Financial Accounting with IFRS PDF

lOMoARcPSD|5814602  lOMoARcPSD|5814602 Financial Accounting with International Financial Reporting Standards Fourth Edition JERRY J. WEYGANDT PhD, CPA...

lOMoARcPSD|5814602  lOMoARcPSD|5814602 Financial Accounting with International Financial Reporting Standards Fourth Edition JERRY J. WEYGANDT PhD, CPA University of Wisconsin—Madison Madison, Wisconsin PAUL D. K IM M EL PhD, C PA University of Wisconsin—Milwaukee Milwaukee, Wisconsin DONALD E. KIESO PhD, CPA Northern Illinois University DeKalb, Illinois  lOMoARcPSD|5814602 DEDICATED TO Our wives, Enid, Merlynn, and Donna, for their love, support, and encouragement. DIRECTOR Michael McDonald ACQUISITIONS EDITOR Zoe Craig LEAD PRODUCT DESIGNER Ed Brislin PRODUCT DESIGNER Lindsey Myers EDITORIAL SUPERVISOR Terry Ann Tatro EDITORIAL ASSOCIATE Margaret Thompson EDITORIAL ASSISTANT Alyce Pellegrino SENIOR CONTENT MANAGER Dorothy Sinclair SENIOR PRODUCTION EDITOR Elena Saccaro SENIOR DESIGNER Wendy Lai SENIOR PHOTO EDITOR Mary Ann Price COVER IMAGE © Teodulo Vida/EyeEm/Getty Images This book was set in Stix Regular by Aptara®, Inc. 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In addition, if the ISBN on the back cover differs from the ISBN on this page, the one on the back cover is correct. Printed in Singapore by Markono Print Media Pte Ltd. 10 9 8 7 6 5 4 3 2 1  lOMoARcPSD|5814602 Brief Contents 1 Accounting in Action 1-1 2 The Recording Process 2-1 3 Adjusting the Accounts 3-1 4 Completing the Accounting Cycle 4-1 5 Accounting for Merchandise Operations 5-1 6 Inventories 6-1 7 Fraud, Internal Control, and Cash 7-1 8 Accounting for Receivables 8-1 9 Plant Assets, Natural Resources, and Intangible Assets 9-1 10 Current Liabilities 10-1 11 Non-Current Liabilities 11-1 12 Corporations: Organization, Share Transactions, and Equity 12-1 13 Investments 13-1 14 Statement of Cash Flows 14-1 15 Financial Analysis: The Big Picture 15-1 APPE N D I C E S A Specimen Financial Statements: TSMC, Ltd. A-1 B Specimen Financial Statements: Nestlé SA B-1 C Specimen Financial Statements: Delfi Limited C-1 D Specimen Financial Statements: Apple Inc. D-1 E Time Value of Money E-1 F Accounting for Partnerships F-1 G Subsidiary Ledgers and Special Journals G-1 CO M PANY INDE X / S UBJ E CT IND E X I-1 iii  lOMoARcPSD|5814602 From the Authors Dear Student, WHY THIS TEXT? Your instructor has chosen this text for you because of the authors’ trusted reputation. The authors have W H Y T H I S C O U R S E? Remember your biology course worked hard to write a text that is engaging, timely, and accurate. in high school? Did you have one of those “invisible man” models (or maybe something more high-tech than that) that HOW TO SUCCEED? We’ve asked many students and many gave you the opportunity to look “inside” the human body? instructors whether there is a secret for success in this course. This accounting course offers something similar. To under- The nearly unanimous answer turns out to be not much of a stand a business, you have to secret: “Do the homework.” This is one understand the financial in- course where doing is learning. The more “Whether you are looking at a large multina- sides of a business organiza- time you spend on the homework assign- tional company like Samsung or adidas or tion. A financial accounting ments—using the various tools that this a single-owner software consulting business text provides—the more likely you are to course will help you under- or coffee shop, knowing the fundamentals of learn the essential concepts, techniques, stand the essential financial financial accounting will help you understand and methods of accounting. Besides the components of businesses. what is happening.” text itself, the book’s companion website Whether you are looking at a large multinational company also offers various support resources. like Samsung or adidas or a single-owner software consult- Good luck in this course. We hope you enjoy the experience ing business or coffee shop, knowing the fundamentals of and that you put to good use throughout a lifetime of success financial accounting will help you understand what is hap- the knowledge you obtain in this course. We are sure you will pening. As an employee, a manager, an investor, a business not be disappointed. owner, or a director of your own personal finances—any of which roles you will have at some point in your life—you Jerry J. Weygandt will make better decisions for having taken this course. Paul D. Kimmel Donald E. Kieso iv  lOMoARcPSD|5814602 Author Commitment Jerry Weygandt Paul Kimmel Don Kieso J ER RY J. W EYGA N D T , P h D, PAU L D. K I M M E L , PhD, CPA, DONALD E. KIESO, PhD, CPA, C PA , is Arthur Andersen Alumni Emeritus received his bachelor’s degree from the Uni- received his bachelor’s degree from Aurora Uni- Professor of Accounting at the University of versity of Minnesota and his doctorate in ac- versity and his doctorate in accounting from the Wisconsin—Madison. He holds a Ph.D. in counting from the University of Wisconsin. University of Illinois. He has served as chairman accounting from the University of Illinois. He teaches at the University of Wisconsin— of the Department of Accountancy and is currently Articles by Professor Weygandt have appeared Milwaukee and Madison, and has public ac- the KPMG Emeritus Professor of Accountancy in The Accounting Review, Journal of Account- counting experience with Deloitte & Touche at Northern Illinois University. He has public ing Research, Accounting Horizons, Journal of (Minneapolis). He was the recipient of the accounting experience with Price Waterhouse Accountancy, and other academic and profes- UWM School of Business Advisory Council & Co. (San Francisco and Chicago) and Arthur sional journals. These articles have examined Teaching Award, the Reggie Taite Excellence Andersen & Co. (Chicago) and research experi- such financial reporting issues as accounting for in Teaching Award and a three-time winner ence with the Research Division of the American price-level adjustments, pensions, convertible of the Outstanding Teaching Assistant Award Institute of Certified Public Accountants (New securities, stock option contracts, and interim at the University of Wisconsin. He is also a York). He has done post doctorate work as a reports. Professor Weygandt is author of other recipient of the Elijah Watts Sells Award for Visiting Scholar at the University of California accounting and financial reporting books and Honorary Distinction for his results on the at Berkeley and is a recipient of NIU’s Teach- is a member of the American Accounting CPA exam. He is a member of the American ing Excellence Award and four Golden Apple Association, the American Institute of Cer- Accounting Association and the Institute of Teaching Awards. Professor Kieso is the author tified Public Accountants, and the Wiscon- Management Accountants and has published of other accounting and business books and is a sin Society of Certified Public Accountants. articles in The Accounting Review, Accounting member of the American Accounting Associa- He has served on numerous committees of Horizons, Advances in Management Accounting, tion, the American Institute of Certified Public the American Accounting Association and Managerial Finance, Issues in Accounting Accountants, and the Illinois CPA Society. as a member of the editorial board of The Education, Journal of Accounting Education, He has served as a member of the Board of Accounting Review; he also has served as Pres- as well as other journals. His research interests Directors of the Illinois CPA Society, then ident and Secretary-Treasurer of the American include accounting for financial instruments AACSB’s Accounting Accreditation Commit- Accounting Association. In addition, he has and innovation in accounting education. He tees, the State of Illinois Comptroller’s Commis- been actively involved with the American has published papers and given numerous talks sion, as Secretary-Treasurer of the Federation Institute of Certified Public Accountants and on incorporating critical thinking into account- of Schools of Accountancy, and as Secretary- has been a member of the Accounting Stand- ing education, and helped prepare a catalog of Treasurer of the American Accounting Associa- ards Executive Committee (AcSEC) of that critical thinking resources for the Federated tion. Professor Kieso is currently serving on the organization. He has served on the FASB task Schools of Accountancy. Board of Trustees and Executive Committee of force that examined the reporting issues related Aurora University, as a member of the Board of to accounting for income taxes and served as a Directors of Kishwaukee Community Hospital, trustee of the Financial Accounting Foundation. and as Treasurer and Director of Valley West Professor Weygandt has received the Chancellor’s Community Hospital. From 1989 to 1993 he Award for Excellence in Teaching and the Beta served as a charter member of the national Ac- Gamma Sigma Dean’s Teaching Award. He is on counting Education Change Commission. He the board of directors of Bascom-Palmer Eye is the recipient of the Outstanding Accounting Institute—Naples and also on the board of Artis— Educator Award from the Illinois CPA Society, Naples. He is the recipient of the Wisconsin In- the FSA’s Joseph A. Silvoso Award of Merit, stitute of CPA’s Outstanding Educator’s Award the NIU Foundation’s Humanitarian Award for and the Lifetime Achievement Award. In 2001 Service to Higher Education, a Distinguished he received the American Accounting Associa- Service Award from the Illinois CPA Society, tion’s Outstanding Educator Award. and in 2003 an honorary doctorate from Aurora University. v  lOMoARcPSD|5814602 Hallmark Features Financial Accounting provides a simple and practical introduction to the fundamentals of financial accounting. It explains the concepts you need to know. This edition continues this approach by offering even more explanations, illustrations, and homework problems to help students get a firm understanding of the accounting cycle. DO IT! Exercises DO IT! Exercises in the body of the text prompt students to stop and review key concepts. They outline the Action Plan necessary to complete the exercise as well as show a detailed solution. ACTION PLAN DO IT! 2 Closing Entries Close revenue and expense accounts to Hancock Heating has the following balances in selected accounts of its adjusted trial balance. Income Summary. Accounts Payable €27,000 Dividends €15,000 Close Income Summary Service Revenue 98,000 Share Capital—Ordinary 42,000 to Retained Earnings. Rent Expense 22,000 Accounts Receivable 38,000 Salaries and Wages Expense 51,000 Supplies Expense 7,000 Close Dividends to Retained Earnings. Prepare the closing entries at December 31. Solution Dec. 31 Service Revenue 98,000 Income Summary 98,000 (To close revenue account to Income Summary) 31 Income Summary 80,000 Salaries and Wages Expense 51,000 Rent Expense 22,000 Supplies Expense 7,000 (To close expense accounts to Income Summary) Review and Practice Each chapter concludes with a Review and Practice section which includes a review of learn- ing objectives, key terms glossary, practice multiple-choice questions with annotated solu- tions, practice brief exercises with solutions, practice exercises with solutions, and a practice problem with a solution. Practice Brief Exercises Prepare the current assets section of a 3. (LO 4) The statement of financial position debit column of the worksheet for Soon Cosmetics statement of financial position. includes the following accounts (amounts in thousands): Accounts Receivable W25,000, Prepaid Insurance W7,000, Cash W8,000, Supplies W11,000, and Inventory W14,000. Prepare the current assets section of the statement of financial position, listing the accounts in proper sequence. Solution 3. Soon Cosmetics Statement of Financial Position (partial) Current assets Prepaid insurance W 7,000 Supplies 11,000 Inventory 14,000 Accounts receivable 25,000 Cash 8,000 Total current assets W65,000 vi  lOMoARcPSD|5814602 Hallmark Features vii Infographic Learning Over half of the text is visual, providing students alternative ways of learning about accounting. In addition, a new interior design promotes accessibility. ILLUSTRATION 2.1 Title of Account Basic form of account Left or debit side Right or credit side Real-World Decision-Making Real-world examples that illustrate interesting situations in companies and how accounting information is used are integrated throughout the text, such as in the opening Feature Story as well as the Insight boxes. People, Planet, and Profit Insight Nestlé SA Creating Value Nutrition: Products meeting or exceeding Nutritional Founda- tion profiling criteria (as percentage of total sales) and products Appendix B contains the financial state- with increase in nutritious ingredients or essential nutrients. ments of Nestlé SA (CHE). Those finan- cial statements report on the company’s Water and Environmental Sustainability: Quality of water dis- profitability and financial position. In charged (average mg COD/I) and packaging weight reduction (tonnes). addition to these financial statements, Rural Development: Farmers trained through capacity-build- Nestlé, like many other companies today, ing programs and suppliers audited for food safety, quality, and also reports its achievements with regard processing. to other, non-financial goals. In Nestlé’s case, it calls these goals “Creating Shared To learn more about Nestlé’s efforts to create shared value, go to Simon Rawles/Alamy Value.” Nestlé has set objectives to help the company’s website. society in areas most directly related to its particular expertise: nutrition, water and environmental sustainability, and rural What are some implications of Nestlé’s decision to measure development. The company evaluates its progress in each area its results using objective measures and then publicly report using objective measures. Examples of measures used are pro- these results? (Go to the book’s companion website for this vided below. answer and additional questions.) Additional Guidance Throughout the text, marginal notes, such as Helpful Hints, Alternative Terminology, and Ethics Notes, are provided as additional guidance. Correcting Entries—An Avoidable Step Unfortunately, errors may occur in the recording process. Companies should correct errors, as soon as they discover them, by journalizing and posting correcting entries. If the account- ing records are free of errors, no correcting entries are needed. You should recognize several differences between correcting entries and adjusting entries. First, adjusting entries are an integral part of the accounting cycle. Correcting entries, on the ETHICS NOTE other hand, are unnecessary if the records are error-free. Second, companies journalize and post When companies find errors adjustments only at the end of an accounting period. In contrast, companies make correcting in previously released income entries whenever they discover an error (see Ethics Note). Finally, adjusting entries always statements, they restate those affect at least one statement of financial position account and one income statement account. In numbers.  lOMoARcPSD|5814602 Contents Summary Illustration of Journalizing and Posting 2-19 1 Accounting in Action 1-1 The Trial Balance 2-21 Limitations of a Trial Balance 2-22 Knowing the Numbers 1-1 Locating Errors 2-22 Accounting Activities and Users 1-3 Currency Signs and Underlining 2-22 Three Activities 1-3 A Look at U.S. GAAP 2-46 Who Uses Accounting Data 1-4 The Building Blocks of Accounting 1-6 Ethics in Financial Reporting 1-6 3 Adjusting the Accounts 3-1 Accounting Standards 1-7 Measurement Principles 1-8 What Was Your Profit?: Cadbury 3-1 Assumptions 1-8 Accrual-Basis Accounting and Adjusting Entries 3-2 The Accounting Equation 1-10 Fiscal and Calendar Years 3-3 Assets 1-11 Accrual- versus Cash-Basis Accounting 3-3 Liabilities 1-11 Recognizing Revenues and Expenses 3-3 Equity 1-11 The Need for Adjusting Entries 3-5 Analyzing Business Transactions 1-13 Types of Adjusting Entries 3-5 Accounting Transactions 1-13 Adjusting Entries for Deferrals 3-6 Transaction Analysis 1-14 Prepaid Expenses 3-6 Summary of Transactions 1-19 Unearned Revenues 3-10 Financial Statements 1-20 Adjusting Entries for Accruals 3-13 Income Statement 1-22 Accrued Revenues 3-13 Retained Earnings Statement 1-22 Accrued Expenses 3-14 Statement of Financial Position 1-22 Summary of Basic Relationships 3-17 Statement of Cash Flows 1-23 Adjusted Trial Balance and Financial Statements 3-20 Comprehensive Income Statement 1-23 Preparing the Adjusted Trial Balance 3-21 Appendix 1A: Career Opportunities in Accounting 1-25 Preparing Financial Statements 3-21 Public Accounting 1-25 Appendix 3A: Alternative Treatment of Deferrals 3-24 Private Accounting 1-26 Prepaid Expenses 3-25 Governmental Accounting 1-26 Unearned Revenues 3-26 Forensic Accounting 1-26 Summary of Additional Adjustment Relationships 3-27 A Look at U.S. GAAP 1-46 Appendix 3B: Financial Reporting Concepts 3-28 Qualities of Useful Information 3-28 2 The Recording Process 2-1 Assumptions in Financial Reporting 3-28 Principles in Financial Reporting 3-29 Accidents Happen: Bank of Taiwan 2-1 Cost Constraint 3-30 Accounts, Debits, and Credits 2-2 A Look at U.S. GAAP 3-56 The Account 2-2 Debits and Credits 2-3 Equity Relationships 2-6 4 Completing the Accounting Summary of Debit/Credit Rules 2-6 Cycle 4-1 The Journal 2-7 The Recording Process 2-7 Speaking the Same Language: IASB 4-1 The Journal 2-8 The Worksheet 4-3 The Ledger and Posting 2-10 Steps in Preparing a Worksheet 4-3 The Ledger 2-10 Preparing Financial Statements from a Worksheet 4-10 Posting 2-12 Preparing Adjusting Entries from a Worksheet 4-11 Chart of Accounts 2-13 Closing the Books 4-11 The Recording Process Illustrated 2-13 Preparing Closing Entries 4-12 viii  lOMoARcPSD|5814602 Contents ix Posting Closing Entries 4-14 Preparing a Post-Closing Trial Balance 4-16 6 Inventories 6-1 The Accounting Cycle and Correcting Entries 4-19 “Where Is That Spare Bulldozer Blade?”: Summary of the Accounting Cycle 4-19 Komatsu 6-1 Reversing Entries—An Optional Step 4-19 Classifying and Determining Inventory 6-2 Correcting Entries—An Avoidable Step 4-19 Classifying Inventory 6-2 Classified Statement of Financial Position 4-23 Determining Inventory Quantities 6-4 Intangible Assets 4-24 Inventory Methods and Financial Effects 6-6 Property, Plant, and Equipment 4-25 Specific Identification 6-7 Long-Term Investments 4-25 Cost Flow Assumptions 6-7 Current Assets 4-25 Financial Statement and Tax Effects of Cost Flow Equity 4-26 Methods 6-11 Non-Current Liabilities 4-27 Using Inventory Cost Flow Methods Consistently 6-12 Current Liabilities 4-27 Effects of Inventory Errors 6-13 Appendix 4A: Reversing Entries 4-29 Income Statement Effects 6-13 Reversing Entries Example 4-29 Statement of Financial Position Effects 6-14 A Look at U.S. GAAP 4-57 Inventory Statement Presentation and Analysis 6-15 Presentation 6-15 Lower-of-Cost-or-Net Realizable Value 6-15 5 Accounting for Merchandise Analysis 6-16 Operations Appendix 6A: Inventory Cost Flow Methods in Perpetual 5-1 Inventory Systems 6-18 Who Doesn’t Shop?: Carrefour 5-1 First-In, First-Out (FIFO) 6-18 Merchandising Operations and Inventory Systems 5-3 Average-Cost 6-19 Operating Cycles 5-3 Appendix 6B: Estimating Inventories 6-19 Flow of Costs 5-4 Gross Profit Method 6-20 Recording Purchases Under a Perpetual System 5-6 Retail Inventory Method 6-21 Freight Costs 5-8 Appendix 6C: LIFO Inventory Method 6-22 Purchase Returns and Allowances 5-9 A Look at U.S. GAAP 6-44 Purchase Discounts 5-9 Summary of Purchasing Transactions 5-10 Recording Sales Under a Perpetual System 5-11 Sales Returns and Allowances 5-12 7 Fraud, Internal Control, Sales Discounts 5-13 and Cash 7-1 The Accounting Cycle for a Merchandising Company 5-14 Adjusting Entries 5-15 Minding the Money at Nick’s: Nick’s Steakhouse and Closing Entries 5-15 Pizza 7-1 Summary of Merchandising Entries 5-16 Fraud and Internal Control 7-2 Financial Statements for a Merchandiser 5-17 Fraud 7-3 Income Statement 5-17 Internal Control 7-3 Classified Statement of Financial Position 5-21 Principles of Internal Control Activities 7-4 Appendix 5A: Worksheet for a Merchandising Limitations of Internal Control 7-10 Company 5-23 Cash Controls 7-10 Using a Worksheet 5-23 Cash Receipts Controls 7-11 Appendix 5B: Periodic Inventory System 5-24 Cash Disbursements Controls 7-13 Determining Cost of Goods Sold Under a Periodic Petty Cash Fund 7-15 System 5-25 Control Features of a Bank Account 7-18 Recording Merchandise Transactions 5-25 Making Bank Deposits 7-18 Recording Purchases of Merchandise 5-26 Writing Checks 7-19 Recording Sales of Merchandise 5-27 Electronic Funds Transfer (EFT) System 7-20 Journalizing and Posting Closing Entries 5-27 Bank Statements 7-20 Using a Worksheet 5-29 Reconciling the Bank Account 7-21 A Look at U.S. GAAP 5-54 Reporting Cash 7-26  lOMoARcPSD|5814602 x Contents Cash Equivalents 7-26 Restricted Cash 7-26 10 Current Liabilities 10-1 A Look at U.S. GAAP 7-46 Financing His Dreams: Wilbert Murdock 10-1 Accounting for Current Liabilities 10-2 What Is a Current Liability? 10-2 8 Accounting for Receivables 8-1 Notes Payable 10-3 Value-Added and Sales Taxes Payable 10-4 Are You Going to Pay Me—or Not?: BNP Paribas 8-1 Unearned Revenues 10-5 Recognition of Accounts Receivable 8-2 Salaries and Wages 10-5 Types of Receivables 8-3 Current Maturities of Long-Term Debt 10-7 Recognizing Accounts Receivable 8-3 Reporting and Analyzing Current Liabilities 10-8 Valuation and Disposition of Accounts Receivable 8-5 Reporting Uncertainty 10-8 Valuing Accounts Receivable 8-5 Reporting of Current Liabilities 10-9 Disposing of Accounts Receivable 8-11 Analysis of Current Liabilities 10-10 Notes Receivable 8-13 A Look at U.S. GAAP 10-26 Determining the Maturity Date 8-14 Computing Interest 8-15 Recognizing Notes Receivable 8-15 11 Non-Current Liabilities 11-1 Valuing Notes Receivable 8-16 Are We Living on Borrowed Time? 11-1 Disposing of Notes Receivable 8-16 Overview of Bonds 11-2 Presentation and Analysis 8-18 Types of Bonds 11-3 Presentation 8-19 Issuing Procedures 11-3 Analysis 8-19 Bond Trading 11-3 A Look at U.S. GAAP 8-38 Determining the Market Price of a Bond 11-4 Bond Transactions 11-6 Issuing Bonds at Face Value 11-6 9 Plant Assets, Natural Resources, Discount or Premium on Bonds 11-7 and Intangible Assets 9-1 Issuing Bonds at a Discount 11-8 Issuing Bonds at a Premium 11-9 How Much for a Ride to the Beach?: Rent-A-Wreck 9-1 Redeeming Bonds 11-10 Plant Asset Expenditures 9-2 Accounting for Non-Current Liabilities 11-11 Determining the Cost of Plant Assets 9-3 Long-Term Notes Payable 11-11 Expenditures During Useful Life 9-5 Lease Liabilities 11-13 Depreciation Methods 9-7 Reporting and Analyzing Non-Current Liabilities 11-14 Factors in Computing Depreciation 9-8 Presentation 11-14 Depreciation Methods 9-8 Analysis 11-14 Component Depreciation 9-13 Debt and Equity Financing 11-15 Depreciation and Income Taxes 9-13 Appendix 11A: Effective-Interest Method of Bond Revaluation of Plant Assets 9-13 Amortization 11-17 Revising Periodic Depreciation 9-14 Amortizing Bond Discount 11-17 Plant Asset Disposals 9-15 Amortizing Bond Premium 11-19 Retirement of Plant Assets 9-16 Appendix 11B: Straight-Line Amortization 11-20 Sale of Plant Assets 9-16 Amortizing Bond Discount 11-20 Natural Resources and Intangible Assets 9-18 Amortizing Bond Premium 11-21 Natural Resources and Depletion 9-18 A Look at U.S. GAAP 11-38 Intangible Assets 9-20 Statement Presentation and Analysis 9-23 Presentation 9-23 12 Corporations: Organization, Share Analysis 9-24 Transactions, and Equity 12-1 Appendix 9A: Exchange of Plant Assets 9-24 Loss Treatment 9-25 To the Victor Go the Spoils: adidas 12-1 Gain Treatment 9-25 The Corporate Form of Organization 12-2 A Look at U.S. GAAP 9-47 Characteristics of a Corporation 12-3  lOMoARcPSD|5814602 Contents xi Forming a Corporation 12-5 Significant Non-Cash Activities 14-5 Shareholder Rights 12-5 Format of the Statement of Cash Flows 14-5 Share Issue Considerations 12-7 Preparing the Statement of Cash Flows—Indirect Corporate Capital 12-9 Method 14-7 Accounting for Share Transactions 12-10 Indirect and Direct Methods 14-8 Accounting for Ordinary Shares 12-10 Indirect Method—Computer Services Accounting for Preference Shares 12-12 International 14-8 Accounting for Treasury Shares 12-13 Step 1: Operating Activities 14-9 Dividends and Splits 12-16 Summary of Conversion to Net Cash Provided Accounting for Cash Dividends 12-17 by Operating Activities—Indirect Method 14-12 Dividend Preferences 12-18 Step 2: Investing and Financing Activities 14-13 Accounting for Share Dividends 12-21 Step 3: Net Change in Cash 14-14 Accounting for Share Splits 12-23 Using Cash Flows to Evaluate a Company 14-17 Reporting and Analyzing Equity 12-24 Free Cash Flow 14-17 Retained Earnings 12-24 Appendix 14A: Statement of Cash Flows—Direct Presentation of Statement of Financial Position 12-26 Method 14-19 Analysis 12-27 Step 1: Operating Activities 14-21 Appendix 12A: Statement of Changes in Equity 12-28 Step 2: Investing and Financing Activities 14-25 Appendix 12B: Book Value—Another per Share Step 3: Net Change in Cash 14-26 Amount 12-29 Appendix 14B: Statement of Cash Flows—T-Account Book Value per Share 12-29 Approach 14-26 Book Value versus Market Price 12-30 A Look at U.S. GAAP 14-50 A Look at U.S. GAAP 12-55 13 Investments 13-1 15 Financial Analysis: The Big Picture 15-1 Playing for Fun and Profit: Sony 13-1 Debt Investments 13-2 Making Money the Old-Fashioned Way: Li Ka-shing 15-1 Why Companies Invest 13-2 Basics of Financial Statement Analysis 15-2 Accounting for Debt Investments 13-4 Need for Comparative Analysis 15-3 Share Investments 13-6 Tools of Analysis 15-3 Holdings of Less than 20% 13-6 Horizontal Analysis 15-3 Holdings Between 20% and 50% 13-7 Vertical Analysis 15-6 Holdings of More than 50% 13-8 Ratio Analysis 15-9 Valuing and Reporting Investments 13-10 Liquidity Ratios 15-9 Categories of Securities 13-10 Profitability Ratios 15-13 Statement of Financial Position Presentation 13-16 Solvency Ratios 15-16 Presentation of Realized and Unrealized Gain or Loss 13-17 Summary of Ratios 15-18 Classified Statement of Financial Position 13-17 Sustainable Income 15-20 Appendix 13A: Preparing Consolidated Financial Discontinued Operations 15-21 Statements 13-19 Changes in Accounting Principle 15-22 Consolidated Statement of Financial Position 13-19 Comprehensive Income 15-22 Consolidated Income Statement 13-23 A Look at U.S. GAAP 15-48 A Look at U.S. GAAP 13-40 Appendix A Specimen Financial 14 Statement of Cash Flows 14-1 Statements: Taiwan What Should We Do with This Cash?: Keyence 14-1 Semiconductor Statement of Cash Flows: Usefulness and Format 14-3 Manufacturing Company, Usefulness of the Statement of Cash Flows 14-3 Limited A-1 Classification of Cash Flows 14-3  lOMoARcPSD|5814602 xii Contents Appendix B Specimen Financial Appendix F Accounting for Statements: Partnerships F-1 Nestlé SA B-1 Forming a Partnership F-2 Characteristics of Partnerships F-2 Organizations with Partnership Characteristics F-3 Advantages and Disadvantages of Partnerships F-4 Appendix C Specimen Financial The Partnership Agreement F-5 Statements: Delfi Accounting for a Partnership Formation F-5 Accounting for Net Income or Net Loss F-6 Limited C-1 Dividing Net Income or Net Loss F-6 Partnership Financial Statements F-9 Liquidation of a Partnership F-10 No Capital Deficiency F-11 Appendix D Specimen Financial Capital Deficiency F-12 Statements: Admissions and Withdrawals of Partners F-15 Admission of a Partner F-15 Apple Inc. D-1 Withdrawal of a Partner F-18 Appendix G Subsidiary Ledgers and Appendix E Time Value of Money E-1 Special Journals G-1 Interest and Future Values E-1 Subsidiary Ledgers G-1 Nature of Interest E-1 Subsidiary Ledger Example G-2 Future Value of a Single Amount E-3 Advantages of Subsidiary Ledgers G-3 Future Value of an Annuity E-5 Special Journals G-4 Present Value Concepts E-7 Sales Journal G-4 Present Value Variables E-7 Cash Receipts Journal G-7 Present Value of a Single Amount E-7 Purchases Journal G-10 Present Value of an Annuity E-9 Cash Payments Journal G-13 Time Periods and Discounting E-11 Effects of Special Journals on the General Present Value of a Long-Term Note or Bond E-11 Journal G-15 Using Financial Calculators E-14 Cybersecurity: A Final Comment G-16 Present Value of a Single Sum E-14 Present Value of an Annuity E-15 Company Index I-1 Useful Applications of the Financial Calculator E-16 Subject Index I-3  lOMoARcPSD|5814602 Thank You Financial Accounting has benefited greatly from the input of those who have sent comments by letter or e-mail, ancillary authors, and proofers. We greatly appreciate the constructive suggestions and innovative ideas of reviewers and the creativity and accuracy of the ancil- lary authors and checkers. Michael Barnes Barbara Muller Truman State University Arizona State University Ellen Bartley Yvonne Phang St. Joseph’s College Borough of Manhattan Community College LuAnn Bean Laura Prosser Florida Institute of Technology Black Hills State University Jack Borke Alice Sineath University of Wisconsin—Platteville Forsyth Technical Community College Larry Falcetto Lynn Stallworth Emporia State University Appalachian State University Heidi Hansel Teresa Speck Kirkwood Community College St. Mary’s University Karen Hern Lakshmy Sivaratnam Grossmont College Kansas City Kansas Community College Derek Jackson Shelia Viel St. Mary’s University University of Wisconsin—Milwaukee Cynthia Lovick Dick Wasson Austin Community College Southwestern College Jill Misuraca Suzanne Wright University of Tampa Pennsylvania State University We appreciate the exemplary support and commitment given to us by editor Zoe Craig, lead product designer Ed Brislin, product designer Lindsey Myers, editorial supervisor Terry Ann Tatro, editorial associate Margaret Thompson, designer Wendy Lai, photo editor Mary Ann Price, indexer Steve Ingle, senior production editor Elena Saccaro, and Jackie Henry at Aptara. All of these professionals provided innumerable services that helped the text take shape. Jerry J. Weygandt Paul D. Kimmel Donald E. Kieso Madison, Wisconsin Milwaukee, Wisconsin DeKalb, Illinois xiii lOMoARcPSD|5814602  lOMoARcPSD|5814602 CHAPTER 1 Tetra Images/SUPERSTOCK Accounting in Action The Chapter Preview describes the purpose of the chapter and highlights major topics. Chapter Preview The following Feature Story highlights the importance of having good financial information and knowing how to use it to make effective business decisions. Whatever your pursuits or occupation, the need for financial information is inescapable. You cannot earn a living, spend money, buy on credit, make an investment, or pay taxes without receiving, using, or dispensing financial information. Good decision-making depends on good information. The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business. Success in any business comes back to the numbers. You Feature Story will rely on them to make decisions, and managers will use them to evaluate your performance. That is true whether your Knowing the Numbers job involves marketing, production, management, or informa- Many students who take this course do not plan to be tion systems. accountants. If you are in that group, you might be think- In business, accounting is the means for communicating ing, “If I’m not going to be an accountant, why do I need the numbers. If you don’t know how to read financial state- to know accounting?” In response, consider the quote from ments, you cannot really know your business. Harold Geneen, the former chairman of a major international Many companies spend significant resources teaching company: “To be good at your business, you have to know their employees basic accounting so that they can read finan- the numbers—cold.” cial statements and understand how their actions affect the 1-1  lOMoARcPSD|5814602 1-2 C HA PTE R 1 Accounting in Action company’s financial results. Employers need managers in all financial reporting by providing numerous references, ques- areas of the company to be “financially literate.” tions, and exercises that encourage you to explore these finan- Taking this course will go a long way to making you cial statements. In addition, we encourage you to visit each financially literate. In this text, you will learn how to read and company’s website where you can view its complete annual prepare financial statements, and how to use basic tools to report. In examining the financial reports of these three compa- evaluate financial results. nies, you will see that the accounting practices of companies in Appendices A, B, and C of this text provide real finan- specific countries that follow IFRS sometimes differ with regard cial statements of three companies from different countries to particular details. However, more importantly, you will find that report using International Financial Reporting Standards that the basic accounting principles are the same. As a result, (IFRS): Taiwan Semiconductor Manufacturing Company by learning these basic principles as presented in this text, you (TSMC) Ltd. (TWN), Nestlé SA (CHE), and Delfi Limited will be well equipped to begin understanding the financial (SGP). Throughout this text, we increase your familiarity with results of companies around the world. The Chapter Outline presents the chapter’s topics and subtopics, as well as practice opportunities. Chapter Outline LEARNING OBJECTIVES LO 1 Identify the activities and Three activities DO IT! 1 Basic Concepts users associated with accounting. Who uses accounting data LO 2 Explain the building blocks of Ethics in financial reporting DO IT! 2 Building Blocks of accounting: ethics, principles, and Accounting standards Accounting assumptions. Measurement principles Assumptions LO 3 State the accounting Assets DO IT! 3 Equity Effects equation, and define its Liabilities components. Equity LO 4 Analyze the effects of Accounting transactions DO IT! 4 Tabular Analysis business transactions on the Transaction analysis accounting equation. Summary of transactions LO 5 Describe the five financial Income statement DO IT! 5 Financial Statement statements and how they are Retained earnings statement Items prepared. Statement of financial position Statement of cash flows Comprehensive income statement Go to the Review and Practice section at the end of the chapter for a review of key concepts and practice applications with solutions.  lOMoARcPSD|5814602 Accounting Activities and Users 1-3 Accounting Activities and Users LEARNING OBJECTIVE 1 Identify the activities and users associated with accounting. What consistently ranks as one of the top career opportunities in business? What frequently rates among the most popular majors on campus? Accounting.1 Why do people choose accounting? They want to acquire the skills needed to understand what is happening finan- cially inside an organization. Accounting is the financial information system that provides these insights. In short, to understand your organization, you have to know the numbers. Accounting consists of three basic activities—it identifies, records, and communicates Essential terms are printed in the economic events of an organization to interested users. Let’s take a closer look at these blue when they first appear, and three activities. are defined in the end-of-chapter Glossary Review. Three Activities As a starting point to the accounting process, a company identifies the economic events rel- evant to its business. Examples of economic events are the sale of food and snacks by Uni- lever (GBR and NLD), the providing of telephone services by Chunghwa Telecom (TWN), and the manufacture of motor vehicles by Tata Motors (IND). Once a company like Unilever identifies economic events, it records those events in or- der to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in monetary units. In recording, Unilever also clas- sifies and summarizes economic events. Finally, Unilever communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. To make the reported financial information meaningful, Unilever reports the recorded data in a standardized way. It accumulates information resulting from similar transactions. For example, Unilever accumulates all sales transactions over a certain period of time and re- ports the data as one amount in the company’s financial statements. Such data are said to be reported in the aggregate. By presenting the recorded data in the aggregate, the accounting process simplifies a multitude of transactions and makes a series of activities understandable and meaningful. A vital element in communicating economic events is the accountant’s ability to ana- lyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Appendix A of this text shows the financial statements of Taiwan Semiconductor Manufacturing Company (TSMC) Ltd. (TWN). Appendix B illustrates the financial statements of Nestlé SA (CHE), and Appendix C includes the financial statements of Delfi Limited (SGP). We refer to these statements at various places throughout the text. (In addition, in the A Look at U.S. GAAP section at the end of each chapter, the U.S. company Apple Inc. is analyzed.) At this point, these financial statements probably strike you as complex and con- fusing. By the end of this course, you’ll be surprised at your ability to understand, analyze, and interpret them. 1 The appendix to this chapter describes job opportunities for accounting majors and explains why accounting is such a popular major.  lOMoARcPSD|5814602 1-4 CHA PT E R 1 Accounting in Action Illustration 1.1 summarizes the activities of the accounting process. ILLUSTRATION 1.1 The activities of the accounting process Communication Identification Recording CHIP CITY DEL Prepare accounting reports L............. Select economic events (transactions) Record, classify, and summarize Analyze and interpret for users You should understand that the accounting process includes the bookkeeping function. Bookkeeping usually involves only the recording of economic events. It is therefore just one part of the accounting process. In total, accounting involves the entire process of identifying, recording, and communicating economic events.2 Who Uses Accounting Data The financial information that users need depends upon the kinds of decisions they make. There are two broad groups of users of financial information: internal users and external users. Internal Users Internal users of accounting information are managers who plan, organize, and run the busi- ness. These include marketing managers, production supervisors, finance directors, and com- pany officers. In running a business, internal users must answer many important questions, as shown in Illustration 1.2. ILLUSTRATION 1.2 Questions that internal users ask Questions Asked by Internal Users ON ON STRIKE ONSTRIKE STRIKE SHARES COLA Snack chips Beverages Finance Marketing Human Resources Management Is cash sufficient to pay What price should Nokia charge Can Toyota afford Which PepsiCo product line is dividends to for a cell phone to maximize the to give its employees pay the most profitable? Should any SAP shareholders? company's net income? raises this year? product lines be eliminated? 2 The origins of accounting are generally attributed to the work of Luca Pacioli, an Italian Renaissance mathemati- cian. Pacioli was a close friend and tutor to Leonardo da Vinci and a contemporary of Christopher Columbus. In his 1494 text Summa de Arithmetica, Geometria, Proportione et Proportionalite, Pacioli described a system to ensure that financial information was recorded efficiently and accurately.  lOMoARcPSD|5814602 Accounting Activities and Users 1-5 To answer these and other questions, internal users need detailed information on a timely basis. Managerial accounting provides internal reports to help users make decisions about their companies. Examples are financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. External Users External users are individuals and organizations outside a company who want financial infor- mation about the company. The two most common types of external users are investors and creditors. Investors (owners) use accounting information to decide whether to buy, hold, or sell ownership shares of a company. Creditors (such as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money. Illustration 1.3 shows some questions that investors and creditors may ask. ILLUSTRATION 1.3 Questions that external users ask Questions Asked by External Users Yeah! What do we do if they catch us? BILL COLLECTOR Investors Investors Creditors Is Lenovo earning How does Disney compare in size Will Singapore Airlines be able satisfactory income? and profitability with Time Warner? to pay its debts as they come due? Financial accounting answers these questions. It provides economic and financial in- formation for investors, creditors, and other external users. The information needs of external users vary considerably. Taxing authorities, such as the State Administration of Taxation in the People’s Republic of China (CHN), want to know whether the company complies with tax laws. Regulatory agencies, such as the Financial Services Authority of Indonesia (IDN), want to know whether the company is operating within prescribed rules. Customers are interested in whether a company like Tesla Motors, Inc. (USA) will continue to honor product warranties and support its product lines. Labor unions, such as the Indian National Trade Union Congress (IND), want to know whether companies have the ability to pay increased wages and benefits to union members. The DO IT! exercises ask you to put newly acquired knowledge to work. They outline the Action Plan necessary to complete the exercise, and they show a Solution. DO IT! 1 Basic Concepts ACTION PLAN Review the basic concepts Indicate whether each of the five statements presented below is true or false. If false, indicate discussed. how to correct the statement. Develop an understanding 1. The three steps in the accounting process are identification, recording, and communication. of the key terms used. 2. Bookkeeping encompasses all steps in the accounting process. 3. Accountants prepare, but do not interpret, financial reports. 4. The two most common types of external users are investors and company officers. 5. Managerial accounting activities focus on reports for internal users. Solution 1. True 2. False. Bookkeeping involves only the recording step. 3. False. Accountants analyze and interpret information in reports as part of the communication step. 4. False. The two most common types of external users are investors and creditors. 5. True. Related exercise material: DO IT! 1.1, E1.1, and E1.2.  lOMoARcPSD|5814602 1-2 C HA PTE R 1 Accounting in Action company’s financial results. Employers need managers in all financial reporting by providing numerous references, ques- areas of the company to be “financially literate.” tions, and exercises that encourage you to explore these finan- Taking this course will go a long way to making you cial statements. In addition, we encourage you to visit each financially literate. In this text, you will learn how to read and company’s website where you can view its complete annual prepare financial statements, and how to use basic tools to report. In examining the financial reports of these three compa- evaluate financial results. nies, you will see that the accounting practices of companies in Appendices A, B, and C of this text provide real finan- specific countries that follow IFRS sometimes differ with regard cial statements of three companies from different countries to particular details. However, more importantly, you will find that report using International Financial Reporting Standards that the basic accounting principles are the same. As a result, (IFRS): Taiwan Semiconductor Manufacturing Company by learning these basic principles as presented in this text, you (TSMC) Ltd. (TWN), Nestlé SA (CHE), and Delfi Limited will be well equipped to begin understanding the financial (SGP). Throughout this text, we increase your familiarity with results of companies around the world. The Chapter Outline presents the chapter’s topics and subtopics, as well as practice opportunities. Chapter Outline LEARNING OBJECTIVES LO 1 Identify the activities and Three activities DO IT! 1 Basic Concepts users associated with accounting. Who uses accounting data LO 2 Explain the building blocks of Ethics in financial reporting DO IT! 2 Building Blocks of accounting: ethics, principles, and Accounting standards Accounting assumptions. Measurement principles Assumptions LO 3 State the accounting Assets DO IT! 3 Equity Effects equation, and define its Liabilities components. Equity LO 4 Analyze the effects of Accounting transactions DO IT! 4 Tabular Analysis business transactions on the Transaction analysis accounting equation. Summary of transactions LO 5 Describe the five financial Income statement DO IT! 5 Financial Statement statements and how they are Retained earnings statement Items prepared. Statement of financial position Statement of cash flows Comprehensive income statement Go to the Review and Practice section at the end of the chapter for a review of key concepts and practice applications with solutions.  lOMoARcPSD|5814602 1-6 C HA PTE R 1 Accounting in Action The Building Blocks of Accounting LEARNING OBJECTIVE 2 Explain the building blocks of accounting: ethics, principles, and assumptions. A doctor follows certain protocols in treating a patient’s illness. An architect follows certain structural guidelines in designing a building. Similarly, an accountant follows certain stan- dards in reporting financial information. These standards are based on specific principles and assumptions. For these standards to work, however, a fundamental business concept must be present—ethical behavior. Ethics in Financial Reporting People won’t gamble in a casino if they think it is “rigged.” Similarly, people won’t invest in the securities market if they think share prices are rigged. In recent years, the financial press has been full of articles about financial scandals at Satyam Computer Services (IND), Toshiba (JPN), Pou Sheng International (HKG), Siwei (CHN), and other companies. As the scandals came to light, mistrust of financial reporting in general grew. One article in the financial press noted that “repeated disclosures about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent share prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting. The standards of conduct by which actions are judged as right or wrong, honest or dishon- est, fair or not fair, are ethics. Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations in business and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this text: 1. A number of the Feature Stories and other parts of the text discuss the central importance of ethical behavior to financial reporting. 2. Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in actual business settings. 3. Many of the People, Planet, and Profit Insight boxes focus on ethical issues that companies face in measuring and reporting social and environmental issues. 4. At the end of the chapter, an Ethics Case simulates a business situation and asks you to put yourself in the position of a decision-maker in that case. When analyzing these various ethics cases, as well as experiences in your own life, it is useful to apply the three steps outlined in Illustration 1.4. ILLUSTRATION 1.4 Steps in analyzing ethics cases and situations 1. Recognize an ethical 2. Identify and analyze 3. Identify the alternatives, situation and the ethical the principal elements and weigh the impact of issues involved. in the situation. each alternative on various Use your personal ethics to Identify the stakeholders— stakeholders. identify ethical situations and persons or groups who may Select the most ethical issues. Some businesses and be harmed or benefited. Ask alternative, considering all the #1 #2 professional organizations the question: What are the consequences. Sometimes there ALT ALT provide written codes of responsibilities and obligations will be one right answer. Other ethics for guidance in some of the parties involved? situations involve more than business situations. one right solution; these situations require an evaluation of each and a selection of the best alternative.  lOMoARcPSD|5814602 The Building Blocks of Accounting 1-7 Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and company social responsibility. Guideline answers to the critical thinking questions and additional questions are available at the book’s companion website. Ethics Insight Dewey & LeBoeuf LLP I Felt the Pressure— “I intentionally gave the auditors incorrect information in the Would You? course of the audit.” “I felt the pressure.” That’s what some What happened here is that a small group of lower- of the employees of the now-defunct law level employees over a period of years carried out the instruc- firm of Dewey & LeBoeuf LLP indicated tions of their bosses. Their bosses, however, seemed to have no when they helped to overstate revenue and concern as evidenced by various e-mails with one another in use accounting tricks to hide losses and which they referred to their financial manipulations as account- cover up cash shortages. These employees ing tricks, cooking the books, and fake income. worked for the former finance director and Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged © Alliance/Shutterstock former chief financial officer (CFO) of the Fraud,” Wall Street Journal (March 28, 2014). firm. Here are some of their comments: “I was instructed by the CFO to create invoices, knowing they Why did these employees lie, and what do you believe should would not be sent to clients. When I created these invoices, I be their penalty for these lies? (Go to the book’s companion knew that it was inappropriate.” website for this answer and additional questions.) Accounting Standards In order to ensure high-quality financial reporting, accountants present financial statements in conformity with accounting standards that are issued by standard-setting bodies. Presently, there are two primary accounting standard-setting bodies—the International Accounting Stan- dards Board (IASB) and the Financial Accounting Standards Board (FASB). More than 130 countries follow standards referred to as International Financial Reporting Standards (IFRS). IFRSs are determined by the IASB. The IASB is headquartered in London, with its 15 board members drawn from around the world. Most companies in the United States follow standards issued by the FASB, referred to as generally accepted accounting principles (GAAP). As markets become more global, it is often desirable to compare the results of companies from different countries that report using different accounting standards. In order to increase comparability, in recent years the two standard-setting bodies made efforts to reduce the dif- ferences between IFRS and U.S. GAAP. This process is referred to as convergence. Because convergence is such an important issue, we provide at the end of each chapter a section called A Look at U.S. GAAP, to provide a comparison with IFRS. Global Insight The Korean Discount change was motivated by a desire to “make the country’s busi- nesses more transparent” in order to build investor confidence and If you think that accounting standards spur economic growth. Many other Asian countries, including don’t matter, consider these events in China, India, Japan, and Hong Kong, have also decided either to South Korea. For many years, interna- adopt international standards or to create standards that are based Toru-Hanai-Pool/ tional investors complained that the finan- Getty Images, Inc. on the international standards. cial reports of South Korean companies were inadequate and inaccurate. Account- ing practices there often resulted in huge differences between Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal stated revenues and actual revenues. Because investors did not (March 16, 2007). have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in What is meant by the phrase “make the country’s businesses share price was often referred to as the “Korean discount.” more transparent”? Why would increasing transparency spur In response, Korean regulators decided that companies would economic growth? (Go to the book’s companion website for have to comply with international accounting standards. This this answer and additional questions.)  lOMoARcPSD|5814602 1-8 C HA PTE R 1 Accounting in Action Measurement Principles HELPFUL HINT IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between Relevance and faithful rep- relevance and faithful representation (see Helpful Hint). Relevance means that financial resentation are two primary qualities that make account- information is capable of making a difference in a decision. Faithful representation means ing information useful for that the numbers and descriptions match what really existed or happened—they are factual. decision-making. Historical Cost Principle The historical cost principle (or cost principle) dictates that companies record assets at their Helpful Hints further clarify cost. This is true not only at the time the asset is purchased, but also over the time the asset is concepts being discussed. held. For example, if Great Wall Manufacturing purchases land for ¥300,000 (amounts in thou- sands), the company initially reports it in its accounting records at ¥300,000. But what does Great Wall do if, by the end of the next year, the fair value of the land has increased to ¥400,000? Under the historical cost principle, it continues to report the land at ¥300,000. Fair Value Principle The fair value principle states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market value information is usually readily available for these types of assets. In determining which measurement principle to use, companies weigh the factual nature of cost figures versus the relevance of fair value. In general, even though IFRS allows companies to revalue property, plant, and equipment and other long-lived assets to fair value, most companies choose to use cost. Only in situations where assets are actively traded, such as investment securities, do companies apply the fair value principle extensively. Assumptions Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary unit assumption and the economic entity assumption. Monetary Unit Assumption The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in money terms. This assumption enables account- ing to quantify (measure) economic events. The monetary unit assumption is vital to applying the historical cost principle. This assumption prevents the inclusion of some relevant information in the accounting records. For example, the health of a company’s owner, the quality of service, and the morale of employees are not included. The reason: Companies cannot quantify this information in money terms. Though this information is important, companies record only events that can be measured in money. Throughout this text, we use a variety of currencies in our examples and end-of-chapter materials, such as the following. Australia, dollar $ Russia, ruble P Brazil, real R$ South Africa, rand R China, yuan renminbi ¥ South Korea, won W Europe, euro € Switzerland, Swiss franc CHF Hong Kong, dollar HK$ Taiwan, new dollar NT$ India, rupee Turkey, lira Indonesia, rupia Rp United Kingdom, pound £ Japan, yen ¥ United States, dollar $ Economic Entity Assumption An economic entity can be any organization or unit in society. It may be a company (such as Maruti Suzuki (IND)), a governmental unit (the Indonesian province of Papua), a munici- pality (Beijing), or a temple (the Temple of the Six Banyan Trees). The economic entity  lOMoARcPSD|5814602 The Building Blocks of Accounting 1-9 assumption requires that the activities of the entity be kept separate and distinct from the ETHICS NOTE activities of its owner and all other economic entities. To illustrate, Barb Su, owner of Barb’s The importance of the eco- Bike Shop, must keep her personal living costs separate from the expenses of the business. nomic entity assumption is Similarly, Maxway Cycles Co. (TWN) and Asia Bicycle Trading Company (TWN) are seg- illustrated by scandals in- regated into separate economic entities for accounting purposes (see Ethics Note). volving Adelphia (USA). In Proprietorship. A business owned by one person is generally a proprietorship. The this case, senior company owner is often the manager/operator of the business. Small service-type businesses (plumbing employees entered into trans- actions that blurred the line companies, beauty salons, and auto repair shops), farms, and small retail stores (antique shops, between the employees’ finan- clothing stores, and used-book stores) are often proprietorships. Usually, only a relatively cial interests and those of the small amount of money (capital) is necessary to start in business as a proprietorship. The company. For example, Adel- owner (proprietor) receives any profits, suffers any losses, and is personally liable for all phia guaranteed over debts of the business. There is no legal distinction between the business as an economic unit $2 billion of loans to the and the owner, but the accounting records of the business activities are kept separate from the founding family. personal records and activities of the owner. Ethics Notes help sensitize you Partnership. A business owned by two or more persons associated as partners is a part- to some of the ethical issues in nership. In most respects a partnership is like a proprietorship except that more than one accounting. owner is involved. Typically, a partnership agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner. Each partner generally has unlimited personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes the partnership transactions must be kept separate from the personal activities of the partners. Partnerships are often used to organize retail and service-type businesses, including professional practices (lawyers, doctors, architects, and accountants). Corporation. A business organized as a separate legal entity under jurisdiction corpora- tion law and having ownership divided into transferable shares is a corporation. The holders of the shares (shareholders) enjoy limited liability; that is, they are not personally liable for the debts of the corporate entity. Shareholders may transfer all or part of their ownership shares to other investors at any time (i.e., sell their shares). The ease with which ownership can change adds to the attractiveness of investing in a corporation. Because ownership can be transferred without dissolving the corporation, the corporation enjoys an unlimited life. Although the combined number of proprietorships and partnerships in the world significantly exceeds the number of corporations, the revenue produced by corporations is much greater. Most of the largest companies in the world—for example, ING (NLD), Royal Dutch Shell (GBR and NLD), Apple Inc. (USA), Fortis (BEL), and Toyota (JPN)—are corporations. Accounting Across the Organization Spinning the Career Wheel Marketing people must be sensitive to costs and benefits, which accounting helps them quantify and understand. One question that students frequently ask is, “How will the study of account- Finance: Do you want to be a banker for Shanghai Commer- ing help me?” A working knowledge of cial and Savings Bank (TWN) or a financial analyst for ICBC accounting is desirable for virtually every (CHN)? These fields rely heavily on accounting. In all of them, field of endeavor. Some examples of how you will regularly examine and analyze financial statements. In accounting is used in other careers include fact, it is difficult to get a good finance job without two or three the following. courses in accounting. © Josef Volavka/ General management: Imagine running Real estate: Are you interested in being a real estate broker for iStockphoto Volkswagen (DEU), Saudi Telecom Hong Kong Property Services (HKG)? Because a third party— (SAU), a Subway (USA) franchise, or a Fuji (JPN) bike shop. All the bank—is almost always involved in financing a real estate general managers need to understand where the company’s cash transaction, brokers must understand the numbers involved: Can comes from and where it goes in order to make wise business the buyer afford to make the payments to the bank? Does the cash decisions.