Accounting Principles:
A Business Perspective
First Global Text Edition, Volume 1
Financial Accounting
Roger H. Hermanson,PhD, CPA
Regents Professor Emeritus of Accounting
Ernst & Young-J. W. Holloway Memorial Professor Emeritus
Georgia State University
James Don Edwards PhD, D.H.C, CPA
J.M. Tull Professor Emeritus of Accounting
Terry College of Business
University of Georgia
Michael W. Maher PhD, CPA
Graduate School of Management
University of California at Davis
Special con to managerial chapters:
Kathleen M. Donelan-Knox
Department of Accountancy
University of Notre Dame
Funding for the First Global Text Edition was provided by the Endeavor Corporation, Houston, Texas, USA
The Global Text Project is funded by the Jacobs Foundation, Zurich, Switzerland
This book is licensed under a Creative Commons Attribution 3.0 License
, Acknowledgments for the Global Text First Edition:
Revision Editor: Donald J. McCubbrey, PhD
Clinical Professor, Daniels College of Business
University of Denver
Life member, American Institute of Certified Public Accountants
Revision Assistants
Emily Anderson
Kyle Block
Assistant Editor
Jackie Sharman
Associate Editor
Marisa Drexel
Conversion Specialist
Varun Sharma
, This book is licensed under a Creative Commons Attribution 3.0 License
Table of Contents
Accounting principles:A business perspective................................................................................................. 8
The accounting environment.......................................................................................................................... 18
Accounting defined......................................................................................................................................... 19
Financial accounting versus managerial accounting.....................................................................................23
Development of financial accounting standards............................................................................................ 25
Ethical behavior of accountants..................................................................................................................... 26
1. Accounting and its use in business decisions.......................................................................30
Forms of business organizations.................................................................................................................... 31
Types of activities performed by business organizations..............................................................................32
Financial statements of business organizations............................................................................................ 33
The financial accounting process................................................................................................................... 37
Analyzing and using the financial results—the equity ratio..........................................................................46
2. Recording business transactions...........................................................................................65
The account and rules of debit and credit...................................................................................................... 66
The accounting cycle....................................................................................................................................... 72
The journal...................................................................................................................................................... 73
The ledger........................................................................................................................................................ 76
The accounting process in operation.............................................................................................................. 76
3. Adjustments for financial reporting....................................................................................116
Cash versus accrual basis accounting............................................................................................................ 117
Classes and types of adjusting entries.......................................................................................................... 120
Adjustments for deferred items.................................................................................................................... 122
Adjustments for accrued items..................................................................................................................... 129
4. Completing the accounting cycle.........................................................................................150
The accounting cycle summarized................................................................................................................ 151
The work sheet............................................................................................................................................... 151
Preparing financial statements from the work sheet....................................................................................157
Journalizing adjusting entries...................................................................................................................... 158
The closing process....................................................................................................................................... 159
Accounting systems: From manual to computerized...................................................................................164
A classified balance sheet.............................................................................................................................. 169
Analyzing and using the financial results — the current ratio.....................................................................175
5. Accounting theory................................................................................................................198
Traditional accounting theory...................................................................................................................... 199
Other basic concepts..................................................................................................................................... 201
The measurement process in accounting..................................................................................................... 202
The major principles.................................................................................................................................... 203
Modifying conventions (or constraints)...................................................................................................... 209
The financial accounting standards board's conceptual framework project...............................................212
Objectives of financial reporting................................................................................................................... 212
Qualitative characteristics............................................................................................................................ 214
Recognition and measurement in financial statements...............................................................................218
6. Merchandising transactions................................................................................................236
Introduction to inventories and the classified income statement...............................................................236
Two income statements compared— Service company and merchandising company...............................237
Sales revenues............................................................................................................................................... 238
Cost of goods sold......................................................................................................................................... 244
Classified income statement......................................................................................................................... 252
Analyzing and using the financial results—Gross margin percentage........................................................256
7. Measuring and reporting inventories..................................................................................279
Accounting Principles: A Business Perspective 4 A Global Text
, Inventories and cost of goods sold............................................................................................................... 280
Determining inventory cost.......................................................................................................................... 282
Departures from cost basis of inventory measurement...............................................................................303
Analyzing and using financial results—inventory turnover ratio................................................................308
8. Control of cash.....................................................................................................................332
Internal control............................................................................................................................................. 333
Controlling cash............................................................................................................................................ 340
The bank checking account.......................................................................................................................... 343
Bank reconciliation....................................................................................................................................... 347
Petty cash funds............................................................................................................................................ 352
Analyzing and using the financial results—The quick ratio.........................................................................355
9. Receivables and payables.....................................................................................................371
Accounts receivable...................................................................................................................................... 372
Current liabilities.......................................................................................................................................... 381
Notes receivable and notes payable............................................................................................................. 387
Short-term financing through notes payable............................................................................................... 391
Analyzing and using the financial results—Accounts receivable turnover and number of days' sales in
accounts receivable............................................................................................................................................ 394
10. Property, plant, and equipment........................................................................................410
Nature of plant assets.................................................................................................................................... 411
Initial recording of plant assets.................................................................................................................... 412
Depreciation of plant assets.......................................................................................................................... 416
Subsequent expenditures (capital and revenue) on assets..........................................................................428
Subsidiary records used to control plant assets...........................................................................................431
Analyzing and using the financial results—Rate of return on operating assets..........................................433
11. Plant asset disposals, natural resources, and intangible assets........................................449
Disposal of plant assets................................................................................................................................ 450
Intangible assets............................................................................................................................................ 461
Analyzing and using the financial results—Total assets turnover...............................................................468
12. Stockholders' equity: Classes of capital stock...................................................................486
The corporation............................................................................................................................................ 487
Documents, books, and records relating to capital stock.............................................................................491
Par value and no-par capital stock............................................................................................................... 492
Other values commonly associated with capital stock................................................................................493
Capital stock authorized and outstanding...................................................................................................493
Classes of capital stock................................................................................................................................. 494
Types of preferred stock............................................................................................................................... 495
Balance sheet presentation of stock............................................................................................................. 497
Stock issuances for cash............................................................................................................................... 498
Capital stock issued for property or services............................................................................................... 500
Balance sheet presentation of paid-in capital in excess of par (or stated) value—Common or preferred. 500
Analyzing and using the financial results—Return on average common stockholders' equity..................503
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock............521
Paid-in (or contributed) capital.................................................................................................................... 522
Retained earnings......................................................................................................................................... 523
Paid-in capital and retained earnings on the balance sheet........................................................................523
Retained earnings appropriations................................................................................................................ 530
Statement of retained earnings.................................................................................................................... 532
Statement of stockholders' equity................................................................................................................ 532
Treasury stock............................................................................................................................................... 533
Net income inclusions and exclusions......................................................................................................... 536
Analyzing and using the financial results—Earnings per share and price-earnings ratio..........................540
5
A Business Perspective
First Global Text Edition, Volume 1
Financial Accounting
Roger H. Hermanson,PhD, CPA
Regents Professor Emeritus of Accounting
Ernst & Young-J. W. Holloway Memorial Professor Emeritus
Georgia State University
James Don Edwards PhD, D.H.C, CPA
J.M. Tull Professor Emeritus of Accounting
Terry College of Business
University of Georgia
Michael W. Maher PhD, CPA
Graduate School of Management
University of California at Davis
Special con to managerial chapters:
Kathleen M. Donelan-Knox
Department of Accountancy
University of Notre Dame
Funding for the First Global Text Edition was provided by the Endeavor Corporation, Houston, Texas, USA
The Global Text Project is funded by the Jacobs Foundation, Zurich, Switzerland
This book is licensed under a Creative Commons Attribution 3.0 License
, Acknowledgments for the Global Text First Edition:
Revision Editor: Donald J. McCubbrey, PhD
Clinical Professor, Daniels College of Business
University of Denver
Life member, American Institute of Certified Public Accountants
Revision Assistants
Emily Anderson
Kyle Block
Assistant Editor
Jackie Sharman
Associate Editor
Marisa Drexel
Conversion Specialist
Varun Sharma
, This book is licensed under a Creative Commons Attribution 3.0 License
Table of Contents
Accounting principles:A business perspective................................................................................................. 8
The accounting environment.......................................................................................................................... 18
Accounting defined......................................................................................................................................... 19
Financial accounting versus managerial accounting.....................................................................................23
Development of financial accounting standards............................................................................................ 25
Ethical behavior of accountants..................................................................................................................... 26
1. Accounting and its use in business decisions.......................................................................30
Forms of business organizations.................................................................................................................... 31
Types of activities performed by business organizations..............................................................................32
Financial statements of business organizations............................................................................................ 33
The financial accounting process................................................................................................................... 37
Analyzing and using the financial results—the equity ratio..........................................................................46
2. Recording business transactions...........................................................................................65
The account and rules of debit and credit...................................................................................................... 66
The accounting cycle....................................................................................................................................... 72
The journal...................................................................................................................................................... 73
The ledger........................................................................................................................................................ 76
The accounting process in operation.............................................................................................................. 76
3. Adjustments for financial reporting....................................................................................116
Cash versus accrual basis accounting............................................................................................................ 117
Classes and types of adjusting entries.......................................................................................................... 120
Adjustments for deferred items.................................................................................................................... 122
Adjustments for accrued items..................................................................................................................... 129
4. Completing the accounting cycle.........................................................................................150
The accounting cycle summarized................................................................................................................ 151
The work sheet............................................................................................................................................... 151
Preparing financial statements from the work sheet....................................................................................157
Journalizing adjusting entries...................................................................................................................... 158
The closing process....................................................................................................................................... 159
Accounting systems: From manual to computerized...................................................................................164
A classified balance sheet.............................................................................................................................. 169
Analyzing and using the financial results — the current ratio.....................................................................175
5. Accounting theory................................................................................................................198
Traditional accounting theory...................................................................................................................... 199
Other basic concepts..................................................................................................................................... 201
The measurement process in accounting..................................................................................................... 202
The major principles.................................................................................................................................... 203
Modifying conventions (or constraints)...................................................................................................... 209
The financial accounting standards board's conceptual framework project...............................................212
Objectives of financial reporting................................................................................................................... 212
Qualitative characteristics............................................................................................................................ 214
Recognition and measurement in financial statements...............................................................................218
6. Merchandising transactions................................................................................................236
Introduction to inventories and the classified income statement...............................................................236
Two income statements compared— Service company and merchandising company...............................237
Sales revenues............................................................................................................................................... 238
Cost of goods sold......................................................................................................................................... 244
Classified income statement......................................................................................................................... 252
Analyzing and using the financial results—Gross margin percentage........................................................256
7. Measuring and reporting inventories..................................................................................279
Accounting Principles: A Business Perspective 4 A Global Text
, Inventories and cost of goods sold............................................................................................................... 280
Determining inventory cost.......................................................................................................................... 282
Departures from cost basis of inventory measurement...............................................................................303
Analyzing and using financial results—inventory turnover ratio................................................................308
8. Control of cash.....................................................................................................................332
Internal control............................................................................................................................................. 333
Controlling cash............................................................................................................................................ 340
The bank checking account.......................................................................................................................... 343
Bank reconciliation....................................................................................................................................... 347
Petty cash funds............................................................................................................................................ 352
Analyzing and using the financial results—The quick ratio.........................................................................355
9. Receivables and payables.....................................................................................................371
Accounts receivable...................................................................................................................................... 372
Current liabilities.......................................................................................................................................... 381
Notes receivable and notes payable............................................................................................................. 387
Short-term financing through notes payable............................................................................................... 391
Analyzing and using the financial results—Accounts receivable turnover and number of days' sales in
accounts receivable............................................................................................................................................ 394
10. Property, plant, and equipment........................................................................................410
Nature of plant assets.................................................................................................................................... 411
Initial recording of plant assets.................................................................................................................... 412
Depreciation of plant assets.......................................................................................................................... 416
Subsequent expenditures (capital and revenue) on assets..........................................................................428
Subsidiary records used to control plant assets...........................................................................................431
Analyzing and using the financial results—Rate of return on operating assets..........................................433
11. Plant asset disposals, natural resources, and intangible assets........................................449
Disposal of plant assets................................................................................................................................ 450
Intangible assets............................................................................................................................................ 461
Analyzing and using the financial results—Total assets turnover...............................................................468
12. Stockholders' equity: Classes of capital stock...................................................................486
The corporation............................................................................................................................................ 487
Documents, books, and records relating to capital stock.............................................................................491
Par value and no-par capital stock............................................................................................................... 492
Other values commonly associated with capital stock................................................................................493
Capital stock authorized and outstanding...................................................................................................493
Classes of capital stock................................................................................................................................. 494
Types of preferred stock............................................................................................................................... 495
Balance sheet presentation of stock............................................................................................................. 497
Stock issuances for cash............................................................................................................................... 498
Capital stock issued for property or services............................................................................................... 500
Balance sheet presentation of paid-in capital in excess of par (or stated) value—Common or preferred. 500
Analyzing and using the financial results—Return on average common stockholders' equity..................503
13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock............521
Paid-in (or contributed) capital.................................................................................................................... 522
Retained earnings......................................................................................................................................... 523
Paid-in capital and retained earnings on the balance sheet........................................................................523
Retained earnings appropriations................................................................................................................ 530
Statement of retained earnings.................................................................................................................... 532
Statement of stockholders' equity................................................................................................................ 532
Treasury stock............................................................................................................................................... 533
Net income inclusions and exclusions......................................................................................................... 536
Analyzing and using the financial results—Earnings per share and price-earnings ratio..........................540
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