FINANCIAL Accounting Seventh Edition Walter T Harrison Jr Baylor University Charles T Horngren ISBN: 0-536-55962-7 Stanford University Upper Saddle River, NJ 07458 Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc Library of Congress Cataloging-in-Publication Data Harrison, Walter T Financial accounting/Walter T Harrison, Jr., Charles T Horngren — 7th ed p cm Includes index ISBN-13: 978-0-13-612934-9 (casebound) ISBN-10: 0-13-612934-X (casebound) Accounting I Horngren, Charles T II Title HF5636.H37 2008 657—dc22 2007040927 AVP/Executive Editor: Jodi McPherson VP/Publisher: Natalie Anderson Director, Product Development: Pamela Hersperger Editorial Project Manager: Ana Jankowski Editorial Assistant: Caroline DeFino Development Editor: Ralph Moore Marketing Manager: Andrew Watts Marketing Assistant: Justin Jacob Senior Managing Editor, Production: Cynthia Zonneveld Production Project Manager: Melissa Feimer Permissions Coordinator: Charles Morris Senior Operations Supervision: Nick Sklitsis AV Project Manager: Rhonda Aversa Senior Art Director: Jonathan Boylan Cover Design: Jonathan Boylan Director, Image Resource Center: Melinda Patelli Manager, Rights and Permissions: Zina Arabia Manager, Visual Research: Beth Brenzel Manager, Cover Visual Research & Permissions: Karen Sanatar Image Permission Coordinator: Jan Marc Quisumbing Photo Researcher: Teri Stratford Composition: GEX Publishing Services Full-Service Project Management: GEX Publishing Services Printer/Binder: Courier Typeface: Berkley Book 11/13.5 Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text Chapter 1: Don Emmert/Getty Images, p 1; Chapter 2: David Young-Wolff/PhotoEdit Inc., p 53; Chapter 3: Andrew Harrer/Bloomberg News/Landov LLC, p 125; Chapter 4: Keith Brofsky/Getty Images/Photodisc, p 213; Chapter 5: Richard B Levine/NewsCom, p 261; Chapter 6: Emile Wansteker/Bloomberg News/Landov LLC, p 309; Chapter 7: Jim Sully/Newscast/NewCom, p 367; Chapter 8: Getty Images/Digital Vision, p 417; Chapter 9: Charles Miller/AP Wid World Photos, p 477; Chapter 10: Robert Clare/Getty Images, Inc., p 537; Chapter 11: Monika Graff/UPI/Landov LLC, p 583; Chapter 12: Getting Images/Digital Vision, p 619; Chapter 13: David Young-Wolff/PhotoEdit Inc., p 685 Copyright © 2008, 2006, 2004, 2001, 1998 by Pearson Education, Inc., Upper Saddle River, New Jersey, 07458 Pearson Prentice Hall All rights reserved Printed in the United States of America This publication is protected by Copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise For information regarding permission(s), write to: Rights and Permissions Department Pearson Prentice Hall™ is a trademark of Pearson Education, Inc Pearson® is a registered trademark of Pearson plc Prentice Hall® is a registered trademark of Pearson Education, Inc Pearson Education LTD Pearson Education Singapore, Pte Ltd Pearson Education, Canada, Ltd Pearson Education–Japan Pearson Education Australia PTY, Limited Pearson Education North Asia Ltd Pearson Educación de Mexico, S.A de C.V Pearson Education Malaysia, Pte Ltd ISBN: 0-536-55962-7 10 ISBN-13: 978-0-13-612934-9 ISBN-10: 0-13-612934-X Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc For our wives, ISBN: 0-536-55962-7 Nancy and Joan Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc Brief Contents Preface Prologue xxv The Financial Statements Chapter 10 Chapter 11 The Income Statement & the Statement of Stockholders’ Equity 583 Chapter 12 13 The Statement of Cash Flows Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter ISBN: 0-536-55962-7 xv Transaction Analysis 53 Accrual Accounting & Income Internal Control & Cash 125 213 Short-Term Investments & Receivables Inventory & Cost of Goods Sold Plant Assets & Intangibles Liabilities 261 309 367 417 Stockholders’ Equity 477 Long-Term Investments & International Operations 537 Financial Statement Analysis 619 685 Appendix A: YUM! Brands Annual Report 2006 Appendix B: Pier Imports Annual Report 2006 Appendix C: Time Value of Money: Future Value and Present Value 777 Appendix D: Typical Charts of Accounts for Different Types of Businesses 787 Appendix E: Summary of Generally Accepted Accounting Principles (GAAP) 789 Appendix F: Check Figures for Assignment Materials Company Index 799 Glindex 803 745 763 791 Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc Contents Increases and Decreases in the Accounts: The Rules of Debit and Credit 67 Additional Stockholders’ Equity Accounts: Revenues and Expenses 69 Chapter The Financial Statements Spotlight: YUM! Brands Recording Transactions Business Decisions Accounting Is the Language of Business Who Uses Accounting Information? Two Kinds of Accounting: Financial Accounting and Management Accounting Ethics in Accounting: Standards of Professional Conduct We Need an Audit to Validate the Financial Statements Organizing a Business Accounting Principles and Concepts The Entity Concept The Reliability Principle The Cost Principle The Going-Concern Concept The Stable-Monetary-Unit Concept The Accounting Equation Assets and Liabilities Owners’ Equity 11 The Trial Balance 5 Chapter 10 Accrual Accounting & Income 13 Relationships Among the Financial Statements End-of-Chapter Summary Problem 24 Chapter Transaction Analysis 53 Spotlight: Apple Computer, Inc 53 54 55 56 ISBN: 0-536-55962-7 Example: Genie Car Wash, Inc 57 Transactions and Financial Statements Mid-Chapter Summary Problem Double-Entry Accounting 67 67 65 57 62 125 Accrual Accounting and Cash Flows The Time-Period Concept 128 The Revenue Principle 128 The Matching Principle 129 Ethical Issues in Accrual Accounting 127 128 130 Updating the Accounts: The Adjusting Process 130 Which Accounts Need to Be Updated (Adjusted)? Categories of Adjusting Entries 131 Prepaid Expenses 132 Depreciation of Plant Assets 135 Accrued Expenses 138 Accrued Revenues 139 Unearned Revenues 141 Summary of the Adjusting Process 143 The Adjusted Trial Balance 145 130 146 148 Which Accounts Need to Be Closed? 152 Classifying Assets and Liabilities Based on Their Liquidity 154 Reporting Assets and Liabilities: Starbucks Corporation 154 Formats for the Financial Statements Balance Sheet Formats 155 Income Statement Formats 156 Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc 125 Accrual Accounting Versus Cash-Basis Accounting Mid-Chapter Summary Problem Accounting for Business Transactions The T-Account 21 Spotlight: Starbucks Corporation Preparing the Financial Statements Assets 55 Liabilities 56 Stockholders’ (Owners’) Equity 82 84 The Income Statement Measures Operating Performance 13 The Statement of Retained Earnings Shows What a Company Did with Its Net Income 15 The Balance Sheet Measures Financial Position 16 The Statement of Cash Flows Measures Cash Receipts and Payments 19 Transactions The Account 77 Analyzing Accounts 78 Correcting Accounting Errors 79 Chart of Accounts 80 The Normal Balance of an Account 81 Account Formats 81 Analyzing Transactions Using Only T-Accounts End-of-Chapter Summary Problem 10 The Financial Statements 70 Copying Information (Posting) from the Journal to the Ledger 71 The Flow of Accounting Data 72 Accounts After Posting to the Ledger 77 155 x ■ Contents Using Accounting Ratios 157 Short-Term Investments Current Ratio 157 Debt Ratio 157 How Do Transactions Affect the Ratios? End-of-Chapter Summary Problem 262 Trading Investments 263 Reporting on the Balance Sheet and the Income Statement 264 Lending Agreements and the Current Ratio 266 158 162 Mid-Chapter Summary Problem Accounts and Notes Receivable Chapter Internal Control & Cash 213 Accounting for Uncollectible Receivables 215 217 Competent, Reliable, and Ethical Personnel Assignment of Responsibilities 218 Separation of Duties 218 Audits 218 Documents 219 Electronic Devices 219 Other Controls 220 Internal Controls for E-Commerce Notes Receivable 217 Using Two Key Ratios to Make Decisions Acid-Test (or Quick) Ratio Days’ Sales in Receivables End-of-Chapter Summary Problem Inventory & Cost of Goods Sold 222 Spotlight: Pier Imports 311 Sale Price vs Cost of Inventory 312 Accounting for Inventory in the Perpetual System Inventory Costing 224 232 232 233 Mid-Chapter Summary Problem Controls over Payment by Check 233 Using a Budget to Manage Cash 235 Reporting Cash on the Balance Sheet 236 Compensating Balance Agreements 237 323 Accounting Principles Related to Inventory 237 Inventory and the Financial Statements 240 327 Additional Inventory Issues 261 Spotlight: Receivables Are Pepsico’s Largest Current Asset 261 329 Using the Cost-of-Goods-Sold Model 329 Estimating Inventory by the Gross Profit Method Effects of Inventory Errors 331 End-of-Chapter Summary Problem 330 334 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Detailed Income Statement 327 Analyzing Financial Statements 327 Chapter Short-Term Investments & Receivables 325 Consistency Principle 325 Disclosure Principle 325 Accounting Conservatism 325 Lower-of-Cost-or-Market Rule 326 237 Corporate and Professional Codes of Ethics Ethical Issues in Accounting 237 314 317 What Goes into Inventory Cost? 317 The Various Inventory Costing Methods 317 The Effects of FIFO, LIFO and Average Cost on Cost of Goods Sold, Gross Profit, and Ending Inventory 320 The Tax Advantage of LIFO 322 Comparison of the Inventory Methods 322 230 Internal Control over Cash Payments End-of-Chapter Summary Problem 309 309 Accounting for Inventory Internal Control over Cash Receipts Ethics and Accounting 284 285 Chapter The Bank Account as a Control Device Cash Receipts over the Counter Cash Receipts by Mail 232 282 283 283 Reporting on the Statement of Cash Flows Pitfalls 220 Security Measures 221 The Limitations of Internal Control—Costs and Benefits 222 Mid-Chapter Summary Problem 277 278 Accounting for Notes Receivable 279 How to Speed Up Cash Flow 281 220 Signature Card 222 Deposit Ticket 222 Check 222 Bank Statement 222 Bank Reconciliation 223 Preparing the Bank Reconciliation Online Banking 227 271 Allowance Method 271 Direct Write-Off Method 277 Computing Cash Collections from Customers The Sarbanes-Oxley Act (SOX) 215 The Components of Internal Control 216 Internal Control Procedures 268 Types of Receivables 268 Internal Controls over Cash Collections on Account 269 How Do We Manage the Risk of Not Collecting? 269 213 Spotlight: AMEX Products Takes a Hit Internal Control 267 Contents Issuing Bonds Payable at a Premium 436 The Straight-Line Amortization Method: A Quick and Dirty Way to Measure Interest Expense 439 Should We Retire Bonds Payable Before Their Maturity? 440 Convertible Bonds and Notes 441 Financing Operations with Bonds or Stock? 442 The Times-Interest-Earned Ratio 444 Chapter Plant Assets & Intangibles Spotlight: FedEx Corporation Types of Assets 367 367 368 Measuring the Cost of a Plant Asset 369 Land 369 Buildings, Machinery, and Equipment 370 Land Improvements and Leasehold Improvements Lump-Sum (or Basket) Purchases of Assets 371 Capital Expenditure vs Immediate Expense 372 Measuring Depreciation on Plant Assets Long-Term Liabilities: Leases and Pensions 371 380 383 387 388 389 Reporting Plant Asset Transactions on the Statement of Cash Flows 392 395 Chapter Spotlight: Southwest Airlines: A Success Story Current Liabilities Spotlight: IHOP: The Best Pancakes in Town 417 Mid-Chapter Summary Problem Stockholders’ Rights 481 Stockholders’ Equity 482 Classes of Stock 483 Issuing Stock 484 Common Stock 486 A Stock Issuance for Other Than Cash Can Create an Ethical Challenge 489 Preferred Stock 490 426 426 Bonds: An Introduction 427 Issuing Bonds Payable at Par (Face Value) 430 Issuing Bonds Payable at a Discount 431 What Is the Interest Expense on These Bonds Payable? 432 Interest Expense on Bonds Issued at a Discount 433 Partial-Period Interest Amounts 436 492 494 Should the Company Declare and Pay Cash Dividends? 495 Cash Dividends 495 Analyzing The Stockholder’s Equity Accounts 496 Dividends on Preferred Stock 497 Stock Dividends 498 Stock Splits 499 Summary of the Effects on Assets, Liabilities, and Stockholders’ Equity 500 Measuring the Value of Stock 501 Market, Redemption, Liquidation, and Book Value Relating Profitability to a Company’s Stock 502 Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc 491 Retained Earnings, Dividends, and Splits 425 Long-Term Liabilities: Bonds and Notes Payable 479 Should a Company Buy Back Its Own Stock? 493 Sale of Treasury Stock 494 Summary of Treasury-Stock Transactions 494 Retirement of Stock 494 418 Summary of the Current Liabilities 477 What’s the Best Way to Organize a Business? Organizing a Corporation 480 Authorized, Issued, and Outstanding Stock Treasury Stock 492 Current Liabilities of Known Amount 418 Current Liabilities That Must Be Estimated 423 Contingent Liabilities 424 Are All Your Liabilities Reported on the Balance Sheet? 425 ISBN: 0-536-55962-7 477 Mid-Chapter Summary Problem 417 450 Chapter Stockholders’ Equity Accounting for Specific Intangibles 389 Accounting for the Impairment of an Intangible Asset 391 Accounting for Research and Development Costs 392 Liabilities 448 End-of-Chapter Summary Problem 381 Depreciation for Tax Purposes 381 Depreciation for Partial Years 383 Changing the Useful Life of a Depreciable Asset Fully Depreciated Assets 384 Accounting for Disposal of Plant Assets 385 T-Accounts for Analyzing Plant Asset Transactions End-of-Chapter Summary Problem 447 Reporting on the Balance Sheet 448 Reporting the Fair Market Value of Long-Term Debt 449 Reporting Financing Activities on the Statement of Cash Flows 449 Other Issues in Accounting for Plant Assets Accounting for Natural Resources Accounting for Intangible Assets 445 Types of Leases 446 Do Lessees Prefer Operating Leases or Capital Leases? Pensions and Postretirement Liabilities 447 Reporting Liabilities 373 How to Measure Depreciation 374 Depreciation Methods 375 Comparing Depreciation Methods 378 Mid-Chapter Summary Problem xi ■ 501 xii ■ Contents Reporting Stockholders’ Equity Transactions 504 Statement of Cash Flows 504 Reporting Stockholders’ Equity on the Balance Sheet End-of-Chapter Summary Problem 504 507 Chapter 10 Long-Term Investments & International Operations 537 Spotlight: Intel Holds Several Different Types of Investments 537 Stock Investments: An Overview 539 539 540 Accounting for Available-for-Sale Investments 541 What Value of an Investment Is Most Relevant? 542 Selling an Available-for-Sale Investment 543 When Should We Sell an Investment? 544 Equity-Method Investments 597 End-of-Chapter Summary Problem 599 Chapter 12 The Statement of Cash Flows 619 544 Buying a Large Stake in Another Company Accounting for Equity-Method Investments Consolidated Subsidiaries Accounting for Corporate Income Taxes 592 Analyzing Retained Earnings 594 Analyzing the Statement of Stockholders’ Equity 594 Responsibility for the Financial Statements 597 Management’s Responsibility Auditor Report 597 Stock Prices 539 Reporting Investments on the Balance Sheet Available-for-Sale Investments Discontinued Operations 588 Extraordinary Gains and Losses (Extraordinary Items) 588 Cumulative Effect of a Change in Accounting Method 589 Watch Out for Voluntary Accounting Changes That Increase Reported Income 589 Earnings per Share of Common Stock 590 Reporting Comprehensive Income 591 What Should You Analyze to Gain an Overall Picture of a Company? 591 Spotlight: Google: The Ultimate Answer Machine 544 545 547 551 Mid-Chapter Summary Problems 553 Accounting for International Operations Preparing the Statement of Cash Flows: Indirect Method 624 Cash Flows from Operating Activities 628 Cash Flows from Investing Activities 630 Cash Flows from Financing Activities 633 Noncash Investing and Financing Activities 635 554 Foreign Currencies and Exchange Rates 555 Do We Collect Cash in Dollars or in Foreign Currency? Do We Pay in Dollars or in Foreign Currency? 556 Reporting Gains and Losses on the Income Statement 557 Should We Hedge Our Foreign-Currency-Transaction Risk? 558 Consolidation of Foreign Subsidiaries 558 International Accounting Standards 560 Investing Activities on the Statement of Cash Flows 561 End-of-Chapter Summary Problem Mid-Chapter Summary Problem 636 Preparing the Statement of Cash Flows: Direct Method 638 Cash Flows from Investing Activities 642 Cash Flows from Financing Activities 643 Noncash Investing and Financing Activities 643 Computing Operating Cash Flows by the Direct Method 644 Computing Investing and Financing Cash Flows 648 Measuring Cash Adequacy: Free Cash Flow End-of-Chapter Summary Problem 562 Chapter 13 The Income Statement & the Statement of Stockholders’ Equity 583 Financial Statement Analysis Spotlight: Pier Imports Had a Tough Year How Does an Investor Evaluate a Company? Horizontal Analysis 687 Continuing Operations 585 Which Income Number Predicts Future Profits? 586 685 Spotlight: How Well Is YUM! Brands Doing? Illustration: YUM! Brands Trend Percentages 690 685 687 688 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 583 585 649 651 Chapter 11 Evaluating the Quality of Earnings 621 How’s Your Cash Flow? Telltale Signs of Financial Difficulty 622 Operating, Investing, and Financing Activities 623 Two Formats for Operating Activities 624 Why Buy Another Company? 547 Consolidation Accounting 547 The Consolidated Balance Sheet and the Related Work Sheet 548 Goodwill and Minority Interest 550 Income of a Consolidated Entity 550 Long-Term Investments in Bonds 619 Basic Concepts: The Statement of Cash Flows ISBN: 0-536-55962-7 Appendix B Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc 764 ■ Appendix B ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Appendix B Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc ■ 765 766 ■ Appendix B ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Appendix B Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc ■ 767 768 ■ Appendix B ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Appendix B Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc ■ 769 770 ■ Appendix B ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Appendix B Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc ■ 771 772 ■ Appendix B ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Appendix B Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc ■ 773 774 ■ Appendix B ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc ISBN: 0-536-55962-7 Appendix B Financial Accounting , Seventh Edition, by Walter Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, T.2009 Copyright © 2008 by Pearson Education, Inc ■ 775 ISBN: 0-536-55962-7 Financial Accounting, Seventh Edition, by Walter T Harrison, Jr and Charles T Horngren Published by Prentice Hall Specially prepared for D03170808 on 21 Oct, 2009 Copyright © 2008 by Pearson Education, Inc Time Value of Money: Future Value and Present Value The following discussion of future value lays the foundation for our explanation of present value in Chapter but is not essential For the valuation of long-term liabilities, some instructors may wish to begin on page 781 of this appendix The term time value of money refers to the fact that money earns interest over time Interest is the cost of using money To borrowers, interest is the expense of renting money To lenders, interest is the revenue earned from lending We must always recognize the interest we receive or pay Otherwise, we overlook an important part of the transaction Suppose you invest $4,545 in corporate bonds that pay 10% interest each year After year, the value of your investment has grown to $5,000 The difference between your original investment ($4,545) and the future value of the investment ($5,000) is the amount of interest revenue you will earn during the year ($455) If you ignored the interest, you would fail to account for the interest revenue you have earned Interest becomes more important as the time period lengthens because the amount of interest depends on the span of time the money is invested Let’s consider a second example, this time from the borrower’s perspective Suppose you purchase a machine for your business The cash price of the machine is $8,000, but you cannot pay cash now To finance the purchase, you sign an $8,000 note payable The note requires you to pay the $8,000 plus 10% interest year from the date of purchase Is your cost of the machine $8,000, or is it $8,800 [$8,000 plus interest of $800 ($8,000 × 10)]? The cost is $8,000 The additional $800 is interest expense and not part of the cost of the machine Future Value The main application of future value is the accumulated balance of an investment at a future date In our first example above, the investment earned 10% per year After year, $4,545 grew to $5,000, as shown in Exhibit C-1 If the money were invested for years, you would have to perform such calculations You would also have to consider the compound interest that your investment is earning Compound interest is not only the interest you earn on your principal amount, but also the interest you receive on the interest you have already earned Most business applications include compound interest The following table shows the interest revenue earned on the original $4,545 investment each year for years at 10%: ... believes it? ?s worth The cost principle also holds that accounting records should maintain historical costs for as long as the business holds the asset Why? Because cost is a reliable measure Suppose... Activities on the Statement of Cash Flows 449 Other Issues in Accounting for Plant Assets Accounting for Natural Resources Accounting for Intangible Assets 445 Types of Leases 446 Do Lessees Prefer... as established by independent appraisers d Selling price The accounting equation can be expressed as: a Assets + Liabilities = Owners’ Equity b Owners’ Equity + Assets = Liabilities c Assets