 620

Contingencies 620

Gain Contingencies 620

Loss Contingencies 621

Off–Balance-Sheet Financing 629

Different Forms 630

Rationale 630

Presentation and Analysis 631

Presentation of Current Liabilities 631

Presentation of Long-Term Debt 631

Presentation of Contingencies 631

Analysis of Current Liabilities 634

Analysis of Long-Term Debt 635

Convergence Corner Liabilities 636

Behind the Numbers: Appendix 12A 640

Effective-Interest Amortization 640

Bonds Issued at a Discount 641

Bonds Issued at a Premium 642

Accruing Interest 643

Chapter 13 STOCKHOLDERS’ EQUITY 670

Everything Else Equal? 670

The Corporate Form of Organization 672

State Corporate Law 672

Capital Stock or Share System 672

Variety of Ownership Interests 673

Corporate Capital 674

Issuance of Stock 675

Reacquisition of Shares 679

Preferred Stock 684

Features of Preferred Stock 685

Accounting for and Reporting Preferred Stock 686

Dividend Policy 687

Financial Condition and Dividend Distributions 687

Types of Dividends 688

Stock Split 693

Disclosure of Restrictions on Retained Earnings 695

Presentation and Analysis of Stockholders’ Equity 697

Presentation 697

Analysis 699

Convergence Corner Stockholders’ Equity 701

Behind the Numbers: Appendix 13A 705

Accounting for Financial Instruments with Both Debt and Equity Characteristics 705

Convertible Debt 705

Stock Warrants Issued with Other Securities 706

Conceptual Questions 708

Chapter 14 INVESTMENTS 730

Who’s in Control Here? 730

Section 1 Investments in Debt Securities 732

Held-to-Maturity Securities 733

Available-for-Sale Securities 736

Example: Single Security 736

Example: Portfolio of Securities 738

Sale of Available-for-Sale Securities 738

Financial Statement Presentation 740

Trading Securities 740

Section 2 Investments in Equity Securities 742

Holdings of Less Than 20% 743

Available-for-Sale Securities 743

Trading Securities 746

Holdings Between 20% and 50% 746

Equity Method 746

Holdings of More Than 50% 748

Section 3 Other Reporting Issues 749

Financial Statement Presentation of Investments 749

Disclosures Required Under the Equity Method 750

Reclassification Adjustments 751

Comprehensive Example 753

Impairment of Value 754

Transfers Between Categories 756

Fair Value Controversy 756

Measurement Based on Intent 757

Gains Trading 757

Liabilities Not Fairly Valued 757

Subjectivity of Fair Values 757

Summary of Reporting Treatment of Securities 757

Convergence Corner Investments 760

Chapter 15 ACCOUNTING FOR INCOME TAXES 780

Tax Uncertainty 780

Fundamentals of Accounting for Income Taxes 782

Future Taxable Amounts and Deferred Taxes 783

Future Deductible Amounts and Deferred Taxes 787

Income Statement Presentation 791

Specific Differences 792

Tax Rate Considerations 795

Accounting for Net Operating Losses 796

Loss Carryback 797

Loss Carryforward 797

Loss Carryback Example 797

Loss Carryforward Example 798

Financial Statement Presentation 803

Balance Sheet 803

Income Statement 805

Review of the Asset–Liability Method 809

Convergence Corner Income Taxes 814

Chapter 16 ACCOUNTING FOR COMPENSATION 840

Where Have All the Pensions Gone? 840

Salary and Bonuses 842

Payroll Deductions 842

Compensated Absences 844

Bonuses 846

Stock Compensation Plans 846

The Major Reporting Issue 848

Accounting for Stock Compensation 850

Employee Stock Purchase Plans 851

Disclosure of Compensation Plans 852

Debate over Stock Option Accounting 853

Postretirement Benefits 854

Defined-Contribution Plan 854

Defined-Benefit Plan 855

Components of Pension Expense 856

Using a Pension Worksheet 858

Reporting Pension Amounts 864

Other Postretirement Expenses 869

Concluding Remarks 871

Convergence Corner Compensation 873

Chapter 17 ACCOUNTING FOR LEASES 890

More Companies Ask, “Why Buy?” 890

The Leasing Environment 892

Who Are the Players? 892

Advantages of Leasing 893

Conceptual Nature of a Lease 895

Accounting by the Lessee 896

Capitalization Criteria 897

Asset and Liability Accounted for Differently 900

Capital Lease Method (Lessee) 901

Operating Method (Lessee) 904

Comparison of Capital Lease with Operating Lease 905

Accounting by the Lessor 907

Economics of Leasing 907

Classification of Leases by the Lessor 908

Direct-Financing Method (Lessor) 909

Operating Method (Lessor) 912

Other Accounting Issues 913

Sales-Type Leases (Lessor) 913

Disclosing Lease Data 914

Lease Accounting_Unresolved Problems 916

Convergence Corner Lease Accounting 918

Chapter 18 ADDITIONAL REPORTING ISSUES 940

So Many Changes 940

Section 1 Accounting Changes 942

Changes in Accounting Principle 942

Retrospective Accounting Change Approach 943

Reporting a Change in Principle 945

Retained Earnings Adjustment 946

Direct and Indirect Effects of Changes 947

Impracticability 948

Changes in Accounting Estimate 951

Disclosures 953

Reporting a Correction of an Error 953

Example 955

Summary of Accounting Changes and Corrections of Errors 957

Section 2 Reporting Earnings per Share 959

Earnings per Share_Simple Capital Structure 960

Preferred Stock Dividends 960

Weighted-Average Number of Shares Outstanding 961

Comprehensive Example 963

Earnings per Share_Complex Capital Structure 964

Diluted EPS—Convertible Securities 966

Diluted EPS—Options and Warrants 967

Antidilution Revisited 969

EPS Presentation and Disclosure 970

Summary of EPS Computation 972

Convergence Corner Additional Financial Reporting Issues 974

Appendix A ACCOUNTING AND THE TIME VALUE OF MONEY 1000

Applications of Time Value Concepts 1000

The Nature of Interest 1001

Simple Interest 1002

Compound Interest 1003

Fundamental Variables 1006

Single-Sum Problems 1007

Future Value of a Single Sum 1007

Present Value of a Single Sum 1009

Solving for Other Unknowns in Single-Sum Problems 1011

Annuities 1012

Future Value of an Ordinary Annuity 1012

Future Value of an Annuity Due 1015

Examples of Future Value of Annuity Problems 1016

Present Value of an Ordinary Annuity 1018

Present Value of an Annuity Due 1020

Examples of Present Value of Annuity Problems 1021

More Complex Situations 1023

Deferred Annuities 1023

Valuation of Long-Term Bonds 1025

Effective-Interest Method of Amortization of Bond Discount or Premium 1026

Present Value Measurement 1027

Choosing an Appropriate Interest Rate 1028

Example of Expected Cash Flow 1029

Appendix B REPORTING CASH FLOWS 1050

Section 1 Indirect Method 1050

Preparing the Statement of Cash

Flows 1051

Step 1: Determining the Net Increase/Decrease in Cash 1052

Step 2: Determining Net Cash Flow Provided/Used by Operating Activities 1052

Step 3: Determining Net Cash Flow Provided/Used by Investing and Financing Activities 1053

Statement of Cash Flows—2008 1054

Special Problems in Statement Preparation 1054

Adjustments Similar to Depreciation 1055

Accounts Receivable (Net) 1055

Other Working Capital Changes 1056

Net Losses 1057

Gains/Losses 1057

Stock Options 1058

Postretirement Benefit Costs 1059

Extraordinary Items 1059

Significant Noncash Transactions 1059

Section 2 Direct Method 1060

Indirect Method 1061

Direct Method—An Example 1061

Summary of Net Cash Flow from Operating Activities—Direct Method 1065

Company Index I-1

Subject Index I-3

Official Accounting Pronouncements P-1

ONLINE APPENDICES (AT WWW.WILEY.COM/COLLEGE/WARFIELD) 00

Appendix C USING FINANCIAL CALCULATORS 00

Future Value of a Single Sum 00

Plus and Minus 00

Compounding Periods 00

Rounding 00

Present Value of a Single Sum 00

Future Value of an Ordinary Annuity 00

Future Value of an Annuity Due 00

Present Value of an Ordinary Annuity 00

Useful Applications of the Financial Calculator 00

Auto Loan 00

Mortgage Loan Amount 00

Individual Retirement Account (IRA) 00

Appendix D RETAIL INVENTORY METHOD 00

Retail Method Concepts 00

Retail Inventory Method with Markups and

Markdowns_Conventional Method 00

Special Items Relating to Retail Method 00

Evaluation of Retail Method 00

Appendix E ACCOUNTING FOR NATURAL RESOURCES 00

Depletion 00

Establishing a Depletion Base 00

Write-Off of Resource Cost 00

Continuing Controversy 00

Special Problems in Depletion Accounting 00

Presentation of Natural Resources 00

Appendix F ACCOUNTING FOR COMPUTER SOFTWARE COSTS 00

Diversity in Practice 00

The Profession’s Position 00

Accounting for Capitalized Software Costs 00

Reporting Software Costs 00

Setting Standards for Software Accounting 00

Appendix G ACCOUNTING FOR TROUBLED DEBT 00

Impairments 00

Example of Loss on Impairment 00

Troubled-Debt Restructurings 00

Settlement of Debt 00

Modification of Terms 00

Concluding Remarks 00

Appendix H ACCOUNTING FOR DERIVATIVE INSTRUMENTS 00

Understanding Derivatives 00

Who Uses Derivatives, and Why? 00

Basic Principles in Accounting for Derivatives 00

Example: of Derivative Financial Instrument—Speculation 00

Differences Between Traditional and Derivative Financial Instruments 00

Derivatives Used for Hedging 00

Fair Value Hedge 00

Cash Flow Hedge 00

Other Reporting Issues 00

Embedded Derivatives 00

Qualifying Hedge Criteria 00

Disclosure Provisions 00

Comprehensive Hedge Accounting Example 00

Fair Value Hedge 00

Financial Statement Presentation of an Interest Rate Swap 00

Controversy and Concluding Remarks 00

Appendix I ERROR ANALYSIS 00

Balance Sheet Errors 00

Income Statement Errors 00

Balance Sheet and Income Statement Errors 00

Counterbalancing Errors 00

Noncounterbalancing Errors 00

Comprehensive Example: Numerous Errors 00

Preparation of Financial Statements with Error Corrections 00