Fundamentals of Financial Accounting

815 Pages·2007·44.101 MB·English

by  Fred Phillips, Robert Libby, Patricia A. Libby

Fundamentals of
FINANCIAL ACCOUNTING
Second Edition
FRED PHILLIPS
University of Saskatchewan
ROBERT LIBBY
Cornell University
PATRICIA A. LIBBY
Ithaca College
Boston Burr Ridge, IL Dubuque, IA Madison, WI New York
San Francisco St. Louis Bangkok Bogotá Caracas Kuala Lumpur
Lisbon London Madrid Mexico City Milan Montreal New Delhi
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FUNDAMENTALS OF FINANCIAL ACCOUNTING
Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the
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This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 0 DOW/DOW 0 9 8 7
ISBN 978-0-07-313648-6
MHID 0-07-313648-4
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Library of Congress Cataloging-in-Publication Data
Phillips, Fred.
Fundamentals of financial accounting / Fred Phillips, Robert Libby,
Patricia A. Libby.—2nd ed.
p. cm.
Includes index.
ISBN-13: 978-0-07-313648-6 (alk. paper)
ISBN-10: 0-07-313648-4 (alk. paper)
1. Accounting. I. Libby, Robert. II. Libby, Patricia A. III. Title.
HF5636.P545 2008
657—dc22
2007026479
www.mhhe.com
I dedicate this book to the best teachers I’ve ever had: my Mom
and Dad, Barb, Harrison, and Daniel
FRED PHILLIPS
Jenni, John, and Emma Rose Drago, Herman and Doris
Hargenrater, Laura Libby, Oscar and Selma Libby
PATRICIA AND ROBERT LIBBY
A Letter to Instructors
Dear Colleagues,
As we finish the second edition of Fundamentals of Financial Accounting, we
want to thank each of you who adopted the first edition. As fellow financial
accounting instructors, we appreciate the importance of selecting the right
book for your students; a book that will give them an engaging, relevant,
and understandable introduction to the world of accounting. We set out to
write a book that students could understand—a book that would carefully
walk them through the fundamentals of financial accounting—and we are
pleased that so many of you found that it accomplished this goal and met
your needs.
The first edition was highly praised for its lively writing style geared directly
to the student, as well as study tools throughout each chapter to carefully
guide students through all of the important details of financial accounting.
You will find that these strengths remain in the second edition and are en-
hanced and refined by the insightful suggestions and observations of so
many thoughtful colleagues, like you.
In the development of the second edition, we received feedback from over
200 financial accounting instructors. Over 132 financial accounting col-
leagues provided us guidance through text reviews and surveys, and an ad-
ditional 79 participated in focus groups and events around the country.
We thank all of you who participated in this process for generously sharing
your time, as well as your excellent and astute suggestions.
It is our continuing commitment to provide a financial accounting textbook
that is both the best possible learning tool for introductory students and the
best teaching tool for instructors. We promise to continue to be diligent in
our writing, development, and preparation of the textbook and ancillary ma-
terials, so that you can count on a total teaching package that is as reliable
and accurate, as it is engaging and readable. We also promise to continue to
listen to you, our colleagues, every step along the way.
Sincerely,
CHAPTER 1 The Role of Accounting in Business v
About the Authors
Fred Phillips
Fred Phillips is a professor and the George C. Baxter Chartered Accountants of Saskatchewan
Scholar at the University of Saskatchewan, where he teaches introductory financial account-
ing. He also has taught introductory accounting at the University of Texas at Austin and the
University of Manitoba. Fred has an undergraduate accounting degree, a professional ac-
counting designation, and a PhD from the University of Texas at Austin. He previously worked
as an audit manager at KPMG.
Fred’s main interest is accounting education. He has won 11 teaching awards, including three
national case-writing competitions. Recently, Fred won the 2007 Alpha Kappa Psi Outstand-
ing Professor award at The University of Texas at Austin, and in 2006, he was awarded the
title Master Teacher at the University of Saskatchewan. He has published instructional cases
and numerous articles in journals such as Issues in Accounting Education, Journal of Ac-
counting Research, and Organizational Behavior and Human Decision Processes. He received
the American Accounting Association’s Outstanding Research in Accounting Education Award
in 2006 and 2007 for one of his articles. Fred is a past associate editor of Issues in Account-
ing Education, and a current member of the Teaching & Curriculum and Two-Year College
sections of the American Accounting Association. In his spare time, he likes to work out, play
video games, and drink iced cappuccinos.
Robert Libby * This award, which has been
Robert Libby is the David A. Thomas Professor of Accounting at Cornell awarded only five times in the
University, where he teaches the introductory financial accounting course. Association’s 90-year history,
He previously taught at the University of Illinois, Pennsylvania State Uni- was given “in recognition of
versity, the University of Texas at Austin, the University of Chicago, and the visionary stewardship of the pub-
University of Michigan. He received his BS from Pennsylvania State Univer- lications collection of the AAA.”
sity and his MAS and PhD from the University of Illinois; he also is a CPA. Professor Libby is the only per-
son to have received all three of
Bob is a widely published author specializing in behavioral accounting. He was selected as
the association’s highest awards
the AAA Outstanding Educator in 2000 and received the AAA Outstanding Service Award
for research, teaching and ser-
in 2006.* His prior text, Accounting and Human Information Processing (Prentice Hall, 1981),
vice. He was the AAA Outstand-
was awarded the AICPA/AAA Notable Contributions to the Accounting Literature Award. He
ing Accounting Educator in 2000
received this award again in 1996 for a paper. He has published numerous articles in The Ac-
and received the AAA Notable
counting Review, Journal of Accounting Research, Accounting, Organizations, and Society;
Contributions to the Literature
and other accounting journals. He has held a variety of offices in the American Accounting
Award in 1985 and 1996.
Association and is a member of the American Institute of CPAs and the editorial boards of
The Accounting Review, Accounting, Organizations, and Society, Journal of Accounting Litera-
ture; and Journal of Behavioral Decision Making.
Patricia A. Libby
Patricia Libby is associate professor of accounting and coordinator of the financial accounting
course at Ithaca College, as well as faculty advisor to Beta Alpha Psi, Ithaca College Account-
ing Association, and Ithaca College National Association of Black Accountants. She previously
taught graduate and undergraduate financial accounting at Eastern Michigan University and
the University of Texas at Austin. Before entering academe, she was an auditor with Price
Waterhouse (now PricewaterhouseCoopers) and a financial administrator at the University
of Chicago. She received her BS from Pennsylvania State University, her MBA from DePaul
University, and her PhD from the University of Michigan; she also is a CPA.
Pat conducts research on using cases in the introductory course and other parts of the ac-
counting curriculum. She has published articles in The Accounting Review, Issues in Account-
ing Education, and The Michigan CPA. She has also conducted seminars nationwide on active
learning strategies, including cooperative learning methods.
Financial Accounting
Instructors tell us that the number one challenge in teaching
financial accounting is helping students to understand the vital role
financial accounting plays in business today. They want to know
how financial accounting is used by decision makers and why it is
important for them to understand accounting concepts. Students
become motivated to learn financial accounting concepts that
are explained in the context of what real-world companies are
doing. That’s where Fundamentals of Financial Accounting comes
in. This text motivates and engages your students by combining
the real-world focus company approach, pioneered by Robert and
Patricia Libby in their market-leading Financial Accounting text,
with an engaging writing style and student-friendly pedagogy.
The key to the success of Fundamentals of Financial Accounting
is its clear, concise, and conversational language. Students will
understand the important business activities and how to prepare
and interpret financial information in an accurate and relevant
way because it is explained to them in a unique and engaging
manner.
vi
from the Ground Up
Fundamentals of Financial Accounting clearly presents the The authors avoid the use
of complicated words when
fundamentals of financial accounting like no other text can.
explaining complex topics. I
Simply put, Phillips/Libby/Libby is the most student-friendly
think this is the real strength
financial book on the market. Flip to any page and you will in the readability of the text
~ Martha Lou Fowler, Missouri
see examples of Phillips’ innovative student-centered ap-
Western State University
proach using three of the most compelling tools:
The authors of FFA do not
presume all students have a
• ENGAGING WRITING. While maintaining its rigor, lot of experience in business...
this is really good ~ Linda
Fundamentals of Financial Accounting uses a mix of con-
Bressler, University of Houston-
versational wording, humor, and everyday examples to Downtown
introduce students to the world of financial accounting. This
The authors use a very friendly
is done without sacrificing any of the content important to
tone to help students to
grasping financial accounting. understand important concepts
~ Bea Bih-Horng Chiang, The
College of New Jersey
• S TUDENT-RELEVANT FOCUS COMPANIES. This successful
approach was pioneered by coauthors Robert Libby and
Patricia Libby. Each chapter of Fundamentals of Financial
Accounting makes financial accounting come alive by us-
ing a real company whose products and services are
popular with students to illustrate fundamental account-
ing concepts. These companies include Skechers (shoes),
Activision (video games), and Oakley (sunglasses). (See
page viii for more on the focus companies.)
• LEARNING THROUGH REINFORCEMENT. Fundamentals
of Financial Accounting introduces students to several
tools that help reinforce the concepts in the text. Coach
Tips and You Should Know are innovative and student-
friendly pedagogical features appearing in the margins to
reinforce concepts in the text as well as provide helpful
insight.
vii
How does Fundamentals of Financial Accounting
give students a window on the real world of business?
The key idea behind FFA’s focus company approach is know-
You effectively mention many ing that the best way for students to learn to prepare and
of the companies used in use financial statements is to study accounting in real busi-
previous chapters. I think ness contexts. Each chapter’s material is integrated around a
this type of carry forward of
real company, its decisions, and its financial statements.
info is good. I also think that
the choice of a real-world We have carefully chosen focus companies that students will
amusement park is good… ~ recognize. We further heighten student engagement by in-
Laurie Larson Gardner, Valencia jecting our discussions with issues and questions that actu-
Community College ally matter in the real world.
• How can a slight improvement in gross profit percentage
I like that you used the
concept of Cedar Fair and translate into over half a billion dollars of profit for Wal-
its amusement park rides Mart?
as an example of buying and
• What decisions does Cedar Fair make when investing in and
constructing fixed assets. I
reporting its roller coasters and other long-lived assets?
especially liked the illustration
showing the construction • How does Nautilus Group monitor and manage its fluctuat-
specs for Top Thrill Dragster. ing cash flows during the pre- and post-holiday seasons?
I also enjoyed the example
of impairment loss. Overall, Companies and issues like these are discussed throughout
a nice job ~ David Juriga, this book.
St. Louis Community College
9
Reporting and Interpreting
Long-Lived Tangible and
Intangible Assets

YOUR LEARNING OBJECTIVES I f you’re an average American, you gobble about three pounds of peanut butter per year,
which equals 1,500 peanut butter sandwiches eaten before your high school graduation. 1
Understand the business That makes you an expert at knowing how much peanut butter to spread on sandwiches.
LO1 Defi ne, classify, and explain the nature of long-lived assets. It also prepares you for learning how to report depreciation on long-lived assets. Really.
Reporting depreciation is a lot like spreading peanut butter on sandwiches. The amount of
Study the accounting methods peanut butter to spread on each sandwich is just like the amount of depreciation to spread
LO2 Apply the cost principle to the acquisition of long-lived assets. owvitehr iena tchhe ajacrc o(ourn tthineg c opsetr iyoodu. bIte dgeinp ewnitdhs ino nt hteh raecec ofaucntto),r (s2: )( 1t)h teh aem aomuonut nyto uth naete ydo tuo bleeagvine
LO3 Apply various depreciation methods as future economic benefi ts in the jar (or account), and (3) the number of sandwiches (or accounting periods) that
are used up over time. you’ll be spreading it over. Just like peanut butter on a sandwich, there’ll be a little
LO4 Explain the effect of asset impairment on the fi nancial depreciation if it’s spread over many years or lots if it’s spread over fewer years.
statements. For the rest of this chapter, we’re going to focus on the amusement park business at
LO5 Analyze the disposal of long-lived tangible assets. Cedar Fair . We’re not leaving peanuts completely behind, because just as Mickey is Disney’s
THAT WAS LO6 Ainntaanlygzieb lteh aes asceqtsu.i sition, use, and disposal of long-lived pmgaaarnskgcs o farto namdn d st ihBxe uw gPasEt BAeruNpnUanrTykS sg® it vcheorsom cuihgca hsrotaurcittp e tarh reteo U f Seniaxitt eFudlrae Sgdst a ,a tSte nCsoe, odCpaeyrd aaFnar diFr .at Whire iti swh hosoneleve e oCnfh atahmrelui esb eBigmrgoeewnsntt N THOISW IS
THEN and best amusement park businesses in the world. 2 As of December 31, 2005, its rides,
Evaluate the results hotels, and other long-lived assets accounted for over 96 percent of its total assets, so it’s
LO7 Interpret the fi xed asset turnover ratio. the perfect setting for you to learn how these assets are reported and the analyses you This chapter focuses on
Iyssneao rlutevh lieoec faep rsgan osteootd d fc esauw baso tncoudhmt a tephrtese. r s, Review L Oth8e chDaespctreibre factors to consider when comparing across companies. c 1 a Rnet crioevneddu Scetp tteom dbeetr e8r, m20in06e, hfroomw wwwewll. ptehaenyu’trbeu tmtear.ncoamge/fdun. facts.asp . tchoem aapnsasdne siteessl lt thgoao s tpoe redrovnsdi acaubenclsdee.
2 “Cedar Fair, L.P.’s Flagship Park, Cedar Point, again Voted Best Amusement Park in the World,” company
press release, August 28, 2006.
LP9
viii
How does Fundamentals of Financial Accounting
provide a foundation for comprehension?
Ethical Insights
Clear and careful
Fundamentals of Financial Accounting Ethical Insights
explanation of the
is loaded with innovative pedagogical More than a Paper Cut most detailed points.
The independent auditing fi rm of Arthur Andersen was convicted in 2002 of
features. From quick review tools to obstructing justice by shredding documents vital to the SEC’s investigation of the Coach’s tips are
Enron fraud. The judge sentenced the fi rm to pay a $500,000 fi ne and serve fi ve
thought provoking ethical dilemmas, years of probation. Upon appeal in 2005, the conviction was overturned for legal particularly effective
technicalities. By that time, it was too late for Arthur Andersen. All of its clients
had found other professional service providers, and all but 200 of its 28,000 employees in this regard
FFA‘s pedagogy continually reinforces had left to fi nd jobs elsewhere. In effect, the accounting fi rm had been given the
death penalty. ~ R. Eugene Bryson,
and expands on what the students are
University of Alabama
learning. envi Lroanumriee’ns ta adnvdic ees ttaob Mlisahu ari sctiroo nagn dsy tsote amll omf cahneacgkesr sa nisd t coo snttrriovles tion scidreea tthee a cno metphaicnayl. Huntsville
Do not put up with blatant acts of fraud, such as employees making up false expenses
for reimbursement, punching in a time card belonging to a fellow employee who will
be late for work, or copying someone’s ideas and claiming them as his or her own.
l b h ll h ldl l ll
EXHIBIT 5.11 Time-Series Analysis Chart
1600 Activision Results for
1400 2006 2005 Coach’s Tips
Ccimanphofapoankrrrsoemaipsscar ttCiteeaionttrOeinicms. yt(Ae sic-eiss eC e otCrhHfih eeas a’p qSctuecaar on Tlui1at)na lIyttthiisPnvaigest MillionsofU.S.Dollars11840620000000000 ECthvoaeatrc ynh ’esste uTddi.p eFsnF taA rn efee ejaudtssut reoennsc eot iuwprsaa,y ga FedmFvAiec nefut, laafi nnlldds
200
0 suggestions about how to learn the fun-
Total Total Stockholders’ Sales Net
Assets Liabilities Equity Revenues Income damentals of accounting.
You Should Know
To prepare a balance sheet for your S upercuts salon after recording transactions (a)–(g),
YOU SHOULD KNOW just take the ending balances from each T-account in Exhibit 2.9 and group them as assets,
Quick recaps reinforce the important terminology A classifi ed balance sheet is one liabilities, and stockholders’ equity in balance sheet format. If you do this, you should end up
that shows a subtotal for current with a balance sheet like the one presented way back in Exhibit 2.1. We realize that the odds
and concepts discussed in the text. aCsusreretsn ta nads sceutrsr ewniltl lbiaeb uilsiteide su.p or of you fl ipping all the way back to page 45 right now are slim, so we’ve taken this opportunity
converted into cash within 12 to show you a slightly different balance sheet format in Exhibit 2.10 called the classifi ed
months of the balance sheet date. balance sheet . A classifi ed balance sheet contains subcategories for assets and liabilities
Current liabilities are debts and labeled current . Current assets are assets your business will use up or turn into cash within 12
osebtlitgleadti,o nosr tfhualfti llewdil l wbiteh inpa i1d2, months of the balance sheet date. For example, your salon will spend the cash and use the
months of the balance sheet date. supplies during the next 12 months, so these assets are classifi ed as current. Current assets are
Noncurrent (or long-term) assets listed in order of how fast they will be used up or turned into cash. C urrent liabilities are
and liabilities are those that do debts and other obligations that will be paid or fulfi lled within 12 months of the balance
not meet the defi nition of current. sheet date. In our example, accounts payable is the only current liability. The other liability—
note payable—is expected to be paid in two years, so it is considered noncurrent.
Lik S ’ i d bl i khld ’ i
How’s It Going? Self-Study Quiz
HOW’S IT GOING? A Self-Study Quiz
This active learning feature helps students master
complex subjects by means of innovative review Analyze, record, and summarize the following June transaction: Florida Flippers
provided $3,000 of diving instruction in June to customers who will pay cash
boxes throughout each chapter. How’s It Going? in July.
boxes pose review questions at key points through-
out the chapter for students to test their knowledge 1. Analyze Assets ⴝ Liabilities ⴙ Stockholders’ Equity
of the material. The answer is printed on the same
page but positioned sideways so the student doesn’t
2. Record dr ( ) . . . . .
accidentally read it before answering the question. cr ( ). . .

ix
How can you get
your students to practice?
The end-of-chapter material is traditionally where students go from
reading to doing: answering review questions, solving problems, and
wrestling with issues that help them assimilate the material and apply
it in a realistic context. FFA doesn’t see reading as a passive process;
the end-of-chapter material offers a wealth of opportunities for stu-
dents to connect to the chapter material and for you to enliven your
class with a variety of assignments and discussion questions.
GROUP A PROBLEMS AHvoamileawbloer wk iMtha MnacgGerraw-Hill’s
PA1-1 Preparing an Income Statement, Statement of Retained Earnings, and LO2 Problems with (and without) the Coach’s Help
Balance Sheet
Assume that you are the president of High Power Corporation. At the end of the fi rst year of We know how important decision-making skills are for students
operations (December 31, 2008), the following fi nancial data for the company are available:
entering business and FFA recognizes this through an innova-
Cash $13,300
Accounts receivable 9,550
Supplies 5,000 tive approach to problem solving. Every chapter includes three
Equipment 86,000
ANcocteosu nptasy paabylea ble 321,0,16807 problem sets: Coached Problems, Group A Problems, and Group
Total sales revenue 91,000
OOptheerar teinxpge enxspeesn ses 588,,870500 B Problems.
Contributed capital, 5,000 shares outstanding 59,103
Dividends declared and paid during 2008 1,950
Required:
(Show your computations):
1. Prepare an income statement for the year 2008.
2. Prepare a statement of retained earnings for the year ended December 31, 2008.
3. Prepare a balance sheet at December 31, 2008.
PA1-2 Interpreting the Financial Statements LO3
Coached Problems
COACHED PROBLEMS
The Coached Problems go beyond the traditional check fi gures
CP8-1 Recording Accounts Receivable Transactions Using the Aging of LO2
Accounts Receivable Method A.T. Cross Company
The A.T. Cross Company is well known for its Cross pens. The company recently reported the to advise students on the process of solving a problem rather
following amounts in its unadjusted trial balance as of December 31, 2005:
than just its outcome. Students are given TIPs at each step of
Debits Credits
Accounts receivable $32,850,941 the problem-solving process.
Allowance for doubtful accounts $ 907,050
Sales 112,114,878
Required:
1. Assume Cross uses the aging of accounts receivable method and estimates that $1,007,000 of
accounts receivable will be uncollectible. Prepare the adjusting journal entry required at
December 31, 2005, for recording bad debt expense.
TIP: The aging of accounts receivable method focuses on calculating what the adjusted
Allowance for doubtful accounts balance should be. You need to consider the existing
balance when determining the adjustment.
2. Repeat requirement 1, except this time assume the unadjusted balance in Cross’s allowance
for doubtful accounts at December 31, 2005, was a debit balance of $10,050.
TIP: See page 346 for advice on how to handle debit balances.
3. If one of Cross’s main customers declared bankruptcy in 2006, what journal entry would be
used to write off its $10,000 balance?
CP8-2 (Supplement A) Recording Bad Debts Using the Percentage of LO2
Credit Sales Method
Complete requirement 1 of CP8-1, except assume Cross uses 1⁄4 of 1 percent of sales to estimate
its bad debt expense for the year.
TIP: The percentage of credit sales method directly calculates bad debt expense.
When students can solve the Coached Problems, they’ll be ready to
tackle the Group A or Group B problems, which echo the content with-
out the advice offered by the Coached Problems.
x