Introduction
Accounting is the language of business, transforming economic events into structured financial statements that guide internal decisions and external investments.
You face a constant challenge when trying to understand business performance without getting lost in complex bookkeeping mechanics. David H. Marshall, Wayne W. McManus, and Daniel E. Viele solve this problem by taking a user-oriented approach to financial and managerial accounting. You learn how to read and interpret data rather than just record transactions.
The book guides you through a clear structural progression. You begin with the foundational role of information and the four core financial statements before mastering the bookkeeping process. You then explore the management of current assets, noncurrent assets, and capital structure. Finally, you apply financial statement analysis and managerial cost planning techniques to real business scenarios.
How do businesses record daily transactions while adhering to accrual accounting principles?
- What do the balance sheet, income statement, and cash flow statement reveal about financial health?
- How do managers use cost-volume-profit analysis and budgets to make strategic decisions?
1. The Role and Environment of Accounting
Accounting identifies, measures, and communicates economic information to facilitate decisions and informed judgments.
You encounter accounting as the foundational language of business. Accountants frequently use the term entity instead of organization because it is more inclusive. The primary objective of financial accounting is to provide historical reports for external users who lack access to day-to-day operations.
Information serves a wide range of users who rely on financial reports for distinct economic assessments:
- management uses accounting for planning, directing, and controlling;
- investors assess future cash returns;
- creditors evaluate collection risks;
- employees judge long-term job prospects;
- regulatory agencies like the SEC check for compliance.
The Financial Accounting Standards Board serves as the authoritative standard-setting body that establishes U.S. Generally Accepted Accounting Principles. The FASB replaced earlier committees and issues Accounting Standards Updates that modify the FASB Accounting Standards Codification, which represents the single source of authoritative U.S. GAAP for nongovernmental entities. The FASB issued 168 Statements of Financial Accounting Standards historically before being superseded by the FASB Codification, 192 ASUs issued by February 2021, and 8 Statements of Financial Accounting Concepts issued through February 2021.
In response to the Enron and WorldCom collapses, the Sarbanes-Oxley Act of 2002 created the Public Company Accounting Oversight Board to oversee audits.
Users and Standard Setters
Professional accounting ethics require adherence to codes of conduct emphasizing integrity, objectivity, independence, and competence. Because users rely heavily on financial information for critical decisions, you must remain impartial, free from conflicts of interest, and maintain honesty in all professional dealings.
The Conceptual Framework project establishes objectives and concepts to guide standard-setting and financial reporting for external users. Concepts Statement No. 8 outlines that general-purpose financial reporting aims to provide information useful to investors and creditors in assessing cash flows, economic resources, obligations, and earnings based on accrual accounting.
Annual reports provide essential general and specific disclosures for evaluating a company's financial meaning. Selected portions of the Campbell Soup Company 2020 annual report are included in the appendix to familiarize students with notes to financial statements and management discussions. The text references excerpts from pages 16, 17, 40, 41, 42, 43, 44, 86, 87, and 88 of the Campbell Soup Company 2020 Annual Report.
- Download the full version of the annual report from campbellsoupcompany.com
- Review the Management Discussion and Analysis section
- Examine notes to financial statements for disclosures on executive compensation, core business, and risk factors
2. The Four Financial Statements
The balance sheet, income statement, statement of cash flows, and statement of changes in stockholders equity form an interrelated reporting system.
Financial statements communicate an entity's economic information to you through four principal reports. Current generally accepted accounting principles require these statements to show financial position, earnings, cash flows, and investments by or distributions to owners during a reporting period.
Businesses can be organized in several ways:
- proprietorships;
- partnerships;
- corporations;
- limited liability companies.
Proprietorships are easy to start but carry unlimited personal liability for the owner. Partnerships group individuals together with similar liability rules. Corporations limit stockholders' liability to their investments but subject distributed income to double taxation. Limited liability companies are treated as corporations for accounting and legal purposes without all corporate formalities.
Main Street Store Inc. is organized as a corporation, whereas PepsiCo Inc. operates with subsidiaries such as Frito-Lay Inc., Tropicana Products Inc., and Quaker Oats Company.
Financial Position and Operating Results
The balance sheet relies on the fundamental accounting equation where assets equal liabilities plus stockholders' equity. Assets represent probable future economic benefits controlled by the entity. Liabilities are present obligations to transfer assets or provide services. Stockholders' equity represents the residual ownership claim in remaining assets. The dollar totals for assets and for liabilities plus stockholders' equity must always balance.
Main Street Store Inc.'s balance sheet at August 31, 2023, shows total assets of $320,000 balancing exactly with total liabilities of $117,000 plus stockholders' equity of $203,000.
The income statement measures your operating profitability over a period of time by subtracting expenses from revenues. Starting with net sales, the statement deducts the cost of goods sold to yield gross profit. It then subtracts operating expenses, interest expense, and income taxes to arrive at net income or net loss.
Main Street Store Inc.'s income statement for the year ended August 31, 2023, reports net sales of $1,200,000, cost of goods sold of $850,000, and a net income of $18,000.
The statement of changes in stockholders' equity links the income statement to the balance sheet through retained earnings. Stockholders' equity consists of paid-in capital and retained earnings. Net income from the income statement is added to beginning retained earnings, while cash dividends paid are subtracted to determine ending retained earnings.
For Main Street Store Inc., beginning retained earnings of $0 plus net income of $18,000 minus cash dividends of $5,000 results in ending retained earnings of $13,000.
The statement of cash flows explains changes in cash by categorizing activities into operating, investing, and financing cash flows. Operating activities start with net income and adjust for non-cash expenses like depreciation and changes in working capital accounts. Investing activities track purchases of long-lived assets. Financing activities reflect transactions involving debt, stock issuance, and dividends.
Main Street Store Inc. reported net cash used by operating activities of $(161,000), cash paid for equipment of $(40,000), and net cash provided by financing activities of $235,000, leading to a net increase in cash of $34,000.
Generally accepted accounting principles serve as flexible guidelines based on conventions such as cost, matching, and accrual accounting. Transactions are recorded at their historical cost using a stable currency unit without inflation adjustments. Under accrual accounting, revenues are recognized when earned and expenses are matched to the revenues they helped generate, regardless of when cash changes hands.
If a parcel of land is purchased for $8,600, it remains recorded at that historical cost even if its market value increases to $80,000 years later.
3. The Bookkeeping Process and Adjustments
Double-entry bookkeeping records transactions in journals and ledgers while utilizing adjusting entries to satisfy accrual accounting principles.
You record transactions initially in a chronological record called a journal using source documents as raw materials and supporting evidence. A journal entry displays the date, the account to be debited on the left, and the indented account to be credited on the right, ensuring that total debits equal total credits. Source documents include supplier invoices, cash register tapes, and check stubs.
In bookkeeping and accounting, the terms debit and credit mean left and right respectively, and nothing more. Asset and expense accounts normally have debit balances and increase with debit entries. Liability, stockholders' equity, and revenue accounts normally have credit balances and increase with credit entries. Decreases are recorded on the opposite side.
You can expand the basic balance sheet equation to include revenues and expenses as components of stockholders' equity to demonstrate how net income affects the balance sheet. Net income is the difference between revenues and expenses reported on the income statement, and it changes the retained earnings portion of stockholders' equity. Reclassifying revenues and expenses into stockholders' equity keeps the fundamental accounting equation in balance after every transaction.
Transaction analysis methodology requires answering five sequential questions to determine the impact of any economic interchange on the financial statements:
- What's going on?
- What accounts are affected?
- How are they affected?
- Does the balance sheet balance? (Do the debits equal the credits?)
- Does my analysis make sense?
Period-end adjustments for accruals and reclassifications are required under accrual accounting to properly match revenues and expenses to the correct fiscal period. Accruals handle cash lags where cash has not yet been received or paid for earned revenues or incurred expenses. Reclassifications handle cash leads where cash was received or paid in advance before the associated revenue was earned or expense incurred.
4. Managing Current Assets and Liabilities
Cash, receivables, and inventories require strict internal controls, bank reconciliations, and cost flow assumptions to reflect accurate values.
A bank reconciliation brings the general ledger cash balance and bank statement balance into agreement by accounting for timing differences and errors. Timing differences occur when the company or the bank records a transaction at different times, including deposits in transit, outstanding checks, bank service charges, interest revenue, and NSF checks.
Cruisers Inc. reconciled its September 30 bank balance of $5,233.21 and ledger balance of $4,614.58 to a corrected balance of $4,565.73 by factoring in a deposit in transit, outstanding checks, service charges, interest earned, and an NSF check.
- Add deposits in transit to the bank's prereconciled balance
- Subtract outstanding checks from the bank's prereconciled balance
- Subtract bank service charges and NSF checks from the company's ledger balance
- Add interest revenue earned to the company's ledger balance
Accounts receivable are reported on the balance sheet at net realizable value using a contra asset account for estimated bad debts. Because specific uncollectible accounts cannot be identified in advance, firms use an allowance account to reduce total accounts receivable. When specific accounts are later identified as uncollectible, they are written off against the allowance without affecting net income or net accounts receivable.
- Estimate bad debts expense using methods like the percentage of credit sales method or aging of receivables method
- Record the valuation adjustment by debiting Bad Debts Expense and crediting Allowance for Bad Debts
- Write off specific uncollectible accounts by debiting Allowance for Bad Debts and crediting Accounts Receivable
Cash discounts encourage prompt payment and represent a significant cost to the seller and a high annualized return for the buyer. Credit terms such as 2/10, n30 mean a 2 percent discount is given if paid within 10 days; otherwise, the full amount is due in 30 days.
- Deduct the cash discount percentage from the invoice amount if paid within the discount period
- Subtract cash discounts on sales from Sales in the income statement to arrive at net sales
- Reduce Accounts Receivable by an allowance for estimated cash discounts expected to be taken
Inventory and Receivables
Inventory cost flow assumptions determine how costs move from the inventory asset account to the cost of goods sold expense account. The four primary cost flow assumptions are specific identification, weighted-average, first-in, first-out (FIFO), and last-in, first-out (LIFO). These assumptions do not necessarily reflect the physical flow of goods.
- Apply specific identification by matching the exact cost of each specific unit sold
- Apply weighted-average by calculating the average cost of beginning inventory plus purchases weighted by unit quantities
- Apply FIFO by assigning the oldest costs to cost of goods sold and newest costs to ending inventory
- Apply LIFO by assigning the newest costs to cost of goods sold and oldest costs to ending inventory
During periods of rising costs, FIFO produces inventory profits and higher taxes, whereas LIFO matches current costs against current revenues. Using FIFO during inflation releases older, lower costs into cost of goods sold, creating phantom profits that inflate taxable income.
Ending inventory errors have a direct dollar-for-dollar effect on cost of goods sold and net income that washes out over two consecutive periods. Overstating ending inventory in the first period understates cost of goods sold and overstates net income.
- Make necessary corrections to determine the as corrected results
- Compare results before and after corrections to determine the exact impact of inventory errors
5. Noncurrent Assets and Capital Structure
Noncurrent assets are capitalized and depreciated over time, while long-term liabilities and equity structures define corporate leverage.
Land owned and used in operations is reported on the balance sheet at its original cost. You include purchase price, title fees, legal fees, and related acquisition costs. If you demolish a building on purchased land, you add those costs plus razing expenses minus salvage proceeds to the land cost. Land is not depreciated because you do not use it up. Cruisers Inc. operated a plant on land that cost $6,000, which was sold years later for $140,000, resulting in a $134,000 nonoperating gain.
Expenditures must be accounted for as either assets through capitalization or as expenses based on whether they provide economic benefits beyond the current fiscal year. Capitalizing an expenditure records it as an asset if its economic benefit extends beyond the current year. Routine maintenance and repairs are expensed as incurred. A $25 wastebasket with a multiyear useful life may be expensed rather than capitalized due to the materiality concept.
Depreciation allocates the cost of a noncurrent asset over its estimated useful life using straight-line or accelerated calculation methods. Depreciation is an application of the matching concept and does not reflect fair market value changes or affect cash. Cruisers Inc. purchased a molding machine for $22,000 with a 5-year useful life and $2,000 estimated salvage value, producing different annual expense patterns under straight-line and double-declining-balance methods.
Financing leases transfer substantially all risks and rewards of ownership to you, requiring the recognition of a right-of-use asset and a lease liability. A financing lease is accounted for similarly to an outright purchase financed by a loan. A firm purchasing a computer system for $217,765 via a note payable or leasing it with equivalent present value payments records a right-of-use asset and lease liability of $217,765.
Intangible assets represent contractual rights or non-physical items whose costs are amortized over time, except for goodwill, which is tested annually for impairment. Intangibles like patents, copyrights, and leasehold improvements are amortized on a straight-line basis. Goodwill arises when you purchase a business for more than the fair value of its net assets. Cruisers Inc. purchased a business for $1,000,000 cash and $100,000 in notes payable, acquiring net assets with a fair value of $700,000 and recording $300,000 in goodwill.
Depreciation and Leverage
Financial leverage uses fixed-cost debt financing to magnify the return on stockholders equity relative to the return on total assets. Borrowing money at a lower interest rate than the return earned on assets increases your return on equity. Comparing two $10,000 firms with $1,200 operating income, the leveraged firm financed with 40 percent debt at 10 percent interest achieves a higher return than the unleveraged firm.
Common stock represents residual ownership in a corporation, giving holders the right to vote for directors and claim all assets remaining after liabilities and preferred claims are satisfied. Racers, Inc. sold 40,000 additional shares of its $2 par value common stock at a price of $13 per share, recording $80,000 to Common Stock and $440,000 to Additional Paid-In Capital. Treasury stock represents your own previously issued shares that have been reacquired but not retired. Racers, Inc. purchased 1,000 shares of its own common stock at a total cost of $12,000, recording it as a deduction within stockholders equity. Coca-Cola held $52.0 billion of treasury stock, measuring 2.7 times its common stock and additional paid-in capital combined.
Cash dividends are a distribution of corporate earnings authorized by the board of directors, becoming a legal liability upon declaration.
- Identify the declaration date when the board approves the dividend and creates a legal liability
- Determine the record date to establish which stockholders on the corporate records will receive the dividend
- Account for the ex-dividend date two business days before the record date where the stock trades without the dividend
- Process the payment date when checks are mailed to the stockholders of record
To be recognized on the income statement under traditional standards, revenues must meet the dual criteria of being realized or realizable and earned. A magazine publishing company receives cash in advance for subscriptions, but recognizes the revenue over time as the magazines are delivered because the earned criterion governs.
6. Financial Statement Analysis
Ratio analysis, DuPont modeling, and cash flow evaluations interpret a firm's liquidity, activity, profitability, and financial leverage.
Large dollar amounts and varying company sizes make ratios the only sensible method for evaluation. A single ratio reveals little, whereas examining trends requires internal consistency across time periods and comparison with industry averages published by trade associations.
A company's sales growth rose from 5.1% in 2019-2020 to 12.3% in 2022-2023, showing an upward trend compared to a flat industry average of 5.0%.
Return on investment (ROI), also known as return on assets (ROA), relates net income earned over a fiscal year to the average total assets used during that year. Using average total assets between the beginning and ending balance sheets is more accurate than a single year-end balance sheet because net income is earned continuously throughout the year.
Cruisers Inc. calculates its ROI using net income of $34,910 divided by average total assets. The firm recorded $364,720 in total assets on September 30, 2022, and $402,654 in total assets on September 30, 2023.
The DuPont Model
The DuPont model expands the ROI calculation into the product of profit margin and asset turnover, linking sales profitability with asset utilization efficiency. Margin emphasizes how much of each sales dollar reaches net income, while turnover measures the efficiency of asset utilization in generating sales.
Cruisers Inc. reported $611,873 in net sales and $34,910 in net income for the year ended September 30, 2023. American merchandising and manufacturing companies experience normal average ROI based on net income between 8% and 12%, or 10% to 15% based on operating income. Margin averages 5% to 10% based on net income, while asset turnover ranges from 1.0 to 1.5, reaching up to 3.0.
A factory operating 5 shifts out of 21 available weekly shifts is utilized less than 25% of the time, remaining idle over 75% of the time. Operating multiple shifts can increase asset turnover even if it slightly reduces margin.
Return on equity (ROE) measures profitability by dividing net income by the average stockholders' equity during the period. Cruisers Inc. held $230,320 in total stockholders' equity on September 30, 2022, and $265,230 on September 30, 2023.
Because assets are funded by liabilities or owner equity, ROE isolates the return generated specifically on the stockholders' share of the investment, often enhanced through financial leverage. American merchandising and manufacturing companies show a historical average ROE of 12% to 18%. Campbell Soup Company utilized financial leverage such that its total assets were 5 to 7 times larger than its total equity, resulting in ROE ranging from 17.0% to 88.5%.
Liquidity measures a firm's ability to meet current obligations through working capital, the current ratio, and the acid-test ratio. Working capital is current assets minus current liabilities. The current ratio relates current assets to current liabilities, while the acid-test ratio, also known as the quick ratio, excludes inventories for a more conservative measure.
You evaluate debt-paying ability by comparing your current ratio to the general rule of 2.0 for adequate liquidity. You test quick liquidity against the general rule of 1.0 for the acid-test ratio.
The price/earnings ratio, also known as the P/E ratio or earnings multiple, evaluates the market price of a company's common stock relative to its earnings per share. Diluted earnings per share is normally used in the calculation, helping compare stock expensiveness across firms. Campbell Soup Company reported a P/E ratio of 9.2 for 2020, influenced by an unusually high diluted EPS of $5.36.
Financial leverage uses debt to finance assets, magnifying the return on equity relative to the return on investment while adding bankruptcy and insolvency risks. When the return on investment exceeds the borrowing cost, financial leverage magnifies the return to equity owners. Interest is also tax-deductible, making debt a preferred fixed-cost capital source.
An illustration in the text shows how adding $4,000 in liabilities to $6,000 in equity increases ROE from 12 percent to 16.4 percent when ROI is 20 percent and debt cost is 9 percent. That computation assumes a 40 percent income tax rate, yielding a 5.4 percent after-tax cost of debt based on a 9 percent interest rate and 40 percent tax rate. Campbell Soup Company reported a 3.2 times interest earned ratio for 2020.
7. Managerial Accounting and Cost Decision Making
Managerial accounting provides internal data through cost-volume-profit analysis, budgeting, and relevant cost decision models.
While financial accounting has a historical, scorekeeping orientation constrained by GAAP and FASB, managerial accounting uses financial and economic data for planning, controlling, and decision-making. Management accounting reports are issued frequently and promptly, prioritizing relevance and reasonable accuracy over absolute precision. You can classify costs into variable and fixed patterns based on how total cost behaves relative to changes in the volume of activity within a relevant range. A variable cost changes in total as activity changes but remains constant per unit. A fixed cost remains constant in total as activity changes but varies inversely if expressed per unit.
Manufacturing labor wages, supplies, shipping costs, and sales commissions are variable costs, whereas supervisor salaries, factory rent, advertising, and property taxes are fixed costs.
Cost Behavior and Budgets
The master budget begins with the sales forecast, which estimates physical units to be sold multiplied by expected selling prices. Because revenue dictates activity, the sales forecast sequentially drives the purchases and production budgets, operating expense budgets, budgeted income statements, cash budgets, and finally the budgeted balance sheet. You can build physical inventory models by following specific steps:
- First enter the beginning and ending inventory quantities based on the firm's inventory management policies.
- Next enter the quantity of goods sold from the sales forecast.
- The goods available for sale amount in units is then calculated by working from the bottom up—the ending inventory is added to quantity of goods sold.
- Finally, the beginning inventory is subtracted from goods available for sale to get the purchase or production quantity.
Cruisers Inc. estimated total annual overhead of $4,200,000 and 300,000 direct labor hours, resulting in a predetermined overhead application rate of $14 per direct labor hour.
10 Key Ideas
- Accounting identifies, measures, and communicates economic information to facilitate decisions and informed judgments by external and internal users.
- The balance sheet, income statement, statement of cash flows, and statement of changes in stockholders equity form an interrelated reporting system.
- Double-entry bookkeeping records transactions in journals and ledgers while utilizing adjusting entries to satisfy accrual accounting principles.
- Cash, receivables, and inventories require strict internal controls, bank reconciliations, and cost flow assumptions to reflect accurate values.
- Noncurrent assets are capitalized and depreciated over time, while long-term liabilities and equity structures define corporate leverage.
- Ratio analysis, DuPont modeling, and cash flow evaluations interpret a firm's liquidity, activity, profitability, and financial leverage.
- Managerial accounting provides internal data through cost-volume-profit analysis, budgeting, and relevant cost decision models.
- Variable costs change in total as activity changes but remain constant per unit, whereas fixed costs remain constant in total as activity changes.
- The master budget begins with the sales forecast, which estimates physical units to be sold multiplied by expected selling prices.
- Financial leverage uses fixed-cost debt financing to magnify the return on stockholders equity relative to the return on total assets.