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Principles of
Accounting
Tenth Edition

Belverd E. Needles, Jr., Ph.D., C.P.A., C.M.A.

DePaul University

Marian Powers, Ph.D.

Northwestern University

Susan V. Crosson, M.S. Accounting, C.P.A.

Santa Fe Community College, Florida

Houghton Mifflin Company Boston New York

To Jennifer, Jeffrey, Annabelle, and Abigail
To my family—Bruce, Brent, and Courtney Crosson—and
in loving memory of my parents Helen and Bryce Van Valkenburgh

Executive Publisher: George Hoffman

Senior Sponsoring Editor: Ann West
Senior Marketing Manager: Mike Schenk
Marketing Coordinator: Erin Lane
Senior Development Editor: Chere Bemelmans
Editorial Assistant: Diane Akerman
Project Editor: Margaret M. Kearney
Art and Design Manager: Gary Crespo
Cover Design Manager: Anne S. Katzeff
Senior Photo Editor: Jennifer Meyer Dare
Composition Buyer: Chuck Dutton

Cover photo © Don Smetzer/Stone/Getty Images

CVS Annual Report reprinted with permission of CVS

Portions of Southwest Airlines Annual Report courtesy of Southwest Airlines

COMPANY LOGO CREDITS: p. 7, Reprinted with permission of CVS; p. 53, Logo provided
by The Boeing Company, Copyright 2006, All Rights Reserved; p. 104, ©2006 Yahoo! Inc.
Yahoo! and the Yahoo! logo are the trademarks of Yahoo! Inc.; p. 152, Reprinted with
permission of Best Buy; p. 293, Reprinted with permission of Costco Wholesale;
(Continued on p. 1312)

PHOTO CREDITS: p. 3, Getty Images; p. 9, AP Images; p. 17, © Jim West/The Image Works;
p. 26, © Frank Trapper/Corbis; p. 51, Boeing Image Licensing; p. 56, © Reuters/Corbis; p. 72,
Getty Images; p. 103, © Yahoo! Inc. Yahoo! and the Yahoo! logo are the trademarks of
Yahoo! Inc.; p. 111, AP Images; p. 118, © Norbert von der Groeben/The Image Works;
(Continued on page 1312)

Copyright © 2008 by Houghton Mifflin Company. All rights reserved.

No part of this work may be reproduced or transmitted in any form or by any means,
electronic or mechanical, including photocopying and recording, or by any information
storage or retrieval system without the prior written permission of Houghton Mifflin
Company unless such copying is expressly permitted by federal copyright law. Address
inquiries to College Permissions, Houghton Mifflin Company, 222 Berkeley Street, Boston,
MA 02116-3764.

Printed in the U.S.A.

Library of Congress Control Number: 2006936632

Instructor’s examination copy

ISBN-10: 0-618-83349-8
ISBN-13: 978-0-618-83349-8
For orders, use student text ISBNs
ISBN-10: 0-618-73661-1
ISBN-13: 978-0-618-73661-4

1 2 3 4 5 6 7 8 9-VH-11 10 09 08 07
Brief Contents

1 Uses of Accounting Information and the Financial Statements 2

2 Analyzing Business Transactions 50

3 Measuring Business Income 102

4 Completing the Accounting Cycle 148

5 Financial Reporting and Analysis 184

SUPPLEMENT TO CHAPTER 5 How to Read an Annual Report 235

6 The Operating Cycle and Merchandising Operations 290

7 Inventories 326

8 Cash and Receivables 368

9 Current Liabilities and the Time Value of Money 410

10 Internal Control 456

11 Long-Term Assets 490

12 Contributed Capital 540

13 Long-Term Liabilities 584

14 The Corporate Income Statement and the Statement of Stockholders’

Equity 638

15 The Statement of Cash Flows 684

16 Investments 732

17 Financial Performance Measurement 776

18 The Changing Business Environment: A Manager’s Perspective 826

19 Cost Concepts and Cost Allocation 876

20 Costing Systems: Job Order and Process Costing 934

21 Activity-Based Systems: ABM and JIT 986

22 Cost Behavior Analysis 1034

23 The Budgeting Process 1080

iii
iv
| Brief Contents

24 Performance Management and Evaluation 1136

25 Standard Costing and Variance Analysis 1182

26 Analysis for Decision Making 1232

APPENDIX A Future Value and Present Value Tables 1284

Contents

Preface xv
User’s Guide xxi
Check Figures xxix
About the Authors xxxii

CHAPTER 1 Uses of Accounting Information and the Financial Statements 2

쐽 DECISION POINT: A USER’S FOCUS CVS CORPORATION 3 Financial Position and the Accounting Equation 17
Accounting as an Information System 4 Assets 18
Business Goals, Activities, and Performance Measures Liabilities 18
5 Owner’s Equity 18
Financial and Management Accounting 7 Financial Statements 20
Processing Accounting Information 7 Income Statement 20
Ethical Financial Reporting 8 Statement of Owner’s Equity 20
Decision Makers: The Users of Accounting The Balance Sheet 21
Information 10 Statement of Cash Flows 21
Management 10 Relationships Among the Financial Statements 22
Users with a Direct Financial Interest 12 Generally Accepted Accounting Principles 24
Users with an Indirect Financial Interest 12 GAAP and the Independent CPA’s Report 25
Governmental and Not-for-Profit Organizations 13 Organizations That Influence GAAP 26
Accounting Measurement 13 Professional Ethics 27
Business Transactions 14 Corporate Governance 27
Money Measure 14 쐽 A LOOK BACK AT CVS CORPORATION 28
Separate Entity 15 CHAPTER REVIEW 30
The Forms of Business Organization 15 CHAPTER ASSIGNMENTS 35

CHAPTER 2 Analyzing Business Transactions 50

쐽 DECISION POINT: A USER’S FOCUS THE BOEING Economic Event That Is Not a Business Transaction 62
COMPANY 51 Prepayment of Expenses in Cash 62
Measurement Issues 52 Purchase of an Asset on Credit 62
Recognition 52 Purchase of an Asset Partly in Cash and Partly on Credit
Valuation 54 63
Classification 55 Payment of a Liability 63
Ethics and Measurement Issues 55 Revenue in Cash 64
Double-Entry System 56 Revenue on Credit 64
Accounts 57 Revenue Collected in Advance 65
The T Account 57 Collection on Account 65
The T Account Illustrated 58 Expense Paid in Cash 66
Rules of Double-Entry Accounting 58 Expense to Be Paid Later 66
Normal Balance 59 Withdrawals 67
Owner’s Equity Accounts 59 Summary of Transactions 67

Business Transaction Analysis 61 The Trial Balance 69

Owners’ Investment to Form the Business 61 Preparation and Use of a Trial Balance 69
v
vi
| Contents

Finding Trial Balance Errors 70 General Ledger 76

Cash Flows and the Timing of Transactions 71 Some Notes on Presentation 78
쐽 A LOOK BACK AT THE BOEING COMPANY 79
Recording and Posting Transactions 73
Chart of Accounts 75 CHAPTER REVIEW 80

General Journal 75 CHAPTER ASSIGNMENTS 84

CHAPTER 3 Measuring Business Income 102

쐽 DECISION POINT: A USER’S FOCUS YAHOO! INC. 103 Type 2 Adjustment: Recognizing Unrecorded, Incurred
Expenses (Accrued Expenses) 115
Profitability Measurement: Issues and Ethics 104
Type 3 Adjustment: Allocating Recorded, Unearned
Net Income 104
Revenues (Deferred Revenues) 116
Income Measurement Assumptions 104
Type 4 Adjustment: Recognizing Unrecorded, Earned
Ethics and the Matching Rule 106 Revenues (Accrued Revenues) 117
Accrual Accounting 108 A Note About Journal Entries 119
Recognizing Revenues 108 Using the Adjusted Trial Balance to Prepare
Recognizing Expenses 108 Financial Statements 121
Adjusting the Accounts 108 Cash Flows from Accrual-Based Information 123
Adjustments and Ethics 109 쐽 A LOOK BACK AT YAHOO! INC. 124
The Adjustment Process 110 CHAPTER REVIEW 126
Type 1 Adjustment: Allocating Recorded Costs (Deferred CHAPTER ASSIGNMENTS 132
Expenses) 111

CHAPTER 4 Completing the Accounting Cycle 148

쐽 DECISION POINT: A USER’S FOCUS BEST BUY ENTERPRISE The Accounts After Posting 156
SERVICES, INC. 149 The Post-Closing Trial Balance 156
From Transactions to Financial Statements 150 Reversing Entries: An Optional First Step 158
The Accounting Cycle 150 The Work Sheet: An Accountant’s Tool 160
Closing Entries 150 Preparing the Work Sheet 160
Preparing Closing Entries 152 Using the Work Sheet 164
Step 1: Closing the Credit Balances 154 쐽 A LOOK BACK AT BEST BUY ENTERPRISE SERVICES, INC.
Step 2: Closing the Debit Balances 155 165
Step 3: Closing the Income Summary Account Balance CHAPTER REVIEW 166
155 CHAPTER ASSIGNMENTS 168
Step 4: Closing the Withdrawals Account Balance 155

CHAPTER 5 Financial Reporting and Analysis 184

쐽 DECISION POINT: A USER’S FOCUS DELL COMPUTER Cost-Benefit 192
CORPORATION 185 Classified Balance Sheet 194
Foundations of Financial Reporting 186 Assets 194
Objectives of Financial Reporting 186 Liabilities 197
Qualitative Characteristics of Accounting Information Owner’s Equity 197
187
Dell’s Balance Sheets 198
Management’s Certification of the Financial Statements
188 Forms of the Income Statement 201
Multistep Income Statement 201
Accounting Conventions 189
Dell’s Income Statements 205
Comparability and Consistency 189
Single-Step Income Statement 205
Materiality 190
Conservatism 191 Using Classified Financial Statements 206
Full Disclosure 191 Evaluation of Liquidity 206
 Contents
| vii

Evaluation of Profitability 208 CHAPTER REVIEW 216

쐽 A LOOK BACK AT DELL COMPUTER CORPORATION 214 CHAPTER ASSIGNMENTS 220

SUPPLEMENT TO CHAPTER 5 How to Read an Annual Report 235

The Components of an Annual Report 235 Notes to the Financial Statements 242
Letter to the Stockholders 235 Reports of Management’s Responsibilities 242
Financial Highlights 236 Reports of Certified Public Accountants 243
Description of the Company 236 Annual Report of CVS Corporation 245
Management’s Discussion and Analysis 236 Financial Statements of Southwest Airlines Co.
Financial Statements 236 281

CHAPTER 6 The Operating Cycle and Merchandising Operations 290

쐽 DECISION POINT: A USER’S FOCUS COSTCO WHOLESALE Perpetual Inventory System 299
CORPORATION 291 Purchases of Merchandise 299
Managing Merchandising Businesses 292 Sales of Merchandise 300
Operating Cycle 292 Periodic Inventory System 303
Choice of Inventory System 293 Purchases of Merchandise 305
Foreign Business Transactions 295 Sales of Merchandise 306
Terms of Sale 296 쐽 A LOOK BACK AT COSTCO WHOLESALE CORPORATION
Sales and Purchases Discounts 296 308
Transportation Costs 297 CHAPTER REVIEW 309
Terms of Debit and Credit Card Sales 298 CHAPTER ASSIGNMENTS 312

CHAPTER 7 Inventories 326

쐽 DECISION POINT: A USER’S FOCUS CISCO SYSTEMS, INC. First-In, First-Out (FIFO) Method 339
327 Last-In, First-Out (LIFO) 340
Managing Inventories 328 Impact of Inventory Decisions 341
Inventory Decisions 328 Effects on the Financial Statements 342
Evaluating the Level of Inventory 329 Effects on Income Taxes 343
Effects of Inventory Misstatements on Income Effects on Cash Flows 344
Measurement 331
Inventory Cost Under the Perpetual Inventory
Inventory Cost and Valuation 334 System 345
Goods Flows and Cost Flows 335
Valuing Inventory by Estimation 347
Lower-of-Cost-or-Market (LCM) Rule 336
Retail Method 347
Disclosure of Inventory Methods 336
Gross Profit Method 348
Inventory Cost Under the Periodic Inventory 쐽 A LOOK BACK AT CISCO SYSTEMS, INC. 349
System 338
CHAPTER REVIEW 351
Specific Identification Method 338
CHAPTER ASSIGNMENTS 355
Average-Cost Method 339

CHAPTER 8 Cash and Receivables 368

쐽 DECISION POINT: A USER’S FOCUS NIKE, INC. 369 Financing Receivables 374
Management Issues Related to Cash and Ethics and Estimates in Accounting for Receivables 376
Receivables 370 Cash Equivalents and Cash Control 378
Cash Needs 370 Cash Equivalents 378
Accounts Receivable and Credit Policies 371 Cash Control Methods 378
Evaluating the Level of Accounts Receivable 373 Bank Reconciliations 379
viii
| Contents

Uncollectible Accounts 382 Interest and Interest Rate 392

The Allowance Method 382 Maturity Value 392
Disclosure of Uncollectible Accounts 383 Accrued Interest 392
Estimating Uncollectible Accounts Expense 383 Dishonored Note 393
Writing Off Uncollectible Accounts 388 쐽 A LOOK BACK AT NIKE, INC. 394
Notes Receivable 390 CHAPTER REVIEW 395
Maturity Date 390 CHAPTER ASSIGNMENTS 397
Duration of a Note 391

CHAPTER 9 Current Liabilities and the Time Value of Money 410

쐽 DECISION POINT: A USER’S FOCUS AMAZON.COM, INC. Future Value 429
411 Present Value 431
Management Issues Related to Current Liabilities Applications of the Time Value of Money 434
412 Valuing an Asset 434
Managing Liquidity and Cash Flows 412 Deferred Payment 435
Evaluating Accounts Payable 412 Investment of Idle Cash 436
Reporting Liabilities 414 Accumulation of a Fund for Loan Repayment 436
Common Types of Current Liabilities 416 Other Applications 437
Definitely Determinable Liabilities 416 쐽 A LOOK BACK AT AMAZON.COM, INC. 438
Estimated Liabilities 423 CHAPTER REVIEW 439
Contingent Liabilities and Commitments 427 CHAPTER ASSIGNMENTS 442
The Time Value of Money 428

CHAPTER 10 Internal Control 456

쐽 DECISION POINT: A USER’S FOCUS HOME DEPOT, INC. Internal Control over Merchandising Transactions
457 463
Management Issues Related to Internal Control Control of Cash 464
458 Control of Cash Receipts 465
The Need for Internal Controls 458 Control of Purchases and Cash Disbursements 466
Management’s Responsibility for Internal Control 459 Petty Cash Funds 471
Independent Accountant’s Audit of Internal Control 460 Establishing the Petty Cash Fund 471
Internal Control: Components, Activities, and Making Disbursements from the Petty Cash Fund 471
Limitations 461 Reimbursing the Petty Cash Fund 472
Components of Internal Control 461 쐽 A LOOK BACK AT HOME DEPOT, INC. 473
Control Activities 461 CHAPTER REVIEW 474
Limitations of Internal Control 463 CHAPTER ASSIGNMENTS 476

CHAPTER 11 Long-Term Assets 490

쐽 DECISION POINT: A USER’S FOCUS APPLE COMPUTER, Acquisition Cost of Property, Plant, and Equipment
INC. 491 497
Management Issues Related to Long-Term Assets General Approach to Acquisition Costs 498
492 Specific Applications 499
Acquiring Long-Term Assets 494 Depreciation 502
Financing Long-Term Assets 495 Factors in Computing Depreciation 503
Applying the Matching Rule 496 Methods of Computing Depreciation 503
 Contents
| ix

Special Issues in Depreciation 507 Development and Exploration Costs in the Oil and Gas
Industry 513
Disposal of Depreciable Assets 509
Discarded Plant Assets 509 Intangible Assets 514
Plant Assets Sold for Cash 510 Research and Development Costs 517
Exchanges of Plant Assets 511 Computer Software Costs 518
Goodwill 518
Natural Resources 511
쐽 A LOOK BACK AT APPLE COMPUTER, INC. 519
Depletion 512
CHAPTER REVIEW 521
Depreciation of Related Plant Assets 513
CHAPTER ASSIGNMENTS 525

CHAPTER 12 Contributed Capital 540

쐽 DECISION POINT: A USER’S FOCUS GOOGLE, INC. 541 Convertible Preferred Stock 556
Management Issues Related to Contributed Callable Preferred Stock 557
Capital 542 Issuance of Common Stock 558
The Corporate Organization 542 Par Value Stock 558
Advantages and Disadvantages of Incorporation 543 No-Par Stock 559
Equity Financing 544 Issuance of Stock for Noncash Assets 560
Dividend Policies 546 Accounting for Treasury Stock 561
Using Return on Equity to Measure Performance 548 Purchase of Treasury Stock 561
Stock Options as Compensation 549 Sale of Treasury Stock 562
Components of Stockholders’ Equity 550 Retirement of Treasury Stock 564
Preferred Stock 554 쐽 A LOOK BACK AT GOOGLE, INC. 565
Preference as to Dividends 554 CHAPTER REVIEW 566
Preference as to Assets 555 CHAPTER ASSIGNMENTS 570

CHAPTER 13 Long-Term Liabilities 584

쐽 DECISION POINT: A USER’S FOCUS MCDONALD’S Case 1: Market Rate Above Face Rate 601
CORPORATION 585 Case 2: Market Rate Below Face Rate 602
Management Issues Related to Issuing Long-Term Amortization of Bond Discounts and Premiums
Debt 586 603
Deciding to Issue Long-Term Debt 586 Amortizing a Bond Discount 603
Evaluating Long-Term Debt 587 Amortizing a Bond Premium 607
Types of Long-Term Debt 589
Retirement of Bonds 612
The Nature of Bonds 594 Calling Bonds 612
Bond Issue: Prices and Interest Rates 595 Converting Bonds 613
Characteristics of Bonds 596
Other Bonds Payable Issues 613
Accounting for the Issuance of Bonds 598 Sale of Bonds Between Interest Dates 613
Bonds Issued at Face Value 598 Year-End Accrual of Bond Interest Expense 615
Bonds Issued at a Discount 599 쐽 A LOOK BACK AT MCDONALD’S CORPORATION 616
Bonds Issued at a Premium 600 CHAPTER REVIEW 618
Bond Issue Costs 600 CHAPTER ASSIGNMENTS 622
Using Present Value to Value a Bond 601

CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity 638
쐽 DECISION POINT: A USER’S FOCUS MOTOROLA, INC. Performance Measurement: Quality of Earnings
639 Issues 640
x
| Contents

The Effect of Accounting Estimates and Methods 641 Diluted Earnings Per Share 653
Gains and Losses 643 Comprehensive Income and the Statement of
Write-downs and Restructurings 643 Stockholders’ Equity 654
Nonoperating Items 644 Comprehensive Income 654
Quality of Earnings and Cash Flows 644 The Statement of Stockholders’ Equity 654
Income Taxes 646 Retained Earnings 656
Deferred Income Taxes 647 Stock Dividends and Stock Splits 657
Net of Taxes 648 Stock Dividends 657
Nonoperating Items 650 Stock Splits 659
Discontinued Operations 650 Book Value 662
Extraordinary Items 650 쐽 A LOOK BACK AT MOTOROLA, INC. 663
Earnings per Share 651 CHAPTER REVIEW 664
Basic Earnings per Share 651 CHAPTER ASSIGNMENTS 668

CHAPTER 15 The Statement of Cash Flows 684

쐽 DECISION POINT: A USER’S FOCUS MARRIOTT Gains and Losses 697
INTERNATIONAL, INC. 685 Changes in Current Assets 698
Overview of the Statement of Cash Flows 686 Changes in Current Liabilities 698
Purposes of the Statement of Cash Flows 686 Schedule of Cash Flows from Operating Activities 699
Uses of the Statement of Cash Flows 686 Investing Activities 701
Classification of Cash Flows 687 Investments 701
Noncash Investing and Financing Transactions 688 Plant Assets 702
Format of the Statement of Cash Flows 688 Financing Activities 704
Ethical Considerations and the Statement of Cash Flows Bonds Payable 705
690
Common Stock 705
Analyzing Cash Flows 691
Retained Earnings 706
Cash-Generating Efficiency 691
Treasury Stock 707
Free Cash Flow 692
쐽 A LOOK BACK AT MARRIOTT INTERNATIONAL, INC. 709
Operating Activities 694 CHAPTER REVIEW 710
Depreciation 696 CHAPTER ASSIGNMENTS 714

CHAPTER 16 Investments 732

쐽 DECISION POINT: A USER’S FOCUS eBAY, INC. 733 Consolidated Financial Statements 746
Management Issues Related to Investments 734 Consolidated Balance Sheet 747
Recognition 734 Consolidated Income Statement 752
Valuation 734 Restatement of Foreign Subsidiary Financial Statements
753
Classification 734
Disclosure 736 Investments in Debt Securities 754
Ethics of Investing 736 Held-to-Maturity Securities 755
Long-Term Investments in Bonds 755
Short-Term Investments in Equity Securities 738
쐽 A LOOK BACK AT EBAY, INC. 756
Trading Securities 738
CHAPTER REVIEW 758
Available-for-Sale Securities 741
CHAPTER ASSIGNMENTS 761
Long-Term Investments in Equity Securities 741
Noninfluential and Noncontrolling Investment 741
Influential but Noncontrolling Investment 744
 Contents
| xi

CHAPTER 17 Financial Performance Measurement 776

쐽 DECISION POINT: A USER’S FOCUS STARBUCKS Trend Analysis 789
CORPORATION 777 Vertical Analysis 790
Foundations of Financial Performance Ratio Analysis 793
Measurement 778 Comprehensive Illustration of Ratio Analysis 793
Financial Performance Measurement: Management’s Evaluating Liquidity 794
Objectives 778
Evaluating Profitability 796
Financial Performance Measurement: Creditors’ and
Investors’ Objectives 778 Evaluating Long-term Solvency 797
Standards of Comparison 779 Evaluating the Adequacy of Cash Flows 798
Sources of Information 782 Evaluating Market Strength 800
쐽 A LOOK BACK AT STARBUCKS CORPORATION 802
Executive Compensation 783
CHAPTER REVIEW 803
Tools and Techniques of Financial Analysis 786
CHAPTER ASSIGNMENTS 809
Horizontal Analysis 786

CHAPTER 18 The Changing Business Environment: A Manager’s Perspective 826

쐽 DECISION POINT: A MANAGER’S FOCUS WAL-MART Achieving Continuous Improvement 843
STORES, INC. 827 Performance Measures: A Key to Achieving
The Role of Management Accounting 828 Organizational Objectives 844
Management Accounting and Financial Accounting: A Using Performance Measures in the Management
Comparison 828 Process 844
Management Accounting and the Management Process The Balanced Scorecard 845
829 Benchmarking 847
Value Chain Analysis 836 Analysis of Nonfinancial Data in a Retail
Primary Processes and Support Services 836 Organization 847
Advantages of Value Chain Analysis 838 Standards of Ethical Conduct 849
Managers and Value Chain Analysis 838 쐽 A LOOK BACK AT WAL-MART STORES, INC. 851
Continuous Improvement 840 CHAPTER REVIEW 853
Management Tools for Continuous Improvement 841 CHAPTER ASSIGNMENTS 857

CHAPTER 19 Cost Concepts and Cost Allocation 876

쐽 DECISION POINT: A MANAGER’S FOCUS SOUTHWEST Cost of Goods Sold and a Manufacturer’s Income
AIRLINES 877 Statement 888
Cost Information 878 Inventory Accounts in Manufacturing
Managers’ Use of Cost Information 878 Organizations 889
Cost Information and Organizations 880 Document Flows and Cost Flows Through the Inventory
Accounts 889
Cost Classifications and Their Uses 880
The Manufacturing Cost Flow 891
Cost Traceability 881
Cost Behavior 882 Elements of Product Costs 894
Value-Adding Versus Nonvalue-Adding Costs 883 Prime Costs and Conversion Costs 895
Cost Classifications for Financial Reporting 883 Computing Product Unit Cost 895
Computing Service Unit Cost 898
Financial Statements and the Reporting of Costs
884 Cost Allocation 899
Cost Reporting and Accounting for Inventories Allocating the Costs of Overhead 900
884 The Importance of Good Estimates 902
Statement of Cost of Goods Manufactured 886 Allocating Overhead:The Traditional Approach 903
xii
| Contents

Allocating Overhead: The ABC Approach 905 쐽 A LOOK BACK AT SOUTHWEST AIRLINES 909
Planning Overhead Rates 906 CHAPTER REVIEW 910
Applying the Overhead Rates 908 CHAPTER ASSIGNMENTS 914

CHAPTER 20 Costing Systems: Job Order and Process Costing 934

쐽 DECISION POINT: A MANAGER’S FOCUS COLD STONE Computing Equivalent Production 955
CREAMERY, INC. 935 Equivalent Production for Direct Materials 956
Product Cost Information and the Management Equivalent Production for Conversion Costs 957
Process 936 Summary of Equivalent Production 957
Planning 936 Preparing a Process Cost Report Using the FIFO
Performing 936 Costing Method 958
Evaluating 937 Accounting for Units 958
Communicating 937 Accounting for Costs 960
Job Order Versus Process Costing 938 Assigning Costs 961
The Job Order Costing System 940 Process Costing for Two or More Production
Cost Flow in a Job Order Costing System for a Departments 962
Manufacturing Company 940 Using Information About Product Cost to Evaluate
The Job Order Cost Card and Computation of Product Performance 963
Unit Costs 947 쐽 A LOOK BACK AT COLD STONE CREAMERY, INC. 964
Job Order Costing in a Service Organization 948 CHAPTER REVIEW 965
The Process Costing System 951 CHAPTER ASSIGNMENTS 969
Patterns of Product Flows and Cost Flows 952
Cost Flows Through the Work in Process Inventory
Accounts 954

CHAPTER 21 Activity-Based Systems: ABM and JIT 986

쐽 DECISION POINT: A MANAGER’S FOCUS LA-Z-BOY, INC. Minimum Inventory Levels 1003
987 Pull-Through Production 1004
Activity-Based Systems and Management 988 Quick Setup and Flexible Work Cells 1004
Activity-Based Systems 988 A Multiskilled Work Force 1004
Using Activity-Based Cost Information 989 High Levels of Product Quality 1005
Activity-Based Management 991 Effective Preventive Maintenance 1005
Value Chains and Supply Chains 991 Continuous Improvement of the Work Environment
1005
ABM in a Service Organization 993
Value-Adding and Nonvalue-Adding Activities Accounting for Product Costs in the New
and Process Value Analysis 994 Operating Environment 1006
Value-Adding and Nonvalue-Adding Activities in a Classifying Costs 1006
Service Organization 995 Assigning Costs 1006
Process Value Analysis 996 Backflush Costing 1007
Activity-Based Costing 997 Comparison of ABM and JIT 1011
The Cost Hierarchy and the Bill of Activities 998 쐽 A LOOK BACK AT LA-Z-BOY, INC. 1012
Activity-Based Costing for Selling and Administrative CHAPTER REVIEW 1013
Activities 1001 CHAPTER ASSIGNMENTS 1018
The New Operating Environment and JIT
Operations 1002
 Contents
| xiii

CHAPTER 22 Cost Behavior Analysis 1034

쐽 DECISION POINT: A MANAGER’S FOCUS KRAFT FOODS Breakeven Analysis 1049
1035 Using Contribution Margin to Determine the Breakeven
Cost Behavior and Management 1036 Point 1051
Planning 1036 The Breakeven Point for Multiple Products 1052
Performing 1037 Using C-V-P Analysis to Plan Future Sales, Costs,
Evaluating and Communicating 1037 and Profits 1054
The Behavior of Costs 1038 Applying C-V-P to a Manufacturing Business 1054
Variable Costs 1038 Applying C-V-P Analysis to a Service Business 1058
쐽 A LOOK BACK AT KRAFT FOODS 1060
Fixed Costs 1042
Mixed Costs 1043 CHAPTER REVIEW 1061
CHAPTER ASSIGNMENTS 1064
Cost-Volume-Profit Analysis 1047

CHAPTER 23 The Budgeting Process 1080

쐽 DECISION POINT: A MANAGER’S FOCUS JOHNSON & The Direct Labor Budget 1095
JOHNSON 1081 The Overhead Budget 1096
The Budgeting Process 1082 The Selling and Administrative Expense Budget 1096
Budgeting and Goals 1083 The Cost of Goods Manufactured Budget 1097
The Importance of Participation 1084 Financial Budgets 1099
Budget Implementation 1085 The Budgeting Income Statement 1099
Managers and the Budgeting Process 1085 The Capital Expenditures Budget 1099
The Master Budget 1087 The Cash Budget 1100
Operating Budgets 1091 The Budgeted Balance Sheet 1104
The Sales Budget 1091 쐽 A LOOK BACK AT JOHNSON & JOHNSON 1106
The Production Budget 1092 CHAPTER REVIEW 1108
The Direct Materials Purchases Budget 1093 CHAPTER ASSIGNMENTS 1112

CHAPTER 24 Performance Management and Evaluation 1136

쐽 DECISION POINT: A MANAGER’S FOCUS VAIL RESORTS Performance Evaluation of Investment Centers
1137 1151
Organizational Goals and the Balanced Scorecard Return on Investment 1151
1138 Residual Income 1153
The Balanced Scorecard and Management 1138 Economic Value Added 1154
Performance Measurement 1142 The Importance of Multiple Performance Measures
What to Measure, How to Measure 1142 1156

Other Measurement Issues 1142 Performance Incentives and Goals 1157

Responsibility Accounting 1143 Linking Goals, Performance Objectives, Measures, and
Performance Targets 1157
Types of Responsibility Centers 1143
Performance-Based Pay 1158
Organizational Structure and Performance Management
1146 The Coordination of Goals 1158
쐽 A LOOK BACK AT VAIL RESORTS 1159
Performance Evaluation of Cost Centers and Profit
Centers 1148 CHAPTER REVIEW 1161

Evaluating Cost Center Performance Using Flexible CHAPTER ASSIGNMENTS 1166

Budgeting 1148
Evaluating Profit Center Performance Using Variable
Costing 1149
xiv
| Contents

CHAPTER 25 Standard Costing and Variance Analysis 1182

쐽 DECISION POINT: A MANAGER’S FOCUS COACH, INC. Analyzing and Correcting Direct Materials Variances
1183 1196
Standard Costing 1184 Computing and Analyzing Direct Labor Variances
Standard Costs and Managers 1184 1198
The Relevance of Standard Costing in Today’s Business Computing Direct Labor Variances 1198
Environment 1186 Analyzing and Correcting Direct Labor Variances 1199
Computing Standard Costs 1186 Computing and Analyzing Overhead Variances
Standard Direct Materials Cost 1187 1201
Standard Direct Labor Cost 1187 Using a Flexible Budget to Analyze Overhead Variances
1201
Standard Overhead Cost 1188
Total Standard Unit Cost 1188 Computing Overhead Variances 1202
Analyzing and Correcting Overhead Variances 1207
Variance Analysis 1190
The Role of Flexible Budgets in Variance Analysis 1190 Using Cost Variances to Evaluate Managers’
Performance 1207
Using Variance Analysis to Control Costs 1192
쐽 A LOOK BACK AT COACH, INC. 1210
Computing and Analyzing Direct Materials
CHAPTER REVIEW 1211
Variances 1194
CHAPTER ASSIGNMENTS 1217
Computing Direct Materials Variances 1194

CHAPTER 26 Analysis for Decision Making 1232

쐽 DECISION POINT: A MANAGER’S FOCUS BANK OF Capital Investment Analysis 1249
AMERICA 1233 Measures Used in Capital Investment Analysis 1250
Short-Run Decision Analysis 1234 The Time Value of Money 1252
Planning 1234 Interest 1252
Performing 1235 Present Value 1253
Evaluating 1236 Present Value of a Single Sum Due in the Future 1254
Communicating 1236 Present Value of an Ordinary Annuity 1255
Incremental Analysis for Short-Run Decisions 1237 Analyzing Capital Investment Proposals: The Net
Irrelevant Costs and Revenues 1237 Present Value Method 1256
Opportunity Costs 1238 Advantages of the Net Present Value Method 1256
Application of Incremental Analysis to Short-Run The Net Present Value Method Illustrated 1256
Decisions 1239 Other Methods of Capital Investment Analysis
Incremental Analysis for Outsourcing Decisions 1239 1259
Incremental Analysis for Special Order Decisions 1241 The Payback Period Method 1259
Incremental Analysis for Segment Profitability Decisions The Accounting Rate-of-Return Method 1260
1243 쐽 A LOOK BACK AT BANK OF AMERICA 1262
Incremental Analysis for Sales Mix Decisions 1245 CHAPTER REVIEW 1263
Incremental Analysis for Sell or Process-Further CHAPTER ASSIGNMENTS 1268
Decisions 1247
Capital Investment Decisions 1249

Appendix A: Future Value and Present Value Tables 1284

Endnotes 1290
Company Name Index 1296
Subject Index 1298
Preface

This revision of Principles of Accounting is the most significant in the book’s long
history. The substantial changes we have made meet the needs of today’s stu-
dents, who not only face a business world increasingly complicated by ethical
issues, globalization, and technology, but who also have more demands on
their time. To help them meet these challenges, we place a heavy emphasis on
developing their decision-making and critical-thinking skills and on providing
information that is easy to understand and process.
We invite you to read the User’s Guide that follows this preface to get a
sense of how this book was written to help students master accounting. Here,
we elaborate on exactly what we set out to achieve in this tenth edition.

Streamlined Coverage and Redesign of the Text

While maintaining a solid foundation in double-entry accounting, we reduced
complexity by eliminating approximately 30 percent of in-text journal entries
and all nonessential procedural coverage and by condensing learning objec-
tives. We also reduced excessive detail, shortened headings, simplified expla-
nations, and increased readability. In addition, we made the text more accessi-
ble to students by using small, diverse companies to illustrate concepts and
techniques and well-known public companies to relate the concepts and tech-
niques to the real world.
To make the text more readable, visually appealing, and pedagogically
useful, we broke it into “user friendly” portions with bulleted and numbered
lists and new art, photographs, end-of-section review material, and Focus on
Business boxes.
쑺 New line art clarifies concepts and appeals to students who are visual
learners.
쑺 Photographs, with captions that underscore concepts in the text,
increase visual interest.
쑺 A new feature called “Stop, Review, and Apply” presents review ques-
tions; the answers to the questions are available on the student website
(Online Study Center). Many of these new sections also include short
exercises and solutions.
쑺 To reduce distractions, the margins of the text include only Study Notes,
which alert students to common misunderstandings of concepts and
techniques; key ratio and cash flow icons, which highlight discussions of
profitability and liquidity; and accounting equations. Icons and equa-
tions appear in the financial chapters (Chapters 1-17).

Emphasis on Accounting Information and Successful Decision Making

Throughout the text, we increased our emphasis on how businesses use
accounting information to make decisions, thus providing a uniform framework
for developing decision-making skills.
쑺 Each chapter opening includes a new Decision Point that shows how a
well-known company—one that students will immediately recognize—

xv
xvi
| Preface

uses accounting information to make decisions. The Decision Point

poses questions that challenge students to think about the relationship
between this information and the decisions management makes. The
company discussed in the Decision Point is highlighted in the chapter
and is revisited in “A Look Back At,” a feature that shows how the ques-
tions introduced in the Decision Point can now be answered.
쑺 To relate accounting information to real-world decision making, we refer
to more than 200 actual companies and use some of those companies’
recent financial statements as illustrations.
쑺 We use the latest available data in tables, figures, and exhibits and
incorporate the most recent FASB pronouncements in the text. We illus-
trate current practices in financial reporting by referring to data from
Accounting Trends and Techniques (AICPA) and integrate international topics
wherever appropriate.

Financial Accounting Coverage: Using Financial Statements for Decision Making

In the financial chapters, our emphasis is on teaching students how to tell a
company’s “story” through its financial statements.
쑺 To emphasize how important financial statements are in decision mak-
ing, the first page of each financial chapter includes a graphic model of
the income statement, balance sheet, and statement of cash flows and a
brief description of how these statements relate to the chapter’s topic.
쑺 We emphasize how ratios are used in evaluating a company’s profitabil-
ity and liquidity and highlight those discussions with key ratio and cash
flow icons.
쑺 The assignment material in every financial chapter includes a case that com-
pares CVS with Southwest Airlines or Walgreens and refers to both compa-
nies’ financial statements. Among other things, the comparison cases
require students to compute ratios, make assumptions, report on the
effect of seasonal sales, and describe each company’s inventory man-
agement system. CVS’s complete annual report and Southwest Airlines’
financial statements and Note 1 to the statements appear in the Supple-
ment to Chapter 5.

Management Accounting Coverage: Applying Accounting Concepts

to Real Businesses
Today, management’s use of information goes far beyond computing the cost of
products and services. In the managerial chapters (Chapters 18-26), we explore
the full range of innovative managerial systems in a value-centered economy in
which managers must make critical decisions about product quality, customer
service, and long-term relationships.
쑺 Rather than focusing on the technical details of cost accounting, we
emphasize the management process critical to operating a successful
business. A figure entitled “The Management Process: To-Dos for Man-
agers,” which appears in the first section of each chapter, highlights man-
agerial activities important at each stage of the management process.
쑺 We emphasize the approaches learned from the most progressive com-
panies, such as how to manage supply chains, analyze value chains,
 Preface
| xvii

operate in a just-in-time environment, utilize activity-based manage-

ment, apply the theory of constraints, and improve quality.
쑺 We discuss the latest in management models and technology and
emphasize that performance measurement and evaluation are essential
to a manager’s success in today’s competitive environment.
쑺 Service businesses, in which many students will ultimately work, receive
expanded emphasis in the text discussion and the chapter assignments.

Ethical Financial Reporting

We believe students need to know more about what constitutes ethical finan-
cial reporting and good corporate governance. We revised the text to address
this need.
쑺 The previews at the start of many chapters point out ethical and gover-
nance issues related to the chapter topic that are discussed in the chapter.
쑺 We cover the provisions of the Sarbanes-Oxley Act of 2002 and stress its
importance in Chapter 1 and at appropriate points throughout the text.
쑺 In the end-of-chapter material, we continue to provide short cases,
based on real companies, that require students to address an ethical
dilemma directly related to the chapter content.

Reorganized Assignment Material

This text has always provided a rich assortment of assignments that address
instructors’ needs. While keeping the range and depth of assignments from
previous editions, we have simplified their organization for easier use.
쑺 The end-of-chapter assignments are organized into two main sections:
Building Your Basic Knowledge and Skills—which consists of Short Exer-
cises, Exercises, Problems, and Alternate Problems—and Enhancing
Your Knowledge, Skills, and Critical Thinking—which consists of cases.
쑺 The first exercises in many chapters present questions useful in generating
class discussion about the decision-making aspects of the chapter topics.
쑺 Problems have been carefully scrutinized to reduce the number of trans-
actions involved and the time it takes to work them. Many of the prob-
lems have a requirement labeled “User Insight” or “Manager Insight.”
These requirements challenge students to think about the numbers and
how they are used in business decision making.
쑺 Cases are grouped by skill: Conceptual Understanding; Interpreting
Financial or Management Reports; Decision Analysis Using Excel; Ethical
Dilemma; Internet; Group Activity; and Business Communication. Each
financial chapter also has an Annual Report Case that focuses on CVS’s
annual report and, as noted earlier, a Comparison Case.

New Instructional Technologies for Today’s Business Environment

New technologies are today a driving force behind business growth and
accounting education. For this tenth edition of Principles of Accounting, we devel-
oped an integrated text and technology program to help instructors take
advantage of the opportunities created by new instructional technologies.
xviii
| Preface

Whether an instructor takes a user or procedural approach to teaching, wants to

incorporate new instructional strategies, wants to develop students’ core skills
and competencies, or desires to integrate technology into the classroom, this
edition provides a total solution. (See the inside back cover of the book for a
complete listing of supplements.)
Course Management
We know that homework and practice are integral parts of accounting courses,
and grading homework and tests can present a challenge to instructors. The
Eduspace® online learning tool pairs the widely recognized resources of
Blackboard with quality, text-specific content from Houghton Mifflin. Auto-
graded homework comprising end-of-chapter short exercises, exercises, and
problems; algorithmic practice exercises; SMARTHINKING online tutoring;
multimedia ebook with links to tutorials; demonstration videos; and other text-
supporting content come ready to use. Premium Blackboard course cartridges
and WebCT ePacks are also available.
Included in Eduspace and new to this edition of Principles of Accounting is HM
Assess, an online diagnostic assessment and study tool. Working in HM Assess,
students take Chapter Assessments and receive Individual Study Paths, with
links to tutorials, video, algorithmic practice questions, and online text con-
tent. Reporting and tracking are also available.
HMTesting
HMTesting—now powered by Diploma®—contains the computerized version
of the Test Bank. HMTesting provides instructors with the tools they need to
create, customize, and deliver multiple types of tests. Instructors can select,
edit, and add questions—some with algorithms—or generate randomly selected
questions to produce a test master for easy duplication. All test questions are
now tagged with AACSB learning outcomes, learning objectives, and key con-
cepts. Online Testing and Gradebook functions allow instructors to administer
tests via their local area network or the Internet, set up classes, record grades
from tests or assignments, analyze grades, and compile class and individual
statistics. HMTesting can be used on both PCs and Macintosh computers.
The Test Bank is also available in print. The printed Test Bank provides the
same questions found in HMTesting—more than 4,000 true-false, multiple
choice, short essay, and critical-thinking questions, as well as exercises and
problems, all of which test students’ ability to recall, comprehend, apply, and
analyze information. Two achievement tests are provided for each chapter.
Instructor and Student Websites
The Online Teaching and Online Study Centers provide instructors and stu-
dents with text-specific resources that reinforce key concepts in the Principles of
Accounting program. For instructors, the Online Teaching Center includes pass-
word-protected course materials, such as completely revised PowerPoint
slides with video and original content; Classroom Response System content;
sample syllabi; the Accounting Instructor’s Report, which explores a wide range of
contemporary teaching issues; and Electronic Solutions, which are fully func-
tioning Excel spreadsheets for all exercises, problems, and cases in the text.
For students, the Online Study Center offers open access to helpful supple-
mentary materials, such as ACE practice tests, answers to Stop, Review, and
Apply questions, weblinks to companies discussed in the text, chapter outlines
and summaries, glossaries (chapter-based and complete), and much more. In
addition, all new texts are packaged with a passkey providing access to a set of
“Your Guide to an ‘A’” premium resources, which focus on helping students suc-
ceed in their course. “Your Guide to an ‘A’” material includes additional (ACE+)
 Preface
| xix

self-test quizzes, Flashcards, crossword puzzles, Study Guide content, Demonstra-

tion Videos, HMAccounting Tutor, and audio chapter reviews (MP3 chapter
summaries and quizzes). Both the student and instructor websites can be
accessed at college.hmco.com/info/needles. See the User’s Guide and endpa-
pers of the text for a complete listing of all the student supplements available.

The Bottom Line

Although we have done more in this revision than in any previous one to make
accounting concepts accessible to students, there is one thing we have not
changed: we still teach students how to use financial statements and the
accounting systems that provide the data needed to make business decisions
and that tell a company’s story. For investors and creditors, financial informa-
tion reveals a company’s financial health, prosperity, and future. For manage-
ment, both financial information and nonfinancial information are a means of
guiding a company’s progress and profitability. Our goal is to improve stu-
dents’ understanding of the “story” revealed in a company’s financial and non-
financial data, and never has that goal been as critical as in current times, with
business events underscoring this fact: accounting really matters.
To follow the “story,” students have to learn how to think. Principles of
Accounting teaches students to think about what they are reading, how they
might make financial decisions, and what roles they might play as future users
of accounting information. Students also have to learn how to analyze and
interpret data—where did the numbers come from? What is the meaning
behind the numbers? What do the numbers say about a company’s financial
health? Today, accounting students need to learn more than how to prepare
financial statements; they also must learn how to analyze meaningful informa-
tion in them and in the supporting data. Principles of Accounting, Tenth Edition,
focuses on teaching students to do just that.

Acknowledgments
A successful textbook is a collaborative effort. We are grateful to the many pro-
fessors, other professional colleagues, and students who have taught and stud-
ied from our book, and we thank all of them for their constructive comments. In
the space available, we cannot possibly mention everyone who has been help-
ful, but we do want to recognize those who made special contributions to our
efforts in preparing the tenth edition of Principles of Accounting.
We wish to express our deep appreciation to colleagues at DePaul Univer-
sity, who have been extremely supportive and encouraging.
The thoughtful and meticulous work of Edward H. Julius (California
Lutheran University) is reflected not only in the Study Guide, but in our Test
Bank and Eduspace course as well. Eric Blazer (Millersville University) wrote
the managerial chapters of the study guide, and Judy R. Colwell (Northern
Oklahoma College) wrote the managerial chapters of the test bank. We also
thank Jeri Condit for creating the PowerPoint slides, Linda Burkell for HMAc-
counting Tutor and GLS, and Cathy Larson for her accuracy review of the text
and solutions. Sarah Evans deserves special recognition for her thoroughness
and clarity in editing portions of the text and laying out the tenth edition.
Also very important to the quality of this book is the supportive collabora-
tion of our senior sponsoring editor, Ann West; senior development editor,
Chere Bemelmans; editorial assistant, Diane Akerman; and project editor, Mar-
garet Kearney—to whom we give special thanks.
Others who have had a major impact on this book through their reviews,
suggestions, and participation in surveys, interviews, and focus groups are
xx
| Preface

listed below. We cannot begin to say how grateful we are for the feedback from the many instruc-
tors who have generously shared their responses and teaching experiences with us.
Daneen Adams, Santa Fe Community College Mark Henry, Victoria College
Gregory D. Barnes, Clarion University Margaret Hoskins, Henderson State Univ.
Mohamed E. Bayou, The University of Michigan—Dearborn Marianne James, California State University, Los Angeles
Charles M. Betts, Delaware Technical and Community College Sharon Johnson, Kansas City Kansas Community College
Michael C. Blue, Bloomsburg University Edward H. Julius, California Lutheran University
Gary R. Bower, Community College of Rhode Island Howard A. Kanter, DePaul University
Lee Cannell, El Paso Community College Ann Kelley, Providence College
Gerald Carnes, Edinboro College Debbie Luna, El Paso Community College
John D. Cunha, University of California—Berkeley Kevin McClure, ESL Language Center
Julie Dailey, Central Virginia Community College George McGowan
Mark W. Dawson, Duquesne University Gail A. Mestas
Patricia A. Doherty, Boston University Jenine Moscove
Lizabeth England, American Language Academy Beth Brooks Patel, University of California—Berkeley
David Fetyko, Kent State University LaVonda Ramey, Schoolcraft College
Albert Fisher, Community College of Southern Nevada Roberta Rettner, American Ways
Robert Flemming, Northern Michigan University Gayle Richardson, Bakersfield College
Sue Garr, Wayne State University James B. Rosa, Queensborough Community College
Roxanne Gooch, Cameron University Donald Shannon, DePaul Univeristy
Christine Uber Grosse, The American Graduate School of S. Murray Simons, Northeastern University
International Management Marion Taube, University of Pittsburgh
Dennis A. Gutting, Orange County Community College Kathleen Villani, Queensborough Community College
John Hancock, University of California—Davis Graduate School of Vicki Vorell, Cuyahoga Community College
Management John Weber, DeVry Institute
Yvonne Hatami, Borough of Manhattan Community College Brenda Werts, Park University
Robert Holtfreter, Centra, Washington University Kay Westerfield, University of Oregon
Harry Hooper, Santa Fe Community College Andy Williams, Edmunds Community College

Finally, we want to thank the facilitators for the last five years of COAE (Conference on Accounting
Education):
2006 COAE Facilitators Richard Fern, Eastern Kentucky University
Salvador Aceves, University of San Francisco Terry Grant, Mississippi College
Rita Grant, Grand Valley State University Yvonne Hatami, Borough of Manhattan Community College
Emmanuel Onifade, Morehouse College Rodger Holland, Columbus State University
Janet Papiernik, Indiana University—Purdue University
Andy Williams, Edmonds Community College 2002 COAE Facilitators
Sharon Bell, University of North Carolina—Pembroke
2005 COAE Facilitators Mark Henry, Victoria College
Peter Aghimien, Indiana University, South Bend Harry Hooper, Santa Fe Community College
Charles Bunn, Wake Technical College Richard Irvine, Pensacola Junior College
James Dougher, DeVry University Nancy Kelly, Middlesex Community College
Frank Lordi, Widener University Paul Mihalek, University of Hartford
Elizabeeth Murphy, DePaul University Paul Weitzel, Eastern Shore Community College
Karen Novey, Robert Morris College
Wendy Tietz, Kent State University 2001 COAE Facilitators
Salvador Aceves, University of San Francisco
2004 COAE Facilitators Betty Habershon, Prince George's Community College
Star Brown, Western Piedmont Community College Jim Mazza, Heald College
Rosie Bukics, Lafayette College Roselyn Morris, Southwest Texas State University
Stanley Chu, Borough of Manhattan Community College Ginger Parker, Creighton University
Michael Cottrill, Northeastern University David Rogers, Mesa State College
Mark Mitschow, SUNY—Genesee Jeanne Yamamura, University of Nevada—Reno
Elizabeth Murphy, DePaul University
—B.N., M.P., and S.C.
2003 COAE Facilitators
Charlene Abendroth, California State University
Daneen Adams, Santa Fe Community College
User’s Guide to
Principles of Accounting
We have designed Principles of Accounting with you—the student—in
mind. Becoming familiar with this textbook will help you succeed in
this course: you will study more effectively and improve your grades
on tests and assignments. The following User’s Guide will introduce
you to your Principles of Accounting textbook.

Preview the Chapter

Use these features to preview the chapter. First, become familiar with
the Learning Objectives (they appear throughout the chapter), and
then read how a leading business uses accounting information.
Review Making a Statement in Chapters 1–17; this feature tells you
which financial statements are important in the chapter.

1 Each Chapter Preview focuses on management issues; many also

present ethical issues. As you read this section, consider the follow-
ing: Why are the concepts in this chapter important to managers?
What are the ethical issues?
2 The Learning Objectives (LOs) help guide you toward mastery
of the material.These brief statements summarize what you should
know after reading the chapter.You will see many references to
1
LOs throughout each chapter.
3 Making a Statement (Chapters 1–17) reinforces the connection
between the financial statements and the chapter’s topics. It indi-
cates which financial statements are important in each chapter.

2
3
4

4 Use the Decision Point feature to see how real companies depend
on accounting information in decision making. Look for references
to the Decision Point company throughout the chapter. Many
of the companies profiled are among the most successful
in the world.
 xxii
| User’s Guide

Reinforce What You Read

As you read each chapter, use the features described below to rein-
force the concepts. Look for the LO before each main section, and
note boldface words: they are terms and definitions you should
know. Use the Stop, Review, and Apply questions at the end of each
main section to assess your understanding of the material.

5 Learning Objectives introduce the key points of each section and 5

are integrated throughout the text.

6 Boldface terms call out important concepts and their definitions.

These words also appear in a glossary at the end of the chapter. 6
7
7 Study Notes highlight important information and provide useful tips
on ways to avoid common mistakes.

56
| CHAPTER 2 Analyzing Business Transactions

8
Senior WorldCom executives violated
standards of good financial reporting
and GAAP when they deliberately
understated expenses to disguise
poor performance. Consequences
were devastating for employees,
investors, and the public trust. Left to
right: Melvin Dick of Arthur Andersen,
Bernard Ebbers and Scott Sullivan of
WorldCom, and Jack Grabman of
Salomon Smith Barney are sworn in
on July 8, 2002, at a congressional
hearing of charges against WorldCom.
8 Photographs with detailed captions reinforce concepts in the text-
쏡 By a simple violation of the guidelines for classification, WorldCom (now
MCI) perpetrated the largest financial fraud in history, which resulted in the
largest bankruptcy in history. Over a period of several years, the company
book and show how accounting is used in the business world.
recorded expenditures that should have been classified as expenses as
assets; this had the effect of understating the company’s expenses and over-
stating its income by more than $10 billion. 9 Stop, Review, and Apply features at the end of every section help
you review important concepts in the section.These questions can
9 also be used for discussion in class.
S T O P • R E V I E W • A P P L Y
1-1. What three issues underlie most major accounting decisions?
1-2. A customer asks the owner of a store to save an item for him and says 10 Accounting equations next to important journal entries
he will pick it up and pay for it next week. The owner agrees to hold it.
Should this transaction be recorded as a sale? Explain your answer. reinforce the impact of the transaction on the financial
1-3. Why do accountants rely on original cost for valuation purposes?
1-4. Why is classification of a transaction as an expense or an asset a critical statements.
issue in accounting?
1-5. How are recognition, valuation, and classification related to the ethics
of financial reporting?
Suggested answers to all Stop, Review, and Apply questions are available at
http://college.hmco.com/accounting/needles/poa/10e/student_home.html.
Uncollectible Accounts
| 383

receivable amounted to $100,000. On December 31, 20x8, management

reviewed the collectible status of the accounts receivable. Approximately
Double-Entry System $6,000 of the $100,000 of accounts receivable were estimated to be uncol-
lectible. The following adjusting entry would be made on December 31 of
LO2 Explain the double-entry system and the usefulness of T accounts in that year:
analyzing business transactions.

10
T
A
L  OE 20x8
he double-entry system, the backbone of accounting, evolved during 6,000 6,000 Dec. 31 Uncollectible Accounts Expense 6,000
the Renaissance. The first systematic description of double-entry book- Allowance for Uncollectible Accounts 6,000
keeping appeared in 1494, two years after Columbus discovered America, To record the estimated uncollectible
accounts expense for the year
 User’s Guide
| xxiii

Reinforce Concepts Visually

These features visually reinforce the concepts in your textbook. Line
art helps explain concepts, exhibits show financial statements and
other information, and tables include material to support topics cov-
ered in the chapter. Also look for icons throughout the text; they are
visual guides to key features.

18
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

11 ■ FIGURE 5
The Accounting Equation
11 An abundance of line art illustrates the relationships between
concepts and processes.

Owner’s
Assets Liabilities
Equity

A = L + OE

Standard Costing
| 1185

■ FIGURE 1
12 The Management Process: To-Do’s for Managers 12 Each managerial chapter (Chapters 18–26) includes a graphic:
To-Do’s for Managers.These figures highlight managerial activities
To-Do’s for Managers
important to each stage of the management process.
• Plan
– Determine standard costs and prepare budgets
– Establish cost-based goals for products or services

• Perform
– Apply cost standards as work is performed in cost centers
– Collect actual cost data

• Evaluate
– Use flexible budgets to evaluate managers’ performance
– Calculate variances between standard and actual costs
for direct materials, direct labor, variable overhead,
and fixed overhead
– Determine their causes and take corrective action

• Communicate
– Prepare cost center performance reports using standard
costing
– Prepare comparative analyses of flexible budget to actual
results for materials, labor and overhead

Financial Statements
| 21

13 EXHIBIT 2 씰 Statement of Owner’s Equity for Ramirez Agency 13 Exhibits throughout the text show financial information.
Ramirez Agency
Statement of Owner’s Equity
For the Month Ended December 31, 20xx
R. Ramirez, Capital, December 1, 20xx $ 0
Investment by R. Ramirez 100,000
Net income for the month 4,200
Subtotal $104,200
Less withdrawals 1,200
R. Ramirez, Capital, December 31, 20xx $103,000

from this amount are $1,200 of withdrawals that the owner made during the
month, leaving an ending balance of $103,000 of capital in the business.

14 The cash flow icon highlights discussion of cash as a measure

14 Statement of Cash Flows
Whereas the income statement focuses on a company’s profitability, the
statement of cash flows focuses on its liquidity (see Exhibit 4). Cash flows are
of liquidity. Measurement of cash flows serves as an indicator
the inflows and outflows of cash into and out of a business. Net cash flows are
the difference between the inflows and outflows. The statement of cash flows of a company’s success; hence the emphasis on cash flows in
shows the cash produced by business operations during an accounting period
this book.

15 15 Tables present factual information referred to in the text.

 xxiv
| User’s Guide

Learn Why Accounting Is Relevant

These features demonstrate how and why accounting is relevant.
Focus on Business Practice boxes introduce you to real companies
and real issues. The Supplement to Chapter 5 helps you learn how to
read—and understand—real financial statements and interpret what
management says about them.

16 Focus on Business Practice boxes highlight the relevance of 16

accounting to business today.

17 The textbook refers to over 200 public, private, and not-for-profit

companies.The Needles Online Study Center website (http://
college.hmco.com/info/needles) provides a direct link to the web-
sites of these companies.The book also has a company name index.
17

18 Graphs and tables illustrate how actual business practices relate to 18

chapter topics. Data for these illustrations come from Accounting
Trends & Techniques and from Dun & Bradstreet, key sources of
business information.

19 Ratios are used to measure a company’s performance.

The key ratio icon appears in the margin to highlight
discussions of important ratios.

19 Current Ratio The current ratio is closely related to working capital. Many
bankers and other creditors believe it is a good indicator of a company’s ability
to pay its debts on time. The current ratio is the ratio of current assets to cur- 20
rent liabilities. For Ling Auto Supply Company, it is computed like this:
Current Assets $248,712
Current Ratio


2.9
Current Liabilities $85,366
Thus, Ling Auto Supply has $2.90 of current assets for each $1.00 of current lia-
bilities. Is that good or bad? The answer requires a comparison of this year’s
current ratio with ratios for earlier years and with similar measures for compa-
nies in the same industry.
ll h f d

20 The complete annual report for CVS and the financial statements
of Southwest Airlines are in the Supplement to Chapter 5. CVS’s
financial statements with annotations also appear in the
Supplement to Chapter 5.
 User’s Guide
| xxv

Summarize and Review

The end-of-chapter features provide summary, review, and assign-
ments for practice. A Look Back At relates the chapter’s concepts to
the company you read about in the Decision Point at the beginning
of the chapter. Review sections include a Review of Learning Objec-
tives and a Review of Concepts and Terminology.

21 A Look Back At shows how the concepts learned in the chapter can
be used to evaluate a company’s performance.
21
22 The Chapter Review restates each learning objective
and its main ideas.
30
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

22 C H A P T E R R E V I E W
REVIEW of Learning Objectives
LO1 Define accounting and Accounting is an information system that measures, processes, and communi-
describe its role in making cates financial information about an economic entity. It provides the informa-
informed decisions, identify busi- tion necessary to make reasoned choices among alternative uses of scarce
ness goals and activities, and resources in the conduct of business and economic activities. A business is an
explain the importance of ethics economic entity that engages in operating, investing, and financing activities to
in accounting. achieve the goals of profitability and liquidity.
Management accounting focuses on the preparation of information prima-
rily for internal use by management. Financial accounting is concerned with the
development and use of reports that are communicated to those outside the
business as well as to management. Ethical financial reporting is important to
the well-being of a company; fraudulent financial reports can have serious con-
sequences for many people.

LO2 Identify the users of Accounting plays a significant role in society by providing information to man-
accounting information. agers of all institutions and to individuals with a direct financial interest in
those institutions, including present or potential investors (owners) and credi-
tors. Accounting information is also important to those with an indirect financial
interest in the business—for example, tax authorities, regulatory agencies, and
economic planners.

LO3 Explain the importance of To make an accounting measurement, the accountant must determine what is
business transactions, money measured, when the measurement should be made, what value should be
measure, and separate entity. placed on what is measured, and how to classify what is measured. The objects
of accounting measurement are business transactions. Financial accounting
uses money measure to gauge the impact of these transactions on a separate
business entity.

LO4 Identify the three basic The three basic forms of business organization are the sole proprietorship, the
forms of business organization. partnership, and the corporation. Accountants recognize each form as an eco-
nomic unit separate from its owners, although legally only the corporation is
separate from its owners. A sole proprietorship is a business owned by one

|
person. A partnership is like a sole proprietorship in most ways, but it has two
or more owners. A corporation, on the other hand, is a business unit chartered Chapter Review 31
by the state and legally separate from its owners (the stockholders).
LO7 Explain how generally Acceptable accounting practice consists of the conventions, rules, and proce-
accepted accounting principles dures that make up generally accepted accounting principles at a particular
LO5 Define financial position, Financial position refers to a company’s economic resources and the claims (GAAP) relate to financial state- time. GAAP are essential to the preparation and interpretation of financial
and state the accounting equation. against those resources at a particular time. The accounting equation shows ments and the independent CPA’s statements and the independent CPA’s report.
financial position as Assets
Liabilities  Owner’s Equity. Business transac- report, and identify the organiza- Among the organizations that influence the formulation of GAAP are the
tions affect financial position by decreasing or increasing assets, liabilities, and tions that influence GAAP. Public Company Accounting Oversight Board, the Financial Accounting Stan-
owner’s equity in such a way that the accounting equation is always in balance. dards Board, the American Institute of Certified Public Accountants, the Securi-
ties and Exchange Commission, and the Internal Revenue Service.
All accountants are required to follow a code of professional ethics, the
LO6 Identify the four basic The four basic financial statements are the income statement, the statement of foundation of which is responsibility to the public. Accountants must act with
financial statements. owner’s equity, the balance sheet, and the statement of cash flows. They are integrity, objectivity, and independence, and they must exercise due care in all
the primary means by which accountants communicate the financial condition their activities.
and activities of a business to those who have an interest in the business. The board of directors is responsible for determining corporate policies
and appointing corporate officers. It is also responsible for corporate gover-
nance, the oversight of a corporation’s management and ethics. The audit com-
mittee, which is appointed by the board and made up of independent direc-

23 Each chapter includes a glossary of the key concepts and terms

tors, is an important factor in corporate governance.

defined in the chapter.The LO next to each term indicates the sec- 23 REVIEW of Concepts and Terminology
tion in which it is discussed. The following concepts and terms were introduced in Business transactions: Economic events that affect a
this chapter: business’s financial position. (LO3)
Accounting: An information system that measures, Cash flows: The inflows and outflows of cash into and
processes, and communicates financial information out of a business. (LO6)
about an economic entity. (LO1) Certified public accountant (CPA): A public account-
Accounting equation: Assets
Liabilities  Owner’s ant who has met stringent state licensing
Want more study aids and review exercises? The Study Guide for Equity. (LO5) requirements. (LO7)
American Institute of Certified Public Accountants Corporate governance: The oversight of a corpora-
this book provides a thorough review of each learning objective, a (AICPA): The professional association of certified
public accountants. (LO7)
tion’s management and ethics by the board of
directors. (LO7)
detailed outline, true/false and multiple-choice questions, and Assets: The economic resources of a company that are Corporation: A business unit granted a state charter
expected to benefit future operations. (LO5) recognizing it as a separate legal entity having its
exercises. Answers are included. Access the Study Guide with “Your Audit: An examination of a company’s financial state- own rights, privileges, and liabilities distinct from
ments in order to render an independent profes- those of its owners. (LO4)
Guide to an A” passkey. sional opinion about whether they have been pre-
sented fairly, in all material respects, in conformity
Due care: Competence and diligence in carrying out
professional responsibilities. (LO7)
with GAAP. (LO7)
Ethics: A code of conduct that addresses whether
Audit committee: A subgroup of a corporation’s board
actions are right or wrong. (LO1)
of directors that is charged with ensuring that the
board will be objective in reviewing management’s Exchange rate: The value of one currency in terms of
performance; it engages the company’s independ- another. (LO3)
ent auditors and reviews their work. (LO7) Expenses: Decreases in owner’s equity that result
Balance sheet: The financial statement that shows a from operating a business. (LO5)
business’s assets, liabilities, and owner’s equity as Financial accounting: The process of generating and
of a specific date. Also called the statement of financial communicating accounting information in the form
position. (LO6) of financial statements to those outside the
Bookkeeping: The process of recording financial organization. (LO1)
transactions and keeping financial records. (LO1) Financial Accounting Standards Board (FASB): The
Business: An economic unit that aims to sell goods most important body for developing rules on
and services to customers at prices that will pro- accounting practice; it issues Statements of Financial
vide an adequate return to its owners. (LO1) Accounting Standards. (LO7)
 xxvi
| User’s Guide

Review and Practice

Continue your review of the chapter with the Review Problem, which
reflects computations or analyses covered in the chapter. For prac-
tice at different levels of difficulty, Chapter Assignments—from Short
Exercises to Cases—let you develop skills learned in the chapter. All
assignments are identified by Learning Objective so you can easily
review the concepts presented in the text.

24 Not sure if you understand the tech- 24 REVIEW Problem

LO6 Preparation and Interpretation of Financial Statements
niques and calculations? Want to find The following financial statement accounts and amounts are from the records of
Jackson Realty for the year ended April 30, 20x8, the company’s first year of
out if you’re ready for a test? The Review operations.

Problem models main computations or Accounts payable

Accounts receivable
$ 19,000
104,000
Cash 111,000
analyses presented in the chapter and Commissions earned 375,000
Equipment 47,000
end-of-chapter assignments.The answer, Investment by J. Jackson 100,000
Marketing expense 18,000
often shown in Excel, is provided for Office and equipment rent expense
Salaries and commission expense
91,000
172,000
immediate feedback. Salaries payable
Supplies
78,000
2,000
Supplies expense 6,000
Utilities expense 11,000
Withdrawals 10,000

25 Short exercises provide additional practice. Learning

Objectives appear in the margin next to all assignments
so you can refer to the text for help.
25

26 Single-topic exercises stress the application of the

chapter’s concepts.
26
 User’s Guide
| xxvii

Develop Important Skills

Use these end-of-chapter features to develop important skills. Five
problems and three alternate problems per chapter allow extensive
application of chapter topics, often covering more than one Learn-
ing Objective. Cases provide opportunities for group assignments,
Internet research, analysis with Excel, and critical thinking.

27 Most problems include at least one User Insight or Manager Insight 27

question.These questions challenge you to think about how finan-
cial information is used for business decision making. 28

28 Problems with this icon can be solved by using General Ledger

Software, which is available on your student CD. Problems often
contain financial data and cover more than one Learning
Objective.

29 Cases at the end of each chapter have been organized to highlight

important skills, such as conceptual understanding, interpretation
of financial statements or management reports, Excel analysis, deci-
sion making, Internet research, and business communication.

29

Interpreting Management Reports

LO3, LO4 ABC and Selling and Administrative Expenses
C 4. Sandy Star, the owner of Star Bakery, wants to know the profitability of
each of her bakery’s customer groups. She is especially interested in the State
Institutions customer group, which is one of the company’s largest customer
groups. Currently, the bakery is selling doughnuts and snack foods to ten state
institutions in three states. The controller has prepared the following income
statement for the State Institutions customer group:

Star Bakery
Income Statement for State Institutions Customer Group
For the Year Ended December 31, 20x8
Sales ($5 per case  50,000 cases) $250,000
Cost of goods sold ($3.50 per case  50,000 cases) 175,000
Gross margin $ 75,000
Less: Selling and administrative activity costs 94,750
Operating income (loss) contributed by State Institutions
customer group ($19,750)
Activity Cost Actual Cost Driver
Activity Rate Level Activity Cost
Make sales calls $60 per sales call 60 sales calls $ 3,600
Prepare sales orders $10 per sales order 900 sales orders 9,000
Handle inquiries $5 per minute 1,000 minutes 5,000
Ship products $1 per case sold 50,000 cases 50,000
Process invoices $20 per invoice 950 invoices 19,000
Process credits $20 per notice 40 notices 800
Process billings and $7 per billing 1,050 billings
collections 7,350
Total selling and administrative activity costs 94,750
 xxviii
| User’s Guide

Student Resources and Study Aids

Principles of Accounting offers a variety of print and multimedia tools to
complement the way you learn. From study guides to downloadable
MP3 audio review files, the Needles Principles of Accounting program
keeps you engaged and on track for success. The following student
resources may come packaged with your new copy of Principles of
Accounting, or can be purchased separately at your local college
bookstore or directly from Houghton Mifflin’s virtual bookstore at
http://college.hmco.com/students.

The Principles of Accounting Electronic Working Papers CD

(0-618-73649-2) is an alternative to printed working papers.
These Excel-based files contain templates that allow you to
work the exercises, problems, and cases in the text; a new
interface makes it easy to navigate among assignments. With the
Electronic Working Papers CD, you master both accounting con-
cepts and the basic skills required for spreadsheet applications.

Also available are print Working Papers (Vol. 1: 0-618-73643-3;

Vol. 2: 0-618-73644-1), which provide the appropriate accounting
forms for solving the exercises, problems, and cases from the text.

The SMARTHINKING ™ online tutoring center provides real-time

access to experienced “e-structors” (online tutors). In addition
to live, one-on-one interaction, you can submit questions,
assignments, and spreadsheets and receive personalized
The Online Study Center contains a variety of resources, includ- feedback—usually within 24 hours.
ing ACE practice tests, chapter outlines and reviews, links to com-
panies mentioned in the text, glossaries, and additional appen- The Principles of Accounting Study Guide is designed to help
dixes. Content to help you improve your grade is available with you improve your performance in the course.This resource con-
the “Your Guide to an A” passkey and includes Flashcards, Cross- sists of five parts:“Reviewing the Chapter,” “Self-Test,” “Testing
word Puzzles, MP3 audio summaries and quizzes, Demonstration Students’ Knowledge,” “Applying Your Knowledge,” and
Videos, and the complete Study Guide. “Answers.”The Study Guide is available with the “Your Guide to an
A” passkey.

To help you become familiar with computerized accounting

systems used in practice, the Peachtree Accounting CD
(0-618-62683-2) features the educational version of this leading
software program.The experience you gain from working with
actual software makes you more desirable as a potential
employee.

The Houghton Mifflin Accounting Bridge Tutorial CD (0-618-

31876-3) emphasizes accounting transactions, presents a review
of the debit/credit mechanism, and provides a foundation for
the preparation of financial statements.This CD features pre-
and post-test activities on accounting concepts, designed to test
your basic understanding of the accounting cycle. Key concept
tutorials provide reinforcement and practice. Interactive Review
and Reinforce questions with rejoinders provide feedback on
right and wrong answers.Tutorials also include demonstration
Nearly all the problems in Chapters 1 to17 can be worked using problems with voice-over narrations and a built-in glossary with
Houghton Mifflin’s General Ledger Software (GLS). These prob- pop-up definitions.
lems are clearly identified with an icon. Our updated GLS includes
Export to Peachtree functionality.
Check Figures

Chapter 1 Chapter 6
P 1. No check figure P 1. Net income: $15,435
P 2. Total assets, Set C: $380; Total liabilities and owner’s P 2. No check figure
equity, Set A: $4,600; Total liabilities and owner’s P 3. Net income: $23,941
equity, Set B: $31,000 P 4. No check figure
P 3. Total assets: $151,500 P 5. Net income: $10,522
P 4. Total assets: $20,900 P 6. No check figure
P 5. No check figure P 7. Net income: $3,435
P 6. Total assets, Set A: $2,700; Total liabilities and P 8. No check figure
owner’s equity, Set B: $18,000; Total liabilities and
owner’s equity, Set C: $1,900 Chapter 7
P 7. Total assets: $156,700 P 1. 1. Cost of goods available for sale: $157,980
P 8. Total assets: $27,300 P 2. 2. Cost of goods sold: March, $4,500; April, $10,540
P 3. 1. Cost of goods sold: March, $4,579; April, $10,518
Chapter 2 P 4. Estimated inventory shortage: At cost, $6,052; At
P 1. Total assets: $28,540 retail, $8,900
P 2. No check figure P 5. Estimated loss of inventory in fire: $653,027
P 3. Trial balance: $16,200 P 6. Cost of goods available for sale: $10,560,000
P 4. Trial balance: $14,800 P 7. 1. Cost of goods sold: April, $9,660; May, $22,119
P 5. Trial balance: $23,805 P 8. 2. Cost of goods sold: April, $9,500; May, $21,880
P 6. Total assets: $67,790
P 7. Trial balance: $10,540 Chapter 8
P 8. Trial balance: $30,710 P 1. Adjusted book balance: $149,473.28
P 2. Uncollectible accounts expense, percentage of net
Chapter 3 sales method: $17,952; Uncollectible accounts
P 1. No check figure expense, accounts receivable aging method:
P 2. No check figure $15,700
P 3. Adjusted trial balance: $121,792 P 3. Amount of uncollectible accounts expense: $9,109
P 4. Adjusted trial balance: $29,778 P 4. Total accrued interest on June 30: $1,928.22
P 5. Adjusted trial balance: $642,209 P 5. Adjusted book balance: $54,485.60
P 6. No check figure P 6. Uncollectible accounts expense, percentage of net
P 7. No check figure sales method: $24,965; Uncollectible accounts
P 8. Adjusted trial balance: $106,167 expense, accounts receivable aging method:
$27,100
Chapter 4 P 7. Amount of uncollectible accounts expense: $73,413
P 1. Income Summary transfer to E. Graff, Capital:
$11,425 Chapter 9
P 2. Adjusted trial balance, May 31: $10,288; Adjusted P 1. No check figure
trial balance, June 30: $10,858 P 2. June 30. Interest Expense: $552.33
P 3. Net income: $98,622 P 3. 1. b. Estimated Product Warranty Liability: $10,800
P 4. Income Summary transfer to S. Perez, Capital: $7,978 P 4. Total current liabilities: $36,988.20
P 5. Net income: $62,392 P 5. Fund Balance: $58,300; Initial Deposit: $110,250;
Purchase Price: $399,300; Annual Payments:
Chapter 5 $136,355.89
P 1. No check figure P 6. December 31. Interest expense: $426.08
P 2. Income from operations: 20x8: $66,426; 20x7: P 7. 1. b. Estimated Product Warranty Liability: $20,160
$110,628 P 8. Fund Balance: $3,310,000; Annual Payment:
P 3. Total assets: $595,600 $327,600; Cost of Buyout: $317,000; Fund Balance:
P 4. No check figure $798,600
P 5. Net income: $86,260; Total assets: $1,083,800
P 6. No check figure Chapter 10
P 7. No check figure P 1. No check figure
P 8. Income from operations: 20x9: $34,320; 20x8: $84,748 P 2. No check figure

xxix
xxx
| Check Figures

P 3. No check figure P 5. 2. Retained earnings: $250,000; Total stockholders’

P 4. Cash Short or Over, $20.00 equity: $2,350,000
P 5. No check figure P 6. 2. Retained earnings: $148,800; Total stockholders’
P 6. No check figure equity: $2,802,800
P 7. Cash Short or Over, $13.50 P 7. 1. Income before extraordinary items: $410,000
P 8. 2. Retained earnings: $211,600; Total stockholders’
Chapter 11 equity: $524,500
P 1. No check figure.
P 2. Totals: Land: $426,212; Land Improvements: Chapter 15
$166,560; Building: $833,940; Machinery: $1,262,640; P 1. No check figure
Expense: $18,120 P 2. 1. Net cash flows from: operating activities, $46,800;
P 3. 1. Depreciation, Year 3: a. $5,000; b. $8000; c. $2,813 investing activities, ($14,400); financing activities,
P 4. 1. Depreciation, Year 3: a. $54,250; b. $81,375; $102,000
c. $53,407 P 3. 1. Net cash flows from: operating activities,
P 5. 2. Depletion expense: $288,000 ($106,000); investing activities, $34,000; financing
P 6. Totals: Land: $723,900; Land Improvements: activities, $24,000
$142,000; Building: $1,383,600; Equipment: $210,800 P 4. 1. Net cash flows from: operating activities,
P 7. 1. Depreciation, Year 3: a. $165,000; b. $132,000; $548,000; investing activities, $6,000; financing activ-
c. $90,000 ities, ($260,000)
P 8. 2. Depletion expense: $243,000 P 5. No check figure
P 6. 1. Net cash flows from: operating activities, $63,300;
Chapter 12 investing activities, ($12,900); financing activities,
P 1. 2. Total stockholders’ equity: $1,342,000 $7,000
P 2. 1. 20x9 Total dividends: Preferred, $280,000; Com-
mon, $820,000 Chapter 16
P 3. No check figure P 1. No check figure
P 4. 2. Total stockholders’ equity: $1,765,900 P 2. Investment in Waters Corporation, Ending Balance:
P 5. 1. Ending balance, Treasury Stock, Common: 0 $734,000
P 6. 2. Total stockholders’ equity: $302,400 P 3. Total Assets, Consolidated Balance Sheet:
P 7. 1. 20x9 Total dividends: Preferred, $80,000; Com- $1,280,000
mon, $180,000 P 4. Total Assets, Consolidated Balance Sheet:
P 8. 2. Total stockholders’ equity: $473,040 $4,488,000
P 5. No check figure
Chapter 13 P 6. No check figure
P 1. No check figure P 7. Total Assets, Consolidated Balance Sheet:
P 2. 1. d. Interest expense: $510,000; 2. d. Interest $4,790,000
Expense: $540,000
P 3. 1. Aug. 31. Bond Interest Expense: $377,200; 2. Aug. Chapter 17
31. Bond Interest Expense: $382,200 P 1. No check figure
P 4. June 30. Bond Interest Expense: $289,332; Sept. 1. P 2. Increase: a, b, e, f, l, m
Bond Interest Expense: $186,580 P 3. 1.c. Receivable turnover, 20x8: 14.1 times; 20x7: 14.4
P 5. 2. Loss on early retirement: $2,261,504 times; 1.e. Inventory turnover, 20x8: 3.6 times; 20x7:
P 6 1. d. Interest expense: $374,400; 2. d. Interest 3.5 times
Expense: $385,600 P 4. 1.b. Quick ratio, Lewis: 1.5 times; Ramsey: 1.2 times;
P 7. 1. Nov. 30. Bond Interest Expense: $1,040,300; 2.d. Return on equity, Lewis: 8.8%; Ramsey: 4.9%
2. Nov. 30. Bond Interest Expense: $1,057,300 P 5. Increase: d, h, i
P 8. June 30. Bond Interest Expense: $93,195; Sept. 30. P 6. 1.a. Current ratio, 20x8: 1.5 times; 20x7: 1.5 times;
Bond Interest Expense: $191,900 2.c. Return on assets, 20x8: 5.0%; 20x7: 10.7%

Chapter 14 Chapter 18
P 1. 2. Difference in net income: $97,600 P 1. No check figure
P 2. 1. Income before extraordinary items: $216,000 P 2. Projected Cost per Unit: $22.25
P 3. 1. Income from continuing operations, December P 3. No check figure
31, 20x9: $157,500 P 4. 2. Molding, Week 4, Second shift: 23.53%
P 4. 2. Total stockholders’ equity, December 31, 20x8: P 5. Total traffic flow goal, 24,182
$2,964,000 P 6. No check figure
 Check Figures
| xxxi

P 7. 2. Decrease in number of rejects: 202 Chapter 23

P 8. Average output, week eight: 92,899 P 1. 1. Total manufacturing costs budgeted, November:
$1,157,000
Chapter 19 P 2. 8. Income from operations: $3,086
P 1. Cost of goods manufactured: $10,163,200 P 3. 1. Ending cash balance, February: $6,000
P 2. 2a. Gross Margin: $191,800; 2d. Cost of Goods Man- P 4. Ending cash balance, February: $17,660
ufactured: $312,100 P 5. 1. Net income: $101,812
P 3. 2. Total unit cost: $13.72 P 6. 7. Manufactured cost per unit: $0.34
P 4. 2. Overhead applied to Job 2214: $29,717 P 7. 1. Ending cash balance, February: $19,555
P 5. 2. Total costs assigned to the Grater order, activity- P 8. 1. Net income: $52,404
based costing method: $69,280.40
P 6. 1. Predetermined overhead rate for 20x9: $5.014 per Chapter 24
machine hour P 1. 1. Flexible Budget, Total Cost: $7,248,000
P 7. 2. Total costs assigned to the Kent order, activity- P 2. 2. Operating Income: $194,782
based costing method: $41,805.60 P 3. 1. Flexible Budget, Contribution margin: $88,200
P 8 1c. Rigger II: $11,665; BioScout: $14,940 P 4. 3. Economic value added for 20x8: $21,850
P 5. 1. Residual income: ($2,500)
Chapter 20 P 6. 2. Operating Income: $418,555
P 1. b. $66,500; i. $57,800 P 7. 3a. Actual Return on Investment: 6.30%
P 2. 1. Overhead applied, January 15: $108,000 P 8. 3. Economic value added: $126,000
P 3. 3. Costs of units sold: $182,857
P 4. 1. Cost per equivalent unit: $6.05; Ending inventory: Chapter 25
$7,225 P 1. Total standard unit cost of front entrance: $8,510
P 5. 1. Cost per equivalent unit: $2.00; Ending inventory: P 2. 2. Flexible budget formula: Total Budgeted Costs =
$5,372 ($.35 x Units Produced) + $10,500
P 6. 2. Cost of units sold: $89,647 P 3. 1. Direct materials price variance-Metal: $832 (F);
P 7. 1. Contract revenue, Job Order No. P-12: $28,990 2. Direct labor rate variance-Molding: $510 (F)
P 8. 1. Cost per equivalent unit: $7.00; Ending inventory: P 4. 1.b. Direct materials quantity variance: $3,720 (U);
$37,200 1.h. Fixed overhead volume variance: $320 (F)
P 5. a. Actual variable overhead: $42,500
Chapter 21 P 6. 1. Total standard direct materials cost per unit:
P 1. No check figure $167.52
P 2. 1. Product unit cost: $270.00; 4. Product unit cost: P 7. 1. Direct materials price variance-Liquid Plastic:
$280.47 $386 (F); 2. Direct labor rate variance-
P 3. 1a. Total materials handling cost rate: 30% per dollar Trimming/Packing: $56 (U)
of direct materials P 8. 1.a. Direct materials price variance-Chemicals:
P 4. 3. Total direct cost, toy car work cell: $17,000 $12,200 (F); 1.e. Variable overhead spending
P 5. 3. Cost of goods sold: $564,400 variance: $100 (U)
P 6. 1. Product unit cost: $878.25
P 7. 3. Product unit cost: $10.43 Chapter 26
P 8. 3. Cost of goods sold: $391,520 P 1. 3. Operating income from further processing, bagel
sandwiches: $.50
Chapter 22 P 2. 1. Segment margin for Book X: $223,560
P 1. 4. Cost per Job: $81.56 P 3. 2. $68.20
P 2. 1. 7,500 Billable Hours P 4. 1. Net present value: $99,672
P 3. 1.a. 3,500 Units P 5. 1. HTZ Machine: 13.4 %; 2. XJS Machine: 5.5 years
P 4. 2. 190,000 Units P 6. 1. Total cost to buy: $1,293,750
P 5. 3. $805.23 per Job (rounded) P 7. 1. Contribution margin per hour for phone calls:
P 6. 1. 740 Systems $130
P 7. 1.a. 7,900 Units P 8. 1.a. Net present value: ($26,895)
P 8. 2. 418 Loans
About the Authors

Central to the success of any accounting text is the expertise of its author team.
This team brings to the text a wealth of classroom teaching experience, rele-
vant business insight, and pedagogical expertise, as well as first-hand knowl-
edge of today’s students.

Belverd E. Needles, Jr., Ph.D., C.P.A., C.M.A.

DePaul University
During his more than 30 years of teaching beginning accounting students,
Belverd Needles has been an acknowledged innovator in accounting educa-
tion. He has won teaching and education awards from DePaul University, the
American Accounting Association, the Illinois CPA Society, the American Insti-
tute of CPAs, and the national honorary society, Beta Alpha Psi. The Conference
on Accounting Education, started by Dr. Needles and sponsored by Houghton
Mifflin, has been in existence for over 20 years and has helped more than 2,000
accounting instructors improve their teaching. Dr. Needles is editor of the
Accounting Instructors’ Report, a newsletter that thousands of accounting teachers
rely on for new ideas in accounting education.

Marian Powers, Ph.D.

Northwestern University
In the course of more than 25 years, Marian Powers has taught beginning
accounting at every level, from large lecture halls of 250 students to small
classes of graduate students. She is a dynamic teacher who incorporates a vari-
ety of instructional strategies designed to broaden students’ skills and experi-
ences in critical thinking, group interaction, and communication. Dr. Powers con-
sistently receives the highest rating from students. She brings practical
experience to her students, including examples of how managers in all levels of
business use and evaluate financial information. In recent years, Dr. Powers has
concentrated on executive education. She has taught thousands of executives
from leading companies around the world how to read and analyze the financial
statements of their own companies and those of their competitors.

Susan V. Crosson, M.S., C.P.A.

Santa Fe Community College, (Florida)
With more than 25 years of teaching experience at the college and university
level, Susan Crosson is recognized for her pedagogical expertise in teaching
managerial accounting. She has a reputation for being able to engage university
students in very large course sections and for encouraging community college
students to master accounting. She believes in integrating technology into
accounting education and actively uses the Internet to teach online, on-campus,
and blended courses. Professor Crosson continues to promote the improve-
ment of accounting education by serving the American Accounting Association
and the Florida Institute of CPAs on a variety of committees, task forces, and
sections. She is a past recipient of an IMA Faculty Development Grant to blend
technology into the classroom, the Florida Association of Community Colleges
Professor of the Year Award for Instructional Excellence, and the University of
Oklahoma’s Halliburton Education Award for Excellence.
xxxii
Principles of
Accounting
 1
C H A P T E R

Uses of Accounting
Information and the
Financial Statements

T oday, more people than ever before recognize the importance of

accounting information and the profound effect that unethical and
misleading financial reports can have on a business, its owners, its
employees, its lenders, and the financial markets. In this chapter, we dis-
cuss the importance of ethical financial reporting, the uses and users of
accounting information, and the financial statements that accountants
prepare. We end the chapter with a discussion of generally accepted
accounting principles.

LEARNING OBJECTIVES

Mak ing a Statement LO1 Define accounting and describe its role in making informed decisions, identify
business goals and activities, and explain the importance of ethics in
Balance accounting.
Sheet
LO2 Identify the users of accounting information.
LO3 Explain the importance of business transactions, money measure, and
Statement of Income separate entity.
Cash Flows Statement
LO4 Identify the three basic forms of business organization.
LO5 Define financial position, and state the accounting equation.
Financial statements measure how well
the business is run.
LO6 Identify the four basic financial statements.
LO7 Explain how generally accepted accounting principles (GAAP) relate to
financial statements and the independent CPA’s report, and identify the
organizations that influence GAAP.

2
DECISION POINT
A USER’S FOCUS C V S C O R P O R AT I O N

● Is CVS meeting its goal of

profitability?
● As a manager at CVS, what
financial knowledge would
you need to measure
progress toward the
company’s goals?
● As a potential investor or
creditor, what financial
knowledge would you need
to evaluate CVS’s financial
performance?

CVS operates a nationwide chain of more than 5,000 drugstores. Having

opened more than 1,300 new stores in the last five years, the company has
increased sales and profits by more than 50 percent.This performance places
it among the fastest-growing retail companies.
Why is CVS considered successful? Customers give the company high
marks because of the quality of the products that it sells and the large selec-
tion and good service that its stores offer. Investment firms and others with a
stake in CVS evaluate the company’s success in financial terms.
Whether a company is large or small, the same financial measures are
used to evaluate its management and to compare it with other companies. In
this chapter, as you learn more about accounting and the business environ-
ment, you will become familiar with these financial measures.
4
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

Accounting as an Information System

LO1 Define accounting and describe its role in making informed decisions,
identify business goals and activities, and explain the importance of
ethics in accounting.

A ccounting is an information system that measures, processes, and com-

municates financial information about an economic entity.1 An economic
entity is a unit that exists independently, such as a business, a hospital,
or a governmental body. Although the central focus of this book is on business
entities, we include other economic units at appropriate points in the text and
end-of-chapter assignments.
Accountants focus on the needs of decision makers who use financial infor-
mation, whether those decision makers are inside or outside a business or
other economic entity. Accountants provide a vital service by supplying the
information decision makers need to make “reasoned choices among alterna-
tive uses of scarce resources in the conduct of business and economic activi-
ties.”2 As shown in Figure 1, accounting is a link between business activities
and decision makers.
1. Accounting measures business activities by recording data about them for
future use.
2. The data are stored until needed and then processed to become useful
information.
3. The information is communicated through reports to decision makers.

■ FIGURE 1
Accounting as an Information System

BUSINESS ACTIVITIES DECISION MAKERS

Actions

Purchase
Order

Data Information

ACCOUNTING

MEASUREMENT PROCESSING COMMUNICATION

SALES INVOICE

ANNUAL
FINANCIAL
REPORT
$5,200
 Accounting as an Information System
| 5

■ FIGURE 2
Business Goals and Activities
BUSINESS GOALS BUSINESS ACTIVITIES

FIRST BANK

PROFITABILITY FINANCING OPERATING

TITLE
DEED

LIQUIDITY INVESTING

In other words, data about business activities are the input to the accounting
system, and useful information for decision makers is the output.

Business Goals, Activities, and Performance

Measures
A business is an economic unit that aims to sell goods and services to cus-
tomers at prices that will provide an adequate return to its owners. The list that
follows contains the names of some well-known businesses and the principal
goods or services that they sell.
Wal-Mart Corp. Comprehensive discount store
Reebok International Ltd. Athletic footwear and clothing
Best Buy Co. Consumer electronics, personal computers
Wendy’s International Inc. Food service
Starbucks Corp. Coffee
Southwest Airlines Co. Passenger airline
Despite their differences, these businesses have similar goals and engage in
Multiple financial goals, namely
similar activities, as shown in Figure 2.
profitability and liquidity, signal The two major goals of all businesses are profitability and liquidity.
that more than one measure of 쏡 Profitability is the ability to earn enough income to attract and hold invest-
performance is of interest to users
ment capital.
of accounting information. For
example, lenders are concerned 쏡 Liquidity is the ability to have enough cash to pay debts when they are due.
primarily with cash flow, and
owners are concerned with For example, Toyota may meet the goal of profitability by selling many cars at
earnings and withdrawals. a price that earns a profit, but if its customers do not pay for their cars quickly
enough to enable Toyota to pay its suppliers and employees, the company
6
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

FOCUS ON BUSINESS PRACTICE

What Does CVS Have to Say About Itself?
In its annual report, CVS’s management describes the com-
pany’s progress in meeting the major business objectives: FINANCING: OPERATING:
Obtains Funds from Sells Products and
Liquidity: “We anticipate that our cash flow from opera- — Stockholders Services Through
tions, supplemented by short-term commercial paper — Investors More Than 5,000
— Banks and Drugstores and
and long-term debt borrowings, will continue to fund Other Creditors Pharmacies
the future growth of our business.”
Profitability: “Pharmacy sales growth continued to ben- INVESTING:
efit from new market expansions, increased penetra- Invests Funds in
— Furniture, Fixtures
tion in existing markets, . . . and favorable industry and Equipment
— Improvements
trends. . . .Net earnings increased $305.9 million or to Buildings
33.3% to over $1.2 billion . . . in 2005.”3 — Computer
Equipment

CVS’s main business activities are shown at the right.

may fail to meet the goal of liquidity. If a company is to survive and be suc-
cessful, it must meet both goals.
All businesses pursue their goals by engaging in operating, investing, and
financing activities.
쏡 Operating activities include selling goods and services to customers, employ-
ing managers and workers, buying and producing goods and services, and
paying taxes.
쏡 Investing activities involve spending the capital a company receives in pro-
ductive ways that will help it achieve its objectives. These activities include
buying land, buildings, equipment, and other resources that are needed to
operate the business and selling them when they are no longer needed.
쏡 Financing activities involve obtaining adequate funds, or capital, to begin
operations and to continue operating. These activities include obtaining
capital from creditors, such as banks and suppliers, and from owners. They
also include repaying creditors and paying a return to the owners.
An important function of accounting is to provide performance measures,
which indicate whether managers are achieving their business goals and
whether the business activities are well managed. These performance meas-
ures must align with the goals of the business. For example, CVS, like all other
companies, considers earned income to be a measure of profitability and cash
flow to be a measure of liquidity.
Ratios of accounting measures are also used as performance measures. For
instance, a performance measure for operating activities might be the ratio of

FOCUS ON BUSINESS PRACTICE

Cash Bonuses Depend on Accounting Numbers!
Nearly all businesses use the amounts reported in their sures, selecting measures that are not easily manipulated is
financial statements as a basis for rewarding management. important. Equally important is maintaining a balance of
Because managers act to achieve these accounting mea- measures that reflect the goals of profitability and liquidity.4
 Accounting as an Information System
| 7

expenses to the revenue of the business. A performance measure for financing

activities might be the ratio of money owed by the company to the total
resources that it controls. Because managers are usually evaluated on whether
targeted levels of specific performance measures are achieved, they must
have a knowledge of accounting to understand how they are evaluated and
how they can improve their performance. In addition, because managers will
act to achieve targeted performance measures, these measures must be
crafted in a way that motivates them to act in the best interests of the owners
of the business.

Financial and Management Accounting

Accounting’s role of assisting decision makers by measuring, processing, and
communicating financial information is usually divided into the categories of
management accounting and financial accounting. Although the functions of
management accounting and financial accounting overlap, the two can be dis-
tinguished by the principal users of the information they provide.
Management accounting provides internal decision makers who are
charged with achieving the goals of profitability and liquidity with information
about operating, investing, and financing activities. Managers and employees
who conduct the activities of the business need information that tells them
how they have done in the past and what they can expect in the future. For
example, The Gap, a retail clothing business, needs an operating report on
each outlet that tells how much was sold at that outlet and what costs were
incurred, and it needs a budget for each outlet that projects the sales and costs
for the next year.
Financial accounting generates reports and communicates them to external
decision makers so they can evaluate how well the business has achieved its
goals. These reports are called financial statements. CVS, whose stock is
traded on the New York Stock Exchange, sends its financial statements to its
owners (called stockholders), its banks and other creditors, and government reg-
ulators. Financial statements report directly on the goals of profitability and
liquidity and are used extensively both inside and outside a business to eval-
uate the business’s success. It is important for every person involved with a
business to understand financial statements. They are a central feature of
accounting and a primary focus of this book.

Processing Accounting Information

It is important to distinguish accounting from the ways in which accounting
information is processed by bookkeeping, computers, and management infor-
mation systems.
Accounting includes the design of an information system that meets users’
needs, and its major goals are the analysis, interpretation, and use of informa-
tion. Bookkeeping , on the other hand, is mechanical and repetitive; it is the
process of recording financial transactions and keeping financial records. It is a
small—but important—part of accounting.
Today, computers collect, organize, and communicate vast amounts of
information with great speed. Computers can perform both routine bookkeep-
ing chores and complex calculations. Accountants were among the earliest and
most enthusiastic users of computers, and today they use computers in all
aspects of their work.
8
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

FOCUS ON BUSINESS PRACTICE

How Did Accounting Develop?
Accounting is a very old discipline. Forms of it have been famous Italian mathematician, scholar, and philosopher Fra
essential to commerce for more than five thousand years. Luca Pacioli. In 1494, Pacioli published his most important
Accounting, in a version close to what we know today, work, Summa de Arithmetica, Geometrica, Proportioni et Pro-
gained widespread use in the 1400s, especially in Italy, portionalita, which contained a detailed description of
where it was instrumental in the development of shipping, accounting as practiced in that age. This book became the
trade, construction, and other forms of commerce. This sys- most widely read book on mathematics in Italy and firmly
tem of double-entry bookkeeping was documented by the established Pacioli as the “Father of Accounting.”

Computers make it possible to create a management information system

to organize a business’s many information needs. A management information
system (MIS) consists of the interconnected subsystems that provide the infor-
Computerized accounting mation needed to run a business. The accounting information system is the
information is only as reliable and most important subsystem because it plays the key role of managing the flow
useful as the data that go into the of economic data to all parts of a business and to interested parties outside
system.The accountant must have
the business.
a thorough understanding of the
concepts that underlie accounting
to ensure the data’s reliability and
usefulness. Ethical Financial Reporting
Ethics is a code of conduct that applies to everyday life. It addresses the ques-
tion of whether actions are right or wrong. Actions—whether ethical or unethi-
cal, right or wrong—are the product of individual decisions. Thus, when an
organization acts unethically by using false advertising, cheating customers,
polluting the environment, or treating employees unfairly, it is not the organi-
zation that is responsible—it is the members of management and other
employees who have made a conscious decision to act in this manner.
Ethics is especially important in preparing financial reports because users
of these reports must depend on the good faith of the people involved in their
preparation. Users have no other assurance that the reports are accurate and
fully disclose all relevant facts.
The intentional preparation of misleading financial statements is called
fraudulent financial reporting.5 It can result from the distortion of records
(e.g., the manipulation of inventory records), falsified transactions (e.g., ficti-
tious sales), or the misapplication of various accounting principles. There are a
number of motives for fraudulent reporting—for instance, to cover up financial
weakness to obtain a higher price when a company is sold, to meet the expec-
tations of investors, owners, and financial analysts, or to obtain a loan. The
incentive can also be personal gain, such as additional compensation, promo-
tion, or avoidance of penalties for poor performance.
Whatever the motive for fraudulent financial reporting, it can have dire
consequences, as the accounting scandals that erupted at Enron Corporation
and WorldCom in 2001 and 2002 attest. Unethical financial reporting and
accounting practices at those two major corporations caused thousands of peo-
ple to lose their jobs, their investment incomes, and their pensions. They also
resulted in prison sentences and fines for the corporate executives who were
involved.
In 2002, Congress passed the Sarbanes-Oxley Act to regulate financial
reporting and the accounting profession among other things. This legislation
 Accounting as an Information System
| 9

In the wake of one of the largest

accounting scandals in history, current
and former members of Enron’s board
of directors John Duncan (left), Her-
bert Winokur (center), and Norman
Blake listen to opening remarks at a
hearing of the Senate Permanent Sub-
committee on Investigations, May 7,
2002. Unethical accounting practices
at Enron led to the collapse of the
company and the loss of thousands of
jobs and pensions.

ordered the Securities and Exchange Commission (SEC) to draw up rules

requiring the chief executives and chief financial officers of all publicly traded
U.S. companies to swear that, based on their knowledge, the quarterly state-
ments and annual reports that their companies file with the SEC are accurate
and complete. Violation can result in criminal penalties.
A company’s management expresses its duty to ensure that financial
reports are not false or misleading in the management report that appears in
the company’s annual report. For example, CVS’s management report contains
the following statement:
We are responsible for establishing and maintaining effective internal
control over financial reporting. . . .Based on our evaluation, we conclude
our Company’s internal control . . . provides reasonable assurance that
assets are safeguarded and that the financial records are reliable for
preparing financial statements.6
However, it is accountants, not management, who physically prepare and
audit financial reports. To meet the high ethical standards of the accounting
profession, they must apply accounting concepts in such a way as to present a
fair view of a company’s operations and financial position and to avoid mis-
leading readers of their reports. Like the conduct of a company, the ethical
conduct of a profession is a collection of individual actions. As a member of a
profession, each accountant has a responsibility—not only to the profession,
but also to employers, clients, and society as a whole—to ensure that any
report he or she prepares or audits provides accurate, reliable information.
The high regard that the public has historically had for the accounting pro-
fession is evidence that an overwhelming number of accountants have upheld
the ethics of the profession. Even as the Enron and WorldCom scandals were
making headlines, a Gallup Poll showed an increase of 14 percent in the
accounting profession’s reputation between 2001 and 2002—larger than the
increase for any other profession and one that placed it among the most highly
rated.7
Accountants and top managers are, of course, not the only people respon-
sible for ethical financial reporting. Managers and employees at all levels must
be conscious of their responsibility for providing accurate financial information
to the people who rely on it.
10
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

S T O P • R E V I E W • A P P L Y
1-1. Why is accounting considered an information system?
1-2. What is the role of accounting in the decision-making process, and what
broad business goals and activities does it help management achieve
and manage?
1-3. Distinguish between management accounting and financial accounting.
1-4. Distinguish among these terms: accounting, bookkeeping, and management
information systems.
1-5. What is the difference between misstated financial statements and
fraudulent financial reporting?
Suggested answers to all Stop, Review, and Apply questions are available at
http://college.hmco.com/accounting/needles/poa/10e/student_home.html.

Decision Makers: The Users of Accounting Information

LO2 Identify the users of accounting information.

A s shown in Figure 3, the people who use accounting information to make

decisions fall into three categories:

1. Those who manage a business

2. Those outside a business enterprise who have a direct financial interest in
the business
3. Those who have an indirect financial interest in a business
These categories apply to governmental and not-for-profit organizations as
well as to profit-oriented ventures.

Management
Management refers to the people who are responsible for operating a busi-
ness and meeting its goals of profitability and liquidity. In a small business,
management may consist solely of the owners. In a large business, manage-
Managers are internal users of ment usually consists of people who have been hired to do the job. Managers
accounting information. must decide what to do, how to do it, and whether the results match their orig-
inal plans. Successful managers consistently make the right decisions based on
timely and valid information. To make good decisions, managers at CVS and
other companies need answers to such questions as:
쏡 What were the company’s earnings during the past quarter?
쏡 Is the rate of return to the owners adequate?
쏡 Does the company have enough cash?
쏡 Which products or services are most profitable?
쏡 What is the cost of manufacturing each product or providing each service?
 Decision Makers: The Users of Accounting Information
| 11

■ FIGURE 3
The Users of Accounting Information

DECISION MAKERS

MANAGEMENT THOSE WITH DIRECT THOSE WITH INDIRECT

FINANCIAL INTEREST FINANCIAL INTEREST
Finance
Investment Investors Tax Authorities
Operations and Creditors Regulatory Agencies
Production Labor Unions
Marketing Customers
Human Resources Economic Planners
Information Systems
Accounting

Because so many key decisions are based on accounting data, management is

one of the most important users of accounting information.
In its decision-making process, management performs functions that are
essential to the operation of a business. Although large businesses have more
elaborate operations than small ones, the same basic functions must be per-
formed, and each requires accounting information on which to base decisions.
The basic management functions are:
Financing the business—obtaining funds so that a company can begin and
continue operating
Investing resources—investing assets in productive ways that support a
company’s goals
Producing goods and services—managing the production of goods and
services
Marketing goods and services—overseeing how goods or services are
advertised, sold, and distributed
Managing employees—overseeing the hiring, evaluation, and compensa-
tion of employees
Providing information to decision makers—gathering data about all
aspects of a company’s operations, organizing the data into usable infor-
mation, and providing reports to managers and appropriate outside par-
ties. Accounting plays a key role in this function.

FOCUS ON BUSINESS PRACTICE

What Do CFOs Do?
According to a recent survey, the chief financial officer many of them are becoming CEOs of their companies.
(CFO) is the “new business partner of the chief executive Those who do become CEOs are finding that “a financial
officer” (CEO). CFOs are increasingly required to take on background is invaluable when they’re saddled with the
responsibilities for strategic planning, mergers and acquisi- responsibility of making big calls.”8
tions, and tasks involving international operations, and
12
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

Users with a Direct Financial Interest

Another group of decision makers who need accounting information are those
with a direct financial interest in a business. They depend on accounting to
measure and report information about how a business has performed. Most
The primary external users of businesses periodically publish a set of general-purpose financial statements
accounting information are that report their success in meeting the goals of profitability and liquidity.
investors and creditors. These statements show what has happened in the past, and they are important
indicators of what will happen in the future. Many people outside the company
carefully study these financial reports. The two most important groups are
investors (including owners) and creditors.

Investors Those, such as CVS’s stockholders, who may invest in a business

and acquire a part ownership in it are interested in its past success and its
potential earnings. A thorough study of a company’s financial statements helps
potential investors judge the prospects for a profitable investment. After
investing, they must continually review their commitment, again by examining
the company’s financial statements.

Creditors Most companies, including CVS, borrow money for both long-
and short-term operating needs. Creditors, those who lend money or deliver
goods and services before being paid, are interested mainly in whether a com-
pany will have the cash to pay interest charges and to repay the debt at the
appropriate time. They study a company’s liquidity and cash flow as well as its
profitability. Banks, finance companies, mortgage companies, securities firms,
insurance firms, suppliers, and other lenders must analyze a company’s finan-
cial position before they make a loan.

Users with an Indirect Financial Interest

In recent years, society as a whole, through governmental and public groups,
has become one of the largest and most important users of accounting infor-
mation. Users who need accounting information to make decisions on public
issues include tax authorities, regulatory agencies, and various other groups.

Tax Authorities Government at every level is financed through the col-

lection of taxes. Companies and individuals pay many kinds of taxes, including
federal, state, and city income taxes; social security and other payroll taxes;
excise taxes; and sales taxes. Each tax requires special tax returns and often a
complex set of records as well. Proper reporting is generally a matter of law and
can be very complicated. The Internal Revenue Code, for instance, contains
thousands of rules governing the preparation of the accounting information
used in computing federal income taxes.

Regulatory Agencies Most companies must report periodically to one

or more regulatory agencies at the federal, state, and local levels. For example,
all publicly traded corporations must report periodically to the Securities and
Exchange Commission (SEC). This body, set up by Congress to protect the
public, regulates the issuing, buying, and selling of stocks in the United States.
Companies listed on a stock exchange also must meet the special reporting
requirements of their exchange.

Other Groups Labor unions study the financial statements of corpora-

tions as part of preparing for contract negotiations; a company’s income and
costs often play an important role in these negotiations. Those who advise
 Accounting Measurement
| 13

investors and creditors—financial analysts, brokers, underwriters, lawyers,

economists, and the financial press—also have an indirect interest in the finan-
cial performance and prospects of a business. Consumer groups, customers,
and the general public have become more concerned about the financing and
earnings of corporations as well as the effects that corporations have on infla-
tion, the environment, social issues, and the quality of life. And economic plan-
ners, among them the President’s Council of Economic Advisers and the Fed-
eral Reserve Board, use aggregated accounting information to set and evaluate
economic policies and programs.

Governmental and Not-for-Profit Organizations

More than 30 percent of the U.S. economy is generated by governmental and
not-for-profit organizations (hospitals, universities, professional organizations,
and charities). The managers of these diverse entities perform the same func-
tions as managers of businesses, and they therefore have the same need for
accounting information and a knowledge of how to use it. Their functions
include raising funds from investors (including owners), creditors, taxpayers,
and donors, and deploying scarce resources. They must also plan how to pay for
operations and to repay creditors on a timely basis. In addition, they have an
obligation to report their financial performance to legislators, boards, and
donors, as well as to deal with tax authorities, regulators, and labor unions.
Although most of the examples in this text focus on business enterprises, the
same basic principles apply to governmental and not-for-profit organizations.

S T O P • R E V I E W • A P P L Y
2-1. Who are the decision makers that use accounting information?
2-2. A business is an economic unit whose goal is to sell goods or services at
prices that will provide an adequate return to its owners. What func-
tions must management perform to achieve this goal?
2-3. Why are investors (and owners) and creditors interested in reviewing a
company’s financial statements?
2-4. Among the users of accounting information are people and organiza-
tions with an indirect interest in business entities. Briefly identify these
people and organizations.
2-5. Why has society as a whole become one of the largest users of account-
ing information?

Accounting Measurement
LO3 Explain the importance of business transactions, money measure, and
separate entity.

I n this section, we begin the study of the measurement aspects of account-

ing—that is, what accounting actually measures. To make an accounting
measurement, the accountant must answer four basic questions:
1. What is measured?
14
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

2. When should the measurement be made?

3. What value should be placed on what is measured?
4. How should what is measured be classified?
Accountants in industry, professional associations, public accounting, govern-
ment, and academic circles debate the answers to these questions constantly,
and the answers change as new knowledge and practice require. But the basis
of today’s accounting practice rests on a number of widely accepted concepts
and conventions, which are described in this book. We begin by focusing on
the first question: What is measured? We discuss the other three questions
(recognition, valuation, and classification) in the next chapter.
Every system must define what it measures, and accounting is no excep-
tion. Basically, financial accounting uses money to gauge the impact of busi-
ness transactions on separate business entities.

Business Transactions
Business transactions are economic events that affect a business’s financial
position. Businesses can have hundreds or even thousands of transactions
every day. These transactions are the raw material of accounting reports.
A transaction can be an exchange of value (a purchase, sale, payment, col-
lection, or loan) between two or more parties. A transaction also can be an eco-
nomic event that has the same effect as an exchange transaction but that does
not involve an exchange. Some examples of “nonexchange” transactions are
losses from fire, flood, explosion, and theft; physical wear and tear on machin-
ery and equipment; and the day-by-day accumulation of interest.
To be recorded, a transaction must relate directly to a business entity. Sup-
pose a customer buys toothpaste from CVS but has to buy shampoo from a
competing store because CVS is out of shampoo. The transaction in which the
toothpaste was sold is entered in CVS’s records. However, the purchase of the
shampoo from the competitor is not entered in CVS’s records because even
though it indirectly affects CVS economically, it does not involve a direct
exchange of value between CVS and the customer.

Money Measure
All business transactions are recorded in terms of money. This concept is
called money measure. Of course, nonfinancial information may also be
recorded, but it is through the recording of monetary amounts that a business’s
The common unit of measurement transactions and activities are measured. Money is the only factor common to
used in the United States for all business transactions, and thus it is the only unit of measure capable of pro-
financial reporting purposes is the
ducing financial data that can be compared.
dollar.
The monetary unit a business uses depends on the country in which the
business resides. For example, in the United States, the basic unit of money is
the dollar. In Japan, it is the yen; in Europe, the euro; and in the United King-
dom, the pound. In international transactions, exchange rates must be used to
translate from one currency to another. An exchange rate is the value of one
currency in terms of another. For example, a British person purchasing goods
from a U.S. company like CVS and paying in U.S. dollars must exchange British
pounds for U.S. dollars before making payment. In effect, currencies are goods
that can be bought and sold.
Table 1 illustrates the exchange rates for several currencies in dollars. It
shows the exchange rate for British pounds as $1.75 per pound on a particular
 The Forms of Business Organization
| 15

TABLE 1. Examples of Foreign Exchange Rates

Price Price
Country in $ U.S. Country in $U.S.
Australia (dollar) 0.73 Hong Kong (dollar) 0.13
Brazil (real) 0.47 Japan (yen) 0.008
Britain (pound) 1.75 Mexico (peso) 0.09
Canada (dollar) 0.87 Russia (ruble) 0.036
Europe (euro) 1.21 Singapore (dollar) 0.62

Source: The Wall Street Journal, April 17, 2006.

date. Like the prices of many goods, currency prices change daily according to
supply and demand. For example, a year earlier, the exchange rate for British
pounds was $1.88. Although our discussion in this book focuses on dollars,
some examples and assignments involve foreign currencies.

Separate Entity
For accounting purposes, a business is a separate entity, distinct not only from
its creditors and customers but also from its owners. It should have its own set
of financial records, and its records and reports should refer only to its own
For accounting purposes, a affairs.
business is always separate and
For example, Just Because Flowers Company should have a bank account
distinct from its owners, creditors,
and customers. Note, however, that
separate from the account of Holly Sapp, the owner. Holly Sapp may own a
there is a difference between home, a car, and other property, and she may have personal debts, but these
separate economic entity and are not the resources or debts of Just Because Flowers. Holly Sapp may own
separate legal entity. another business, say a stationery shop. If she does, she should have a com-
pletely separate set of records for each business.

S T O P • R E V I E W • A P P L Y
3-1. Use the terms business transactions, money measure, and separate entity in a sin-
gle sentence that demonstrates their relevance to financial accounting.
3-2. Suppose you buy a disposable camera from CVS. From CVS’s perspec-
tive, how would the terms business transactions, money measure, and separate
entity relate to your purchase?

The Forms of Business Organization

LO4 Identify the three basic forms of business organization.

T he three basic forms of business organization are the sole proprietorship,

the partnership, and the corporation. Accountants recognize each form as
an economic unit separate from its owners. Legally, however, only the cor-
poration is separate from its owners. Here, we point out the most important
features of each form of business.
16
| CHAPTER 1 Uses of Accounting Information and the Financial Statements

■ FIGURE 4
Number and Receipts of U.S. Proprietorships, Partnerships, and Corporations, 2004
NUMBER OF BUSINESSES

Proprietorships 19,710

Partnerships 2,375

Corporations 5,401

0 2 4 6 8 10 12 14 16 18 20 22 Millions

RECEIPTS OF BUSINESSES

Proprietorships $ 1,050

Partnerships 2,923

Corporations 20,690

$0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000 Billions

Source: U.S. Treasury Department, Internal Revenue Service, Statistics of Income Bulletin, Winter 2006.

A sole proprietorship is a business owned by one person.* The owner

takes all the profits or losses of the business and is liable for all its obligations.
As Figure 4 shows, sole proprietorships represent the largest number of busi-
nesses in the United States, but typically they are the smallest in terms of
receipts.
A partnership is like a sole proprietorship in most ways, but it has two or
more owners. The partners share the profits and losses of the business accord-
ing to a prearranged formula. Generally, any partner can obligate the business
A key disadvantage of a to another party, and the personal resources of each partner can be called on
partnership is the unlimited to pay the obligations. A partnership must be dissolved if the ownership
liability of its owners. Unlimited
changes, as when a partner leaves or dies. If the business is to continue as a
liability can be avoided by
organizing the business as a partnership after this occurs, a new partnership must be formed.
corporation or, in some states, by Both the sole proprietorship and the partnership are convenient ways of
forming what is known as a limited separating the owners’ commercial activities from their personal activities.
liability partnership (LLP). Legally, however, there is no economic separation between the owners and the
businesses. A corporation, on the other hand, is a business unit chartered by
the state and legally separate from its owners (the stockholders). The stock-
holders, whose ownership is represented by shares of stock, do not directly
control the corporation’s operations. Instead, they elect a board of directors to
run the corporation for their benefit. In exchange for their limited involvement
in the corporation’s operations, stockholders enjoy limited liability; that is,
their risk of loss is limited to the amount they paid for their shares. Thus, stock-
holders are often willing to invest in risky, but potentially profitable activities.
Also, because stockholders can sell their shares without dissolving the corpo-

*Accounting for a sole proprietorship is simpler than accounting for a partnership or corpo-
ration. For that reason, we focus on the sole proprietorship in the early part of this book. At
critical points, however, we call attention to the essential differences between accounting
for a sole proprietorship and accounting for a partnership or corporation.
 Financial Position and the Accounting Equation
| 17

Avalon International Breads in Detroit

is a partnership owned by Jackie Victor
and Ann Perrault. Because it is a part-
nership, the owners share the profits
and losses of the business, and their
personal resources can be called on to
pay the obligations of the business.

ration, the life of a corporation is unlimited and not subject to the whims or
health of a proprietor or a partner.

S T O P • R E V I E W • A P P L Y
4-1. How do sole proprietorships, partnerships, and corporations differ?
4-2. How is the owner of a sole proprietorship similar to an investor in a cor-
poration? How do the two differ?
4-3. What are the principal characteristics of a partnership?

Financial Position and the Accounting Equation

LO5 Define financial position, and state the accounting equation.

F inancial position refers to a company’s economic resources, such as cash,

inventory, and buildings, and the claims against those resources at a par-
ticular time. Another term for claims is equities.
Every company has two types of equities: creditors’ equities, such as bank
loans, and owner’s equity. The sum of these equities equals a company’s
resources:
Economic Resources
Creditors’ Equities  Owner’s Equity

FOCUS ON BUSINESS PRACTICE

Are Most Corporations Big or Small Businesses?
Most people think of corporations as large national or only about 15,000 have stock that is publicly bought and
global companies whose shares of stock are held by thou- sold.The vast majority of corporations are small businesses
sands of people and institutions. Indeed, corporations can privately held by a few stockholders. Illinois alone has more
be huge and have many stockholders. However, of the than 250,000 corporations. Thus, the study of corporations
approximately 4 million corporations in the United States, is just as relevant to small businesses as it is to large ones.
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 (This concludes the first lesson, during which the words and
significations of Variability, Variate, Array, and Median will have been
learnt.)
The second lesson is intended to give more precision to the idea
of an Array. The variates in any one of these strung loosely on a
cord, should be disposed at equal distances apart in front of an
equal number of compartments, like horses in the front of a row of
stalls (Fig. 4), and their tops joined. There will be one more side to
the row of stalls than there are horses, otherwise a side of one of
the extreme stalls would be wanting. Thus there are two ways of
indicating the position of a particular variate, either by its serial
number as ‘first,’ ‘second,’ ‘third,’ or so on, or by degrees like those
of a thermometer. In the latter case the sides of the stalls serve as
degrees, counting the first of them as 0°, making one more
graduation than the number of objects, as it should be. The
difference between these two methods has to be made clear, and
that while the serial position of the Median object is always the same
in any two Arrays whatever be the number of variates, the serial
position of their subdivisions cannot be the same, the ignored half
interval at either end varying in width according to the number of
variates, and becoming considerable when that number is small.
Lines of proportionate length will then be drawn on a blackboard,
and the limits of the Array will be also drawn, at a half interval from
either of its ends. The base is then to be divided centesimally.
Next join the tops of the lines with a smooth curve, and wipe out
everything except the curve, the Limit at either side, and the
Centesimally divided Base (Fig. 5). This figure forms a Scheme of
Distribution of Variates. Explain clearly that its shape is independent
of the number of Variates, so long as they are sufficiently numerous
to secure statistical constancy.
Show numerous schemes of variates of different kinds, and
remark on the prevalent family likeness between the bounding
curves. (Words and meanings learnt—Schemes of Distribution,
Centesimal graduation of base.)
 The third lesson passes from Variates, measured upwards from
the base, to Deviates measured upwards or downwards from the
Median, and treated as positive or negative values accordingly (Fig.
6).
Draw a Scheme of Variates on the blackboard, and show that it
consists of two parts; the median which represents a constant, and
the curve which represents the variations from it. Draw a horizontal
line from limit to limit, through the top of the Median to serve as
Axis to the Curve. Divide the Axis centesimally, and wipe out
everything except Curve, Axis, and Limits. This forms a Scheme of
Distribution of Deviates. Draw ordinates from the axis to the curve at
the 25th and 75th divisions. These are the ‘Quartile’ deviates.
At this stage the Genesis of the theoretical Normal curve might be
briefly explained and the generality of its application; also some of
its beautiful properties of reproduction. Many of the diagrams
already shown would be again employed to show the prevalence of
approximately normal distributions. Exceptions of strongly marked
Skew curves would be exhibited and their genesis briefly described.
It will then be explained that while the ordinate at any specified
centesimal division in two normal curves of deviation measures their
relative variability, the Quartile is commonly employed as the unit of
variability under the almost grotesque name of ‘Probable Error,’
which is intended to signify that the length of any Deviate in the
system is as likely as not to exceed or to fall short of it. This, by
construction, is the case of either Quartile.
(New words and meanings—Scheme of Distribution of Deviates,
Axis, Normal, Skew, Quartile, and Probable Error.)
In the fourth lesson it has to be explained that the Curve of
Normal Distribution is not a direct result of calculation, neither does
the formula that expresses it lend itself so freely to further
calculation, as the curve of Frequency. Their shapes differ; the first
is an Ogive, the second (Fig. 7) is Bell-shaped. In the curve of
Frequency the Deviations are reckoned from the Mean of all the
Variates, and not from the Median. Mean and Median are the same
in Normal Curves, but may differ much in others. Either of these
normal curves can be transformed into the other, as is best
exemplified by using a Polygon (Fig. 8) instead of the Curve,
consisting of a series of rectangles differing in height by the same
amounts, but having widths respectively representative of the
frequencies of 1, 3, 3, 1. (This is one of those known as a Binomial
series, whose genesis might be briefly explained.) If these rectangles
are arrayed in order of their widths, side by side, they become the
equivalents of the ogival curve of Distribution. Now if each of these
latter rectangles be slid parallel to itself up to either limit, their bases
will overlap and they become equivalent to the bell-shaped curve of
Frequency with its base vertical.
The curve of Frequency contains no easily perceived unit of
variability like the Quartile of the Curve of Distribution. It is therefore
not suited for and was not used as a first illustration, but the formula
that expresses it is by far the more suitable of the two for
calculation. Its unit of variability is what is called the ‘Standard
Deviation,’ whose genesis will admit of illustration. How the
calculations are made for finding its value is far beyond the reach of
the present lessons. The calculated ordinates of the normal curve
must be accepted by the learner much as the time of day by his
watch, though he be ignorant of the principles of its construction.
Much further beyond his reach are the formulae used to express
quasi-normal and skew curves. They require a previous knowledge
of rather advanced mathematics.
(New words and ideas—Curve of Frequency, Standard Deviation,
Mean, Binomial Series).
The fifth and last lesson deals with the measurement of
Correlation, that is, with the closeness of the relation between any
two systems whose variations are due partly to causes common to
both, and partly to causes special to each. It applies to nearly every
social relation, as to environment and health, social position and
fertility, the kinship of parent to child, of uncle to nephew, &c. It may
be mechanically illustrated by the movements of two pulleys with
weights attached, suspended from a cord held by one of the hands
of three different persons, 1, 2, and 3. No. 2 holds the middle of the
cord, one half of which then passes round one of the pulleys up to
the hand of No. 1; the other half similarly round the other pulley up
to the hand of No. 3. The hands of Nos. 1, 2, and 3 move up and
down quite independently, but as the movements of both weights
are simultaneously controlled in part by No. 2, they become
‘correlated.’
The formation of a table of correlations on paper ruled in squares,
is easily explained on the blackboard (Fig. 9). The pairs of correlated
values A and B have to be expressed in units of their respective
variabilities. They are then sorted into the squares of the paper,—
vertically according to the magnitudes of A, horizontally according to
those of B—, and the Mean of each partial array of B values,
corresponding to each grade of A, has to be determined. It is found
theoretically that where variability is normal, the Means of B lie
practically in a straight line on the face of the Table, and observation
shows they do so in most other cases. It follows that the average
deviation of a B value bears a constant ratio to the deviation of the
corresponding A value. This ratio is called the ‘Index of Correlation,’
and is expressed by a single figure. For example: if the thigh-bone of
many persons deviate ‘very much’ from the usual length of the
thigh-bones of their race, the average of the lengths of the
corresponding arm-bones will differ ‘much,’ but not ‘very much,’ from
the usual length of arm-bones, and the ratio between this ‘very
much’ and ‘much’ is constant and in the same direction, whatever be
the numerical value attached to the word ‘very much.’ Lastly, the
trustworthiness of the Index of Correlation, when applied to
individual cases, is readily calculable. When the closeness of
correlation is absolute, it is expressed by the number 1·0; and by
0·0, when the correlation is nil.
(New words and ideas—Correlation and Index of Correlation.)
This concludes what I have to say on these suggested Object
lessons. It will have been tedious to follow in its necessarily much
compressed form,—but will serve, I trust, to convey its main purpose
of showing that a very brief course of lessons, copiously illustrated
by diagrams and objects to handle, would give an acceptable
introduction to the newer methods employed in Biometry and in
Eugenics. Further, that when read leisurely by experts in its printed
form, it would give them sufficient guidance for elaborating details.

Influence of Collective Truths upon Individual Conduct.

We have thus far been concerned with Probability, determined by
methods that take cognizance of Variations, and yield exact results,
thereby affording a solid foundation for action. But the stage on
which human action takes place is a superstructure into which
emotion enters, we are guided on it less by Certainties and by
Probabilities than by Assurance to a greater or lesser degree. The
word Assurance is derived from sure, which itself is an abbreviation
of secure, that is of se- cura, or without misgiving. It is a contented
attitude of mind largely dependent on custom, prejudice, or other
unreasonable influences which reformers have to overcome, and
some of which they are apt to utilize on their own behalf. Human
nature is such that we rarely find our way by the pure light of
reason, but while peering through spectacles furnished with coloured
and distorting glasses.
Locke seems to confound certainty with assurance in his forcible
description of the way in which men are guided in their daily affairs
(Human Understanding, iv. 14, par. 1):
Man would be at a great loss if he had nothing to direct him but what has the
certainty of true knowledge. For that being very short and scanty, he would be
often utterly in the dark, and in most of the actions of his life, perfectly at a stand,
had he nothing to guide him in the absence of clear and certain knowledge. He
that will not eat till he has demonstration that it will nourish him, he that will not
stir till he infallibly knows the business he goes about will succeed, will have little
else to do than to sit still and perish.
A society may be considered as a highly complex organism, with a
consciousness of its own, caring only for itself, establishing
regulations and customs for its collective advantage, and creating a
code of opinions to subserve that end. It is hard to over-rate its
power over the individual in regard to any obvious particular on
which it emphatically insists. I trust in some future time that one of
those particulars will be the practice of Eugenics. Otherwise the
influence of collective truths on individual conduct is deplorably
weak, as expressed by the lines:—
For others’ follies teach us not,
Nor much their wisdom teaches,
But chief of solid worth is what
Our own experience preaches.

Professor Westermarck, among many other remarks in which I

fully concur, has aptly stated (Sociological Papers, published for the
Sociological Society. Macmillan, 1906, vol. ii., p. 24), with reference
to one obstacle which prevents individuals from perceiving the
importance of Eugenics, ‘the prevalent opinion that almost anybody
is good enough to marry is chiefly due to the fact that in this case,
cause and effect, marriage and the feebleness of the offspring, are
so distant from each other that the near-sighted eye does not
distinctly perceive the connexion between them.’ (The Italics are
mine.)
The enlightenment of individuals is a necessary preamble to
practical Eugenics, but social opinion is the tyrant by whose praise or
blame the principles of Eugenics may be expected hereafter to
influence individual conduct. Public opinion may, however, be easily
directed into different channels by opportune pressure. A common
conviction that change in the established order of some particular
codes of conduct would be impossible, because of the shock that the
idea of doing so gives to our present ideas, bears some resemblance
to the conviction of lovers that their present sentiments will endure
for ever. Conviction, which is that very Assurance of which mention
has just been made, is proved by reiterated experience to be a
highly fallacious guide. Love is notoriously fickle in despite of the
fervent and genuine protestations of lovers, and so is public opinion.
I gave a list of extraordinary variations of the latter in respect to
restrictions it enforced on the freedom of marriage, at various times
and places (Sociological Papers, quoted above). Much could be
added to that list, but I will not now discuss the effects of public
opinion on such a serious question. I will take a much smaller
instance which occurred before the time to which the recollections of
most persons can now reach, but which I myself recall vividly. It is
the simple matter of hair on the face of male adults. When I was
young, it was an unpardonable offence for any English person other
than a cavalry officer, or perhaps someone of high social rank, to
wear a moustache. Foreigners did so and were tolerated, otherwise
the assumption of a moustache was in popular opinion worse than
wicked, for it was atrociously bad style. Then came the Crimean War
and the winter of Balaclava, during which it was cruel to compel the
infantry to shave themselves every morning. So their beards began
to grow, and this broke a long established custom. On the return of
the army to England the fashion of beards spread among the laity,
but stopped short of the clergy. These, however, soon began to
show dissatisfaction; they said the beard was a sign of manliness
that ought not to be suppressed, and so forth, and at length the
moment arrived. A distinguished clergyman, happily still living,
‘bearded’ his Bishop on a critical occasion. The Bishop yielded
without protest, and forthwith hair began to sprout in a thousand
pulpits where it had never appeared before within the memory of
man.
It would be no small shock to public sentiment if our athletes in
running public races were to strip themselves stark naked, yet that
custom was rather suddenly introduced into Greece. Plato says
(Republic V, par. 452, Jowett’s translation):
Not long ago the Greeks were of the opinion, which is still generally received
among the barbarians, that the sight of a naked man was ridiculous and improper,
and when first the Cretans and the Lacedaemonians introduced naked exercises,
the wits of that day might have ridiculed them....
Thucydides (I. 6) also refers to the same change as occurring
‘quite lately’.
Public opinion is commonly far in advance of private morality,
because society as a whole keenly appreciates acts that tend to its
advantage, and condemns those that do not. It applauds acts of
heroism that perhaps not one of the applauders would be disposed
to emulate. It is instructive to observe cases in which the
benevolence of public opinion has out-stripped that of the Law—
which, for example, takes no notice of such acts as are enshrined in
the parable of the good Samaritan. A man on his journey was
robbed, wounded and left by the wayside. A priest and a Levite
successively pass by and take no heed of him. A Samaritan follows,
takes pity, binds his wounds, and bears him to a place of safety.
Public opinion keenly condemns the priest and the Levite, and
praises the Samaritan, but our criminal law is indifferent to such
acts. It is most severe on misadventure due to the neglect of a
definite duty, but careless about those due to the absence of
common philanthropy. Its callousness in this respect is painfully
shown in the following quotations (Kenny, Outlines of Criminal Law,
1902, p. 121, per Hawkins in Reg. v. Paine, Times, February 25,
1880):
If I saw a man who was not under my charge, taking up a tumbler of poison, I
should not be guilty of any crime by not stopping him. I am under no legal
obligation to protect a stranger.
That is probably what the priest and the Levite of the parable said
to themselves.
A still more emphatic example is in the Digest of Criminal Law, by
Justice Sir James Stephen, 1887, p. 154. Reg. v. Smith, 2 C. and P.,
449:
A sees B drowning and is able to help him by holding out his hand. A abstains
from doing so in order that B may be drowned, and B is drowned. A has
committed no offence.
It appears, from a footnote, that this case has been discussed in a
striking manner by Lord Macaulay in his notes on the Indian Penal
Code, which I have not yet been able to consult.
Enough has been written elsewhere by myself and others to show
that whenever public opinion is strongly roused it will lead to action,
however contradictory it may be to previous custom and sentiment.
Considering that public opinion is guided by the sense of what best
serves the interests of society as a whole, it is reasonable to expect
that it will be strongly exerted in favour of Eugenics when a
sufficiency of evidence shall have been collected to make the truths
on which it rests plain to all. That moment has not yet arrived.
Enough is already known to those who have studied the question to
leave no doubt in their minds about the general results, but not
enough is quantitatively known to justify legislation or other action
except in extreme cases. Continued studies will be required for some
time to come, and the pace must not be hurried. When the desired
fulness of information shall have been acquired then, and not till
then, will be the fit moment to proclaim a ‘Jehad,’ or Holy War
against customs and prejudices that impair the physical and moral
qualities of our race.
 LOCAL ASSOCIATIONS FOR PROMOTING
EUGENICS[8]

I propose to take the present opportunity of submitting some

views of my own relating to that large province of eugenics which is
concerned with favouring the families of those who are exceptionally
fit for citizenship. Consequently, little or nothing will be said relating
to what has been well termed by Dr. Saleeby “negative” eugenics,
namely, the hindrance of the marriages and the production of
offspring by the exceptionally unfit. The latter is unquestionably the
more pressing subject of the two, but it will soon be forced on the
attention of the legislature by the recent report of the Royal
Commission on the Feeble-minded. We may be content to await for
awhile the discussions to which it will give rise, and which I am sure
the members of this society will follow with keen interest, and with
readiness to intervene when what may be advanced seems likely to
result in actions of an anti-eugenic character.
The remarks I am about to make were suggested by hearing of a
desire to further eugenics by means of local associations more or
less affiliated to our own, combined with much doubt as to the most
appropriate methods of establishing and conducting them. It is upon
this very important branch of our wide subject that I propose to
offer a few remarks.
It is difficult, while explaining what I have in view, to steer a
course that shall keep clear of the mud flats of platitude on the one
hand, and not come to grief against the rocks of over-precision on
the other. There is no clear issue out of mere platitudes, while there
is great danger in entering into details. A good scheme may be
entirely compromised merely on account of public opinion not being
ripe to receive it in the proposed form, or through a discovered flaw
in some non-essential part of it. Experience shows that the safest
course in a new undertaking is to proceed warily and tentatively
towards the desired end, rather than freely and rashly along a
predetermined route, however carefully it may have been elaborated
on paper.
Again, whatever scheme of action is proposed for adoption must
be neither Utopian nor extravagant, but accordant throughout with
British sentiment and practice.
The successful establishment of any general system of
constructive eugenics will, in my view (which I put forward with
diffidence), depend largely upon the efforts of local associations
acting in close harmony with a central society, like our own. A
prominent part of its business will then consist in affording
opportunities for the interchange of ideas and for the registration
and comparison of results. Such a central society would tend to
bring about a general uniformity of administration the value of which
is so obvious that I do not stop to insist on it.
Assuming, as I do, that the powers at the command of the local
associations will be almost purely social, let us consider how those
associations might be formed and conducted so as to become
exceedingly influential.
It is necessary to be somewhat precise at the outset, so I will
begin with the by no means improbable supposition that in a given
district a few individuals, some of them of local importance, are
keenly desirous of starting a local association or society, and are
prepared to take trouble to that end. How should they set to work?
Their initial step would seem to be to form themselves into a
provisional executive committee, and to nominate a president,
council, and other officers of the new society. This done, the society
in question, though it would have no legal corporate existence, may
be taken as formed.
 The committee would next provide, with the aid of the central
society, for a few sane and sensible lectures to be given on eugenics,
including the A B C of heredity, at some convenient spot, and they
would exert themselves to arouse a wide interest in the subjects by
making it known in the district. They would seek the co-operation of
the local medical men, clergy, and lawyers, of the sanitary
authorities, and of all officials whose administrative duties bring
them into contact with various classes of society, and they would
endeavour to collect round this nucleus that portion of the local
community which was likely to be brought into sympathy with the
eugenic cause. Every political organisation, every philanthropic
agency, proceeds on some such lines as I have just sketched out.
The committee might next issue, on the part of the president and
council of the new society, a series of invitations to guests at their
social gatherings, where differences of rank should be studiously
ignored. The judicious management of these gatherings would, of
course, require considerable tact, but there are abundant precedents
for them, among which I need only mention the meetings of the
Primrose League at one end of the scale, and those held in Toynbee
Hall at the other end. Given a not inclement day, an hour suitable to
the occasion, a park or large garden to meet in, these informal yet
select reunions might be made exceedingly pleasant, and very
helpful to the eugenic cause.
The inquiries made by the committee when they were considering
the names of strangers to whom invitations ought to be sent, would
put them in possession of a large fund of information concerning the
qualities of many notable individuals in their district, and their family
histories. These family histories should be utilised for eugenic
studies, and it should be the duty of the local council to cause them
to be tabulated in an orderly way, and to communicate the more
significant of them to the central society.
The chief of the notable qualities, to which I refer in the preceding
paragraph, is the possession of what I will briefly call by the general
term of “Worth.” By this I mean the civic worthiness, or the value to
the State, of a person, as it would probably be assessed by experts,
or, say, by such of his fellow-workers as have earned the respect of
the community in the midst of which they live. Thus the worth of
soldiers would be such as it would be rated by respected soldiers,
students by students, business men by business men, artists by
artists, and so on. The State is a vastly complex organism, and the
hope of obtaining a proportional representation of its best parts
should be an avowed object of issuing invitations to these
gatherings.
Speaking only for myself, if I had to classify persons according to
worth, I should consider each of them under the three heads of
physique, ability, and character, subject to the provision that
inferiority in any one of the three should outweigh superiority in the
other two. I rank physique first, because it is not only very valuable
in itself and allied to many other good qualities, but has the
additional merit of being easily rated. Ability I should place second
on similar grounds, and character third, though in real importance it
stands first of all. It is very difficult to rate character justly; the
tenure of a position of trust is only a partial test of it, though a good
one so far as it goes. Again, I wish to say emphatically that in what I
have thrown out I have no desire to impose my own judgment on
others, especially as I feel persuaded that almost any intelligent
committee would so distribute their invitations to strangers as to
include most, though perhaps not all, of the notable persons in the
district.
By the continued action of local associations as described thus far,
a very large amount of good work in eugenics would be incidentally
done. Family histories would become familiar topics, the existence of
good stocks would be discovered, and many persons of “worth”
would be appreciated and made acquainted with each other who
were formerly known only to a very restricted circle. It is probable
that these persons, in their struggle to obtain appointments, would
often receive valuable help from local sympathisers with eugenic
principles. If local societies did no more than this for many years to
come, they would have fully justified their existence by their valuable
services.
 A danger to which these societies will be liable arises from the
inadequate knowledge joined to great zeal of some of the most
active among their probable members. It may be said, without
mincing words, with regard to much that has already been
published, that the subject of eugenics is particularly attractive to
“cranks.” The councils of local societies will therefore be obliged to
exercise great caution before accepting the memoirs offered to
them, and much discretion in keeping discussions within the bounds
of sobriety and common sense. The basis of eugenics is already
firmly established, namely, that the offspring of “worthy” parents
are, on the whole, more highly gifted by nature with faculties that
conduce to “worthiness” than the offspring of less “worthy” parents.
On the other hand, forecasts in respect to particular cases may be
quite wrong. They have to be based on imperfect data. It cannot be
too emphatically repeated that a great deal of careful statistical work
has yet to be accomplished before the science of eugenics can make
large advances.
I hesitate to speculate farther. A tree will have been planted; let it
grow. Perhaps those who may thereafter feel themselves or be
considered by others to be the possessors of notable eugenic
qualities—let us for brevity call them “Eugenes”—will form their own
clubs and look after their own interests. It is impossible to foresee
what the state of public opinion will then be. Many elements of
strength are needed, many dangers have to be evaded or overcome,
before associations of Eugenes could be formed that would be stable
in themselves, useful as institutions, and approved of by the outside
world.
The suggestion I made in the earlier part of this paper that the
executive committee of local associations should co-operate,
wherever practicable, with local administrative authorities,
proceeded on the assumption that the inhabitants of the districts
selected as the eugenic “field” had a public spirit of their own and a
sense of common interest. This sense would be greatly strengthened
by the enlargement of mutual acquaintanceship and the spread of
the eugenic idea consequent on the tactful action of the committee.
It ought not to be difficult to arouse in the inhabitants a just pride in
their own civic worthiness, analogous to the pride which a soldier
feels in the good reputation of his regiment or a lad in that of his
school. By this means a strong local eugenic opinion might easily be
formed. It would be silently assisted by local object lessons, in which
the benefits derived through following eugenic rules and the bad
effects of disregarding them were plainly to be discerned.
The power of social opinion is apt to be underrated rather then
overrated. Like the atmosphere which we breathe and in which we
move, social opinion operates powerfully without our being
conscious of its weight. Everyone knows that governments,
manners, and beliefs which were thought to be right, decorous, and
true at one period have been judged wrong, indecorous, and false at
another; and that views which we have heard expressed by those in
authority over us in our childhood and early manhood tend to
become axiomatic and unchangeable in mature life.
In circumscribed communities especially, social approval and
disapproval exert a potent force. Its presence is only too easily read
by those who are the object of either, in the countenances, bearing,
and manner of persons whom they daily meet and converse with. Is
it, then, I ask, too much to expect that when a public opinion in
favour of eugenics has once taken sure hold of such communities
and has been accepted by them as a quasi-religion, the result will be
manifested in sundry and very effective modes of action which are
as yet untried, and many of them even unforeseen?
Speaking for myself only, I look forward to local eugenic action in
numerous directions, of which I will now specify one. It is the
accumulation of considerable funds to start young couples of
“worthy” qualities in their married life, and to assist them and their
families at critical times. The gifts to those who are the reverse of
“worthy” are enormous in amount; it is stated that the charitable
donations or bequests in the year 1907 amounted to 4,868,050l. I
am not prepared to say how much of this was judiciously spent, or in
what ways, but merely quote the figures to justify the inference that
many of the thousands of persons who are willing to give freely at
the prompting of a sentiment based upon compassion might be
persuaded to give largely also in response to the more virile desire
of promoting the natural gifts and the national efficiency of future
generations.
 Footnotes

1. The second Huxley Lecture of the Anthropological Institute, delivered by

Francis Galton, D.C.L., D.Sc., F.R.S., on October 29, 1901.

2. The 80 charitable bequests of and exceeding £9000, made in 1808 alone,

amounted to more than 3–1/2 millions of pounds. (Whitaker’s Almanack to
1909, p. 433).
“It being far more humane to prevent suffering than to alleviate it after it
has occurred, why will not charitably disposed persons leave substantial
sums of money to the furtherance of Eugenic Study and practice, and of
popularising the result? The money would be well bestowed.” Francis Galton,
1909.
I learn on high legal authority that the form of bequest which would be most
appropriate in present circumstances, and be free from the pit-falls that lie in
the way of charitable bequests, is “I bequeath to my trusted friend A.B., of
....., absolutely, the sum of £...... in the hope and confidence that he will
apply the same in furtherance of Eugenic Study and practice, but without
imposing on him any trust or legal obligation so to do.” F.G.

3. Read before the Sociological Society at a Meeting in the School of Economics

and Political Science (London University), on May 16th, 1904. Professor Karl
Pearson, F.R.S., in the chair.

4. Read before the Sociological Society, on Tuesday, February 14th, at a

meeting in the School of Economics and Political Science (University of
London), Clare Market, W.C., Dr. E. Westermarck in the Chair.

5. Communicated at a meeting of the Sociological Society held in the School of

Economics and Political Science (University of London), Clare Market, W.C.,
on Tuesday, February 14th, at 4 p.m.

6. The Herbert Spencer Lecture delivered before the University at Oxford, June
5th, 1907.
7. Dent’s “Everyman’s Library,” price One Shilling.

8. Address to a meeting of the Eugenics Education Society at the Grafton

Galleries, on October 14th, 1908.
 Transcriber’s Notes

Some inconsistencies in spelling, hyphenation, and

punctuation have been retained.
Two charts have been rendered here only in image
form. They were too visually complex to format as
HTML tables.
1. “STANDARD SCHEME OF DESCENT” just after the
Table of Contents
2. “Illustrations of the Herbert Spencer Lecture 1907.”
on p. 72.
Some tables are wide and may display poorly.
*** END OF THE PROJECT GUTENBERG EBOOK ESSAYS IN
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