Financial Accounting 9th Edition

Robert Libby
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 NINTH EDITION

Financial
Accounting
Robert Libby
Cornell University

Patricia A. Libby
Ithaca College

Frank Hodge
University of Washington
ABOUT THE AUTHORS
ROBERT LIBBY
Robert Libby is the David
A. Thomas Professor of
Accounting and Account-
ing Area Coordinator at
Cornell University, where
he teaches the introduc-
tory financial account-
ing course. He previously
taught at the University of
Illinois, Pennsylvania State
University, the University
of Texas at Austin, the University of Chicago, and
the University of Michigan. He received his BS from
Pennsylvania State University and his MAS and PhD
from the University of Illinois; he also successfully
completed the CPA exam (Illinois).
Bob was selected as the AAA Outstanding Edu-
cator in 2000 and received the AAA Outstanding
Service Award in 2006 and the AAA Notable Con-
tributions to the Literature Award in 1985 and
1996. He has received the Core Faculty Teaching
Award multiple times at Cornell. Bob is a widely
published author and researcher specializing in
behavioral accounting. He has published numer-
ous articles in The Accounting Review; Journal of
Accounting Research; Accounting, Organizations,
and Society; and other accounting journals. He
has held a variety of offices, including vice presi-
dent, in the American Accounting Association, and
he is a member of the American Institute of CPAs
and the editorial boards of The Accounting Review
and Accounting, Organizations, and Society.
PATRICIA A. LIBBY
Patricia Libby is associate
professor of accounting at
Ithaca College, where she
teaches the undergraduate
financial accounting course.
She previously taught gradu-
ate and undergraduate
financial accounting at
Eastern Michigan Univer-
sity and the University of
Texas. Before entering aca-
demia, she was an auditor with Price Waterhouse
(now PricewaterhouseCoopers) and a financial
administrator at the University of Chicago. She is
also faculty advisor to Beta Alpha Psi and Ithaca
College Accounting Association. She received her
BS from Pennsylvania State University, her MBA
from DePaul University, and her PhD from the
University of Michigan; she also successfully com-
pleted the CPA exam (Illinois).
Pat conducts research on using cases in the intro-
ductory course and other parts of the account-
ing curriculum. She has published articles in The
Accounting Review, Issues in Accounting Educa-
tion, and The Michigan CPA.
FRANK HODGE
Frank Hodge is the chair of
the Accounting Depart-
ment and the Harrington
Family Endowed Professor
at the University of Wash-
ington’s Foster School of
Business. Frank also serves
in the President’s Office
as the University of Wash-
ington’s Faculty Athletics
Representative to the PAC-
12 Conference and the National Collegiate Athletic
Association.
Frank joined the faculty at the University of Wash-
ington in 2000. He earned his MBA and PhD
degrees from Indiana University. Frank teaches
financial accounting and financial statement analy-
sis to undergraduate students, full-time MBA stu-
dents, executive MBA students, and intercollegiate
athletic administrators. Frank’s research focuses
on how individuals use accounting information to
make investment decisions and how technology
influences their information choices. Frank was
one of six members of the Financial Accounting
Standards Research Initiative team and has pre-
sented his research at the Securities and Exchange
Commission. Frank is on the editorial boards of
The Accounting Review; Contemporary Accounting
Research; and Accounting, Behavior and Organiza-
tions. He also has published articles in The Account-
ing Review; Contemporary Accounting Research;
Accounting, Organizations, and Society; Account-
ing Horizons; and several other journals. Frank lives
in Seattle with his wife and two daughters. III
 A TRUSTED LEADER FOR
New author Frank Hodge joins the award-winning author team of Bob Libby and Pat
Libby to continue Financial Accounting’s best-selling tradition of helping the instruc-
tor and student become partners in learning. Libby/Libby/Hodge uses a remarkable
learning approach that keeps students engaged and involved in the material from the
first day of class.

Libby/Libby/Hodge’s Financial Accounting maintains its leadership by focusing on

three key attributes:

THE PIONEERING FOCUS COMPANY APPROACH

The Libby/Libby/Hodge authors’ trademark focus company approach is the best method
for helping students understand financial statements and the real-world implications
of financial accounting for future managers. This approach shows that accounting is
relevant and motivates students by explaining accounting in a real-world context.
Throughout each chapter, the material is integrated around a familiar focus company,
its decisions, and its financial statements. This provides the perfect setting for dis-
cussing the importance of accounting and how businesses use accounting information.

A BUILDING-BLOCK APPROACH TO TEACHING

TRANSACTION ANALYSIS
Faculty agree the accounting cycle is the most critical concept to learn and master for
students studying financial accounting. Libby/Libby/Hodge believes students strug-
gle with the accounting cycle when transaction analysis is covered in one chapter. If
students are exposed to the accounting equation, journal entries, and T-accounts for
both balance sheet and income statement accounts in a single chapter, many are left
behind and are unable to grasp material in the next chapter, which typically covers
adjustments and financial statement preparation.

The market-leading Libby/Libby/

“The book does an excellent job of using real-world examples to Hodge approach spreads transaction
highlight the importance of understanding financial accounting analysis coverage over two chapters
to students who may or may not be interested in pursuing so that students have the time to
accounting careers. I think this book will hold students’ master the material. In Chapter 2 of
attention, without sacrificing the technical information that Financial Accounting, students are
provides the foundation for further accounting coursework. exposed to the accounting equation
Exceptionally well-written and nicely organized.” and transaction analysis for investing
—Paul Hribar, University of Iowa and financing transactions that affect
only balance sheet accounts. This

IV
STUDENTS AND INSTRUCTORS
provides students with the oppor- Accounting Cycle
tunity to learn the basic structure Start Early Compress Coverage Extend Coverage
and tools used in accounting in (Libby/Libby/Hodge approach)
a simpler setting. In Chapter 3,
Overview of F/S and Users, Overview of F/S and Users Overview of F/S and Users
students are exposed to more
B/S and I/S Transactions with
complex operating transactions Accounting Equation
B/S Transactions
that also affect income statement F/S, Ratios, and Conceptual
with Accounting Equation,
Framework
accounts. By slowing down the Journal Entries, and T-accounts
introduction of transactions and B/S and I/S Transactions
with Journal Entries and B/S and I/S Transactions
giving students time to practice with Accounting Equation,
B/S and I/S Transactions
T-accounts with Accounting Equation,
and gain mastery, this building- Journal Entries, and T-accounts Journal Entries, and T-accounts
block approach leads to greater
student success in their study of Adjustments, Closing Adjustments, Closing Adjustments, Closing
later topics in financial account- Entries, F/S Preparation Entries, F/S Preparation Entries, F/S Preparation
ing such as adjusting entries.
After the students have devel-
oped an understanding of the complete accounting cycle and the resulting statements,
Chapter 5 takes students through the corporate reporting and analysis process.

This graphic shows a detailed comparison of the Libby/Libby/Hodge approach to

the accounting cycle chapters compared to the approach taken by other financial
accounting texts.

The authors’ approach to introducing the accounting cycle has been tested in peer-
reviewed, published research studies. One of these award-winning studies has
shown that the accounting cycle approach
used in this textbook yields learning gains that
“[Libby, Libby, Hodge] does a great job explaining
outpace approaches used in other textbooks
by a significant margin.
financial accounting concepts to college students
on an introductory level.”
POWERFUL TECHNOLOGY FOR —Peggy O’Kelly, Northeastern University
TEACHING AND STUDY
Students have different learning styles and
conflicting time commitments, so they want “The text has some of the best discussions that I
technology tools that will help them study have seen in introductory texts of statement of
more efficiently and effectively. The ninth
cash flows and financial statement analysis topics.”
edition includes the best technology available
—Marilyn Misch, Pepperdine University
with Connect’s latest features—SmartBook,
Connect Insight, and new study, practice, and
assessment materials. V
 MARKET-LEADING PEDAGOGY
Financial Accounting, 9e, offers a host of pedagogical tools that complement the
different ways you like to teach and the ways your students like to learn. Some offer
information and tips that help you present a complex subject; others highlight issues
relevant to what your students read online or see on television. Either way, Financial
Accounting’s pedagogical support will make a real difference in your course and in
your students’ learning.

FINANCIAL Interpreting Assets, Liabilities, and Stockholders’

A N A LY S I S Equity on the Balance Sheet
Assessment of Le-Nature’s assets was important to its creditors, Wells Fargo Bank and others, and its
stockholders because assets provide a basis for judging whether the company has sufficient resources
A QUESTION
Ethics and
available the Need
to operate. Assetsfor
areInternal Control
also important because they could be sold for cash in the event that
OF ETHICS

Some people are bothered by the recommendation that all well-run companies should have strong inter-
nal control procedures. These people believe that control procedures suggest that management does not
K E Y R AT I O
Net Profit
trust the Margin
company’s employees. Although the vast majority of employees are trustworthy, employee theft
A N A LY S I S

? ANALYTICAL QUESTION
FOCUS ON How effective is management in generating profit on every dollar of sales?
Working Capital and Cash Flows
CASH FLOWS

Many working capital accounts have a direct relationship to income-producing activities. Accounts
receivable, for example, are related to sales revenue: Accounts receivable increase when sales are made
I N T E R N AT I O N A L The International Accounting Standards Board and Global
PERSPECTIVE Convergence of Accounting Standards
Financial accounting standards and disclosure requirements are adopted by national regulatory agen-
cies. Since 2002, there has been substantial movement toward the adoption of International Finan-
cial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB).
Examples of jurisdictions requiring the use of IFRS currently include:

FINANCIAL ANALYSIS BOXES—These features tie important chapter concepts to

real-world decision-making examples. They also highlight alternative viewpoints and
add to the critical-thinking and decision-making focus of the text.

A QUESTION OF ETHICS BOXES—These boxes appear throughout the text, convey-

ing the importance and the consequences of acting responsibly in business practice.

“Excellent book with very good and clear writing, coverage,

illustrations and overall very student friendly.”
—Kashi Balachandran, New York University

VI
 Balance at December 31, 2014 $400 $290,200 $1,721,800 $2,012,400
Additional stock issuance 100 3,600 3,700 From transaction (a) in Ch. 2
Net income 122,600 122,600 From the income statement
Dividends declared (3,000) (3,000) From transaction (f ) in Ch. 2
Balance at March 31, 2015 $500 $293,800 $1,841,400 $2,135,700 On the balance sheet

Balance Sheet
The ending balances for Common Stock, Additional Paid-in Capital, and Retained Earnings

AND CONTENT
from the statement of stockholders’ equity are included on the balance sheet that follows. You
will notice that the contra-asset account, Accumulated Depreciation (used cost), has been sub-
tracted from the total of the land, buildings, and equipment accounts (at cost) to reflect net
book value (or carrying value) at month-end for balance sheet purposes. Also recall that assets
are listed in order of liquidity, and liabilities are listed in order of due dates. Current assets are
those used or turned into cash within one year (as well as inventory). Current liabilities are
obligations to be paid with current assets within one year. We present the balances at the end of
2014 and the balances at the end of the first quarter of 2015.

FOCUS ON CASH FLOWS BOXES—Each
of the first eleven chapters includes a dis-
cussion and analysis of changes in the cash
Cash Flows from Operations, Net Income, and the Quality of Earnings
FOCUS ON
CASH FLOWS
As presented in the previous chapters, the statement of cash flows explains the difference between the
ending and beginning balances in the Cash account on the balance sheet during the accounting period.
Put simply, the cash flow statement is a categorized list of all transactions of the period that affected the

flows of the focus company and explores
the decisions that caused those changes.
Cash account. The three categories are operating, investing, and financing activities. Since no adjust-
ments made in this chapter affected cash, the cash flow categories identified on the Cash T-account
at the end of Chapter 3 remain the same.
Many standard financial analysis texts warn analysts to look for unusual deferrals and accruals when they
attempt to predict future periods’ earnings. They often suggest that wide disparities between net income and
cash flow from operations are a useful warning sign. For example, Subramanyan suggests the following:

KEY RATIO ANALYSIS BOXES—Each box Accounting accruals determining net income rely on estimates, deferrals, allocations, and valuations.
These considerations sometimes allow more subjectivity than do the factors determining cash flows.
For this reason we often relate cash flows from operations to net income in assessing its quality.
presents ratio analysis for the focus com-
pany in the chapter as well as for comparative companies. Cautions are also provided
to help students understand the limitations of certain ratios. lib22136_ch04_164-229.indd 183 10/09/15 06:56 PM

INTERNATIONAL PERSPECTIVE BOXES—These boxes highlight the emergence

of global accounting standards (IFRS) at a level appropriate for the introductory
student.

“The textbook focuses on the key accounting concepts and is written

clearly so that it is easy for students to understand.”
—Rada Brooks, University of California Berkeley, Haas School of Business

“The real-life examples are an excellent way to draw in the student

and I thought that the ethics components and IFRS components
were an excellent addition.”
—Tammy Metzke, Milwaukee Area Technical College

VII
 PRACTICE IS KEY TO SUCCESS
PAU S E F O R F E E D B AC K PAUSE FOR FEEDBACK AND
Inventory should include all items owned that are held for resale. Costs flow into inventory when
goods are purchased or manufactured. They flow out (as an expense) when they are sold or disposed
SELF-STUDY QUIZ
of. The cost of goods sold equation describes these flows.

SELF-STUDY QUIZ
Research shows that students learn best when they are
1. Assume the following facts for Harley-Davidson’s Motorclothes leather baseball jacket
product line for the year 2016.
actively engaged in the learning process. This active
Beginning inventory: 400 units at unit cost of $75.
Purchases: 600 units at unit cost of $75.
learning feature engages the student, provides interac-
tivity, and promotes efficient learning. These quizzes ask
Sales: 700 units at a sales price of $100 (cost per unit $75).
Using the cost of goods sold equation, compute the dollar amount of goods available for
sale, ending inventory, and cost of goods sold of leather baseball jackets for the period.

Beginning inventory
+ Purchases of merchandise during the year
students to pause at strategic points throughout each
Goods available for sale
- Ending inventory
chapter to ensure they understand key points before mov-
ing ahead.
Cost of goods sold

2. Assume the following facts for Harley-Davidson’s Motorclothes leather baseball jacket
product line for the year 2017.
Beginning inventory: 300 units at unit cost of $75.
Ending inventory: 600 units at unit cost of $75.
Sales: 1,100 units at a sales price of $100 (cost per unit $75).

Using the cost of goods sold equation, compute the dollar amount of purchases of leather
baseball jackets for the period. Remember that if three of these four values are known, the
cost of goods sold equation can be used to solve for the fourth value.

“The Pause for Feedback and Self-Study

Beginning inventory
+ Purchases of merchandise during the year
- Ending inventory
Cost of goods sold

After you have completed your answers, check them below.

Quizzes give the student the opportunity
GUIDED HELP 7-1
to test their understanding of the
For additional step-by-step video instruction on using the cost of goods sold equation to compute
relevant income statement amounts, go to www.mhhe.com/libby9e_gh7a. material before moving forward and also
1. Beginning inventory (400 × $75) $30,000
Solutions to
SELF-STUDY QUIZ
assist in breaking up the chapter into
manageable sections.”
+ Purchases of merchandise during the year (600 × $75) 45,000
Goods available for sale (1,000 × $75) 75,000
- Ending inventory (300 × $75) 22,500
Cost of goods sold (700 × $75) $52,500
2. BI = 300 × $75 = $22,500
EI = 600 × $75 = $45,000
BI + P - EI = CGS
22,500 + P - 45,000 = 82,500 —Betty P. David, Francis Marion University
CGS = 1,100 × $75 = $82,500 P = 105,000

GUIDED HELP
Today’s students have a wide variety of time com-
mitments. And research shows that when they
have difficulty understanding a key concept, they
benefit most when help is available immediately.
Our unique Guided Help feature provides a nar-
rated, animated, step-by-step walk-through of
select topics covered in the Self-Study Quiz that
students can view at any time through their mobile
device or online. It also saves office hour time!

VIII
IN FINANCIAL ACCOUNTING

CHAPTER TAKE-AWAYS
End-of-chapter summaries complement the learning objectives outlined at the begin-
ning of the chapter.

C H A P T E R TA K E -AWAYS

7-1. Apply the cost principle to identify the amounts that should be included in inventory and the
expense matching principle to determine cost of goods sold for typical retailers, wholesalers,
and manufacturers. p. 335
Inventory should include all items owned that are held for resale. Costs flow into inventory when
goods are purchased or manufactured. They flow out (as an expense) when they are sold or disposed
of. In conformity with the expense matching principle, the total cost of the goods sold during the
period must be matched with the sales revenue earned during the period. A company can keep track
of the ending inventory and cost of goods sold for the period using (1) the perpetual inventory sys-
tem, which is based on the maintenance of detailed and continuous inventory records, and (2) the
periodic inventory system, which is based on a physical count of ending inventory and use of the
cost of goods sold equation to determine cost of goods sold.
7-2. Report inventory and cost of goods sold using the four inventory costing methods. p. 340
The chapter discussed four different inventory costing methods used to allocate costs between the
units remaining in inventory and the units sold and their applications in different economic circum-
stances. The methods discussed were specific identification, FIFO, LIFO, and average cost. Each of
the inventory costing methods conforms to GAAP. Public companies using LIFO must provide note
disclosures that allow conversion of inventory and cost of goods sold to FIFO amounts. Remember
that the cost flow assumption need not match the physical flow of inventory.

COMPREHENSIVE PROBLEMS
Selected chapters include problems that cover topics from earlier chapters to
refresh, reinforce, and build an integrative understanding of the course material.

COMPREHENSIVE PROBLEM (CHAPTERS 6–8)

COMP8-1 Complete the requirements for each of the following independent cases:
Case A. Dr Pepper Snapple Group, Inc., is a leading integrated brand owner, bottler, and distributor of
nonalcoholic beverages in the United States, Canada, and Mexico. Key brands include Dr. Pep-
per, Snapple, 7-UP, Mott’s juices, A&W root beer, Canada Dry ginger ale, Schweppes ginger
ale, and Hawaiian Punch, among others.
The following represents selected data from recent financial statements of Dr Pepper Snapple Group
(dollars in millions):

DR PEPPER SNAPPLE GROUP, INC.

Consolidated Balance Sheets (partial)
(in millions) December 31, 2014 December 31, 2013

Assets
Current assets:
Cash and cash equivalents $237 $153
Accounts receivable (net of allowances
of $2 and $3, respectively) 61 58

Consolidated Statements of Income (partial)

For the Year Ended

December 31

(in millions) 2014 2013 2012

Net sales $6,121 $5,997 $5,995

...
Net income $ 703 $ 624 $ 629

IX
 CASES AND PROJECTS CASES AND PROJECTS
Annual Report Cases This section includes annual report cases,
CP1-1
LO1-1
Finding Financial Information
Refer to the financial statements of American Eagle Outfitters in Appendix B at the end of this book.
financial reporting and analysis cases, crit-
Required:
Skim the annual report. Look at the income statement, balance sheet, and cash flow statement closely
ical thinking cases, and financial reporting
and attempt to infer what kinds of information they report. Then answer the following questions based
on the report. and analysis team projects. The real-world
1. What types of products does American Eagle Outfitters sell?
2. On what date does American Eagle Outfitters’s most recent reporting year end?
3. For how many years does it present complete
company analysis theme is continued in
this section, giving students practice com-
a. Balance sheets?
b. Income statements?
c. Cash flow statements?
4. Are its financial statements audited by independent CPAs? How do you know?
5. Did its total assets increase or decrease over the last year? paring American Eagle and Urban Outfit-
6. How much inventory (in dollars) did the company have as of January 31, 2015 (accountants would
call this the ending balance)?
7. Write out the basic accounting (balance sheet) equation and provide the values in dollars reported by
ters among other relevant companies.
the company as of January 31, 2015.
New for the ninth edition: several of these
CP1-2 Finding Financial Information
LO1-1 Refer to the financial statements of Urban Outfitters in Appendix C at the end of this book. Cases and Projects are now in Connect as
auto-graded assignment option.

CONTINUING PROBLEM CONTINUING PROBLEM

CON1-1 Financial Statements for a New Business Plan The continuing case revolves around
Penny Cassidy is considering forming her own pool service and supply company, Penny’s Pool Ser-
vice & Supply, Inc. (PPSS). She has decided to incorporate the business to limit her legal liability.
She expects to invest $20,000 of her own savings and receive 1,000 shares of common stock. Her plan
Penny’s Pool Service & Supply, Inc., and
for the first year of operations forecasts the following amounts at December 31, the end of the current
year: Cash in bank, $2,900; amounts due from customers for services rendered, $2,300; pool supplies its largest supplier, Pool Corporation,
inventory, $4,600; equipment, $28,000; amounts owed to Pool Corporation, Inc., a pool supply
wholesaler, $3,500; note payable to the bank, $5,000. Penny forecasts first-year sales of $60,000,
wages of $24,000, cost of supplies used of $8,200, other administrative expenses of $4,500, and
Inc. In the first five chapters, the con-
tinuing case follows the establishment,
income tax expense of $4,000. She expects to pay herself a $10,000 dividend as the sole stockholder
of the company.

operations, and financial reporting for

Required:
If Penny’s estimates are correct, what would the following first-year financial statements look like for
Penny’s Pool Service & Supply (use Exhibits 1.2, 1.3, and 1.4 as models)?
1. Income statement
2. Statement of stockholders’ equity Penny’s. In Chapter 5, Pool Corporation,
3. Balance sheet
a real publicly traded corporation, is also
introduced in more detail. The Pool Cor-
poration example is then extended to
encompass each new topic in the remain-
ing chapters.

“This is an excellent book that can be used for both an introductory

course as well as an MBA class. The book has a simple, conversational
and easy-to-understand writing style. The book is also very well
organized and has a lot of end-of-chapter material. This is one of
the best financial accounting books that I have come across. It is a
must for a financial accounting course.”
—Syed Hasan, George Mason University

X
WHAT’S NEW IN THE 9th EDITION?
In response to feedback and guidance from numerous financial accounting faculty,
the authors have made many important changes to the ninth edition of Financial
Accounting, including the following:

Ů
*OUFHSBUFE
new focus companies including Amazon, the world’s largest Internet
retailer; Whole Foods Market, a supermarket chain specializing in organic food; and
Graham Holdings Company, a company that expands primarily through investing in other
companies, including Kaplan, Inc.
Ů
Detailed edit of Chapters 9, 10, and 11 to use consistent terminology throughout each
chapter and more closely link content to other chapters.
Ů
Expanded the number of Guided Help features in the text to provide more of these nar-
rated, animated, step-by-step examinations of select topics in the Self-Study Quizzes in
each chapter.
Ů
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port new topics and learning objectives. In addition, other new McGraw-Hill Connect®
problem formats include General Ledger Problems that auto-post from journal entries to
T-accounts to trial balances, Excel Simulations, and Interactive Presentations.
Ů
"EEFEǂnew Annual Report Cases that can be auto-graded in Connect. In addition, the
Cases and Projects content from the book is also now available in Connect as either auto-
graded or manually graded questions.

Chapter 1
Focus Company: Le-Nature’s Inc.
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accounting fraud that is exciting, yet
simple. Students are introduced to the
structure, content, and use of the four
basic financial statements through the
story of two brothers who founded
Le-Nature’s Inc., a natural beverage
company. Le-Nature’s financial state-
ments are used to support increases in
borrowing for expansion. When actual
sales do not live up to expectations, the
brothers turn to financial statement
fraud to cover up their failure, which
emphasizes the importance of controls,
responsible ethical conduct, and accu-
rate financial reporting.
Ů
GUIDED HELP feature provides all users
of the text with free access to step-by-
step video instruction on preparing a
simple balance sheet, income statement,
and statement of stockholders’ equity
for LaCrosse Footwear, a leading out-
door footwear company.
Ů
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Connect®.
Ů
New CONTINUING PROBLEM added
to the end-of-chapter problems based
on the activities of Penny’s Pool Service
& Supply and its supplier, Pool Cor-
poration. These companies provide a
consistent context for summarizing the
key points emphasized in each chapter.
In Chapter 1, students prepare a basic
income statement, statement of stock-
holders’ equity, and balance sheet based
on Penny’s estimates for the first year.
Ů
New Annual Report Case that can be
graded through Connect.
Ů
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end-of-chapter exercises, problems, and
cases.
Chapter 2
Focus Company: Chipotle Mexican Grill
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cycle for Chipotle Mexican Grill, a
trendy, yet relatively simple company.
The chapter integrates financial informa-
tion for investing and financing activities
for the first quarter of 2015, resulting in
the company’s actual quarterly balance
sheet (with a few simplifications). This
fast-casual restaurant does not utilize
franchising, thus reducing the complexi-
ties found with most other competitors
and allowing focused emphasis on
transaction analysis, journal entries,
T-accounts, and the structure of the bal-
ance sheet.
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reflect the new definitions from the FASB.
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more closely to end-of-chapter material.
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to illustrate posting the effects, while
marginal notes have been deleted for a
cleaner visual approach.
Ů
New additional GUIDED HELP feature
provides free access to step-by-step
video instruction applying transaction
analysis to identify accounts and effects
on the accounting equation. This is in
addition to the existing Guided Help
for recording, posting, and classifying
accounts for financing and investing
activities.
XI
Ů
New CONTINUING PROBLEM added
to the end-of-chapter problems based
on the activities of Penny’s Pool Ser-
vice & Supply and its supplier, Pool
Corporation. These companies pro-
vide a consistent context for sum-
marizing the key points emphasized
in each chapter. In Chapter 2, stu-
dents prepare journal entries, post
to T-accounts, prepare a trial balance
and classified balance sheet, iden-
tify investing and financing activities
affecting cash flows, and compute and
interpret the current ratio based on
the balance sheet for Penny’s Pool Ser-
vice & Supply.
Ů
New and updated real companies, as
well as additional exercises on key con-
cepts, in end-of-chapter exercises, prob-
lems, and cases.
Ů
New Annual Report Case that can be
graded through Connect.
Chapter 3
Focus Company: Chipotle Mexican Grill
Ů
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ing and illustrating transaction analysis
for operating activities for the first
quarter of 2015 for Chipotle Mexican
Grill. Students apply their knowledge
of accounting concepts by preparing
journal entries and posting to T-accounts
using Chapter 2 transactions involving
revenues and expenses.
Ů
'PDVT
BOE
DPOUSBTU
DPNQBOZ
EBUB

updated.
Ů
New concepts based on the FASB’s
Accounting Standards Updates for rev-
enue recognition and expense recogni-
tion are incorporated in the chapter and
end-of-chapter material.
Ů
New additional GUIDED HELP feature
provides free access to step-by-step
video instruction applying transac-
tion analysis to identify accounts and
effects on the accounting equation.
This is in addition to the existing
Guided Help for identifying revenue
and expense account titles and amounts
for a given period.
XII
Ů
New CONTINUING PROBLEM added
to the end-of-chapter problems based
on the activities of Penny’s Pool Ser-
vice & Supply and its supplier, Pool
Corporation. These companies provide
a consistent context for summariz-
ing the key points emphasized in each
chapter. In Chapter 3, students prepare
journal entries, create a classified
income statement, and calculate and
analyze the net profit margin for Penny’s
Pool Service & Supply.
Ů
New and updated real companies,
as well as additional exercises on key
concepts, in end-of-chapter exercises,
problems, and cases.
Ů
New Annual Report Case that can be
graded through Connect.
Chapter 4
Focus Company: Chipotle Mexican
Grill
Ů
$IBQUFS

CVJMET
PO
$IBQUFST

BOE

CZ

explaining and illustrating end-of-period
adjustments, financial statements, and
closing the records for the first quarter
of 2015 for Chipotle Mexican Grill.
Ů
'PDVT
BOE
DPOUSBTU
DPNQBOZ
EBUB

updated.
Ů
5IF
QSPDFTT
GPS
JEFOUJGZJOH
BOE
SFDPSE-
ing an adjustment at the end of the
period has been modified to provide a
logical progression—with the journal
entry followed by the effects on the
accounting equation, followed by posting
the effects in the T-accounts—with less
marginal clutter.
Ů
New additional GUIDED HELP feature
provides free access to step-by-step
video instruction on recording a closing
entry. This is in addition to the existing
Guided Help for recording adjusting
entries.
Ů
New CONTINUING PROBLEM added to
the end-of-chapter problems based on
the activities of Penny’s Pool Service &
Supply and its supplier, Pool Corpora-
tion. These companies provide a con-
sistent context for summarizing the key
points emphasized in each chapter. In
$IBQUFS

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BEKVTUJOH

journal entries for Penny’s Pool Service &
Supply.
Ů
New and updated real companies,
as well as additional exercises on key
concepts, in end-of-chapter exercises,
problems, and cases.
Ů
New Annual Report Case that can be
graded through Connect.
Chapter 5
Focus Company: Apple Inc.
Ů
$IBQUFS

IBT
CFFO
SFXSJUUFO
BSPVOE
UIF

most recent financial statements and
corporate governance and disclosure
processes of Apple Inc., students’ favor-
ite technology company.
Ů
'PDVT
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DPNQBOZ
EBUB

updated.
Ů
'PDVT
PG
UIF
DIBQUFS
IBT
CFFO
OBSSPXFE

to three topics: details of the corporate
governance and disclosure process;
financial statement formats and impor-
tant subtotals, totals, and additional
disclosures; and the analysis of financial
statements through gross profit, net
profit, total asset turnover, and return
on assets analysis.
Ů
'SBVE
USJBOHMF
QSPWJEFT
UIF
CBTJT

for the corporate governance
discussion.
Ů
New section on the effects of transac-
tions on key ratios added to tie in the
chapter to material in Chapters 2, 3,
BOEǂ
Ů
GUIDED HELP feature provides free
access to step-by-step video instruction
on preparing a detailed classified income
statement and balance sheet from a trial
balance for Amazon.com, the world’s
largest online retailer.
Ů
.PSF
BMHPSJUINJD
FYFSDJTFT
JODMVEFE
JO

Connect.
Ů
Two new CONTINUING PROBLEMS
added to the end-of-chapter problems.
The first asks students to evaluate the
effects of key transactions on important
statement subtotals and financial ratios
 for Penny’s Pool Service & Supply. The
second introduces Penny’s supplier, Pool
Corporation, a public company, and asks
students to prepare a detailed classified
income statement and balance sheet and
compute the gross profit percentage and
return on assets ratios.
Ů
New Annual Report Case that can be
graded through Connect.
Ů
New and updated real companies in
end-of-chapter exercises, problems, and
cases.
Chapter 6
Focus Company: Deckers Brands
Ů
'PDVT
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DPNQBOZ
EBUB

updated.
Ů
$POUFOU
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UP
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topics: determinants of net sales,
receivables valuation, and control
of cash.
Ů
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UP
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SFGMFDU

the chapter flow.
Ů
$PWFSBHF
PG
CBE
EFCU
SFDPWFSJFT

increased.
Ů
$PWFSBHF
PG
FMFDUSPOJD
CBOLJOH

increased.
Ů
Two New GUIDED HELP features
provide free access to step-by-step video
instruction on (1) preparing entries
related to bad debts and determining
their financial statement effects and
(2) using aging to estimate bad debt
expense.
Ů
.PSF
BMHPSJUINJD
FYFSDJTFT
JODMVEFE

in Connect.
Ů
New CONTINUING PROBLEM added
to the end-of-chapter problems. Stu-
dents are asked to make summary
entries for bad debts and compute
the amount to be reported as net
sales for Pool Corporation, a public
company.
Ů
New Annual Report Case that can be
graded through Connect.
Ů
New and updated real companies in
end-of-chapter exercises, problems,
and cases.
Chapter 7
Focus Company: Harley-Davidson, Inc.
Ů
'PDVT
BOE
DPOUSBTU
DPNQBOZ
EBUB

updated.
Ů
$PWFSBHF
PG
QFSQFUVBM
WFSTVT
QFSJPEJD

inventory systems moved to section on
cost of goods sold near the beginning of
the chapter.
Ů
New rules for applying lower-of-cost-
or-market to inventories covered at an
appropriate level for the introductory
course.
Ů
Two New GUIDED HELP features pro-
vide free access to step-by-step video
instruction on (1) computation of goods
available for sale and cost of goods sold
and (2) computing cost of goods sold and
ending inventory under FIFO and LIFO
costing methods.
Ů
&YIJCJUT

BOE

SFWJTFE
UP
NBLF
JU

easier to see the effects of FIFO, LIFO,
and average costing methods on the
financial statements.
Ů
Supplement B added to demonstrate the
effects of determining FIFO and LIFO
cost of goods sold under periodic versus
perpetual inventory systems.
Ů
.PSF
BMHPSJUINJD
FYFSDJTFT
JODMVEFE
JO

Connect.
Ů
New CONTINUING PROBLEM added to
the end-of-chapter problems. Students
are asked to compute the effects of the
LIFO/FIFO choice for inventory items
with increasing and decreasing costs for
Pool Corporation, a public company.
Ů
New Annual Report Case that can be
graded through Connect.
Ů
New and updated real companies in
end-of-chapter exercises, problems, and
cases.
Chapter 8
Focus Company: Southwest Airlines
Ů
$IBQUFS

JMMVTUSBUFT
UIF
BDRVJTJUJPO

use, repair and improvement, and dis-
posal of property, plant, and equipment,
followed by an illustration of accounting
and reporting for intangible assets and
natural resources, at several companies
including Cisco Systems, Walt Disney
Company, Papa John’s International,
and International Paper, among others.
Ů
'PDVT
BOE
DPOUSBTU
DPNQBOZ
EBUB

updated.
Ů
New additional GUIDED HELP feature
provides free access to step-by-step
video instruction on recording a disposal
of an asset. This is in addition to the
existing Guided Help for determining
cost and creating depreciation schedules
under straight-line, units-of-production,
and declining-balance methods.
Ů
New CONTINUING PROBLEM added
to the end-of-chapter problems. Based
on the activities of Pool Corporation,
students are asked to determine cost;
create depreciation schedules under
straight-line, units-of-production, and
declining-balance methods; and dispose
of an asset.
Ů
New and updated real companies, as
well as additional exercises on key con-
cepts, in end-of-chapter exercises, prob-
lems, and cases.
Ů
New Annual Report Case that can be
graded through Connect.
Chapter 9
Focus Company: Starbucks
Ů
'PDVT
DPNQBOZ
EBUB
VQEBUFE
/FX

contrast companies added.
Ů
$PNQMFUF
SFWJTJPO
PG
DIBQUFS
DPOUFOU
UP

more closely link content to other chap-
ters and to use consistent terminology
throughout the chapter.
Ů
6QEBUFE
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WBMVF
EJTDVTTJPO
BOE

graphics for both single amounts and
annuities. Chapter now includes descrip-
tions of how to calculate present values
using tables, calculators, and Excel.
Ů
New GUIDED HELP features teach
students the steps required to compute
present values using two popular calcula-
tor models (HP 10BII+ and HP 12C) and
Excel.
Ů
New Supplement A uses vivid graphics
to display the steps required to compute
XIII
 present values using two popular
calculator models (HP 10BII+ and HP
12C) and Excel.
Ů
New CONTINUING PROBLEM added to
the end-of-chapter problems. Students
are asked to record transactions that
affect the liabilities section of the
balance sheet for Pool Corporation, a
public company.
Ů
New Annual Report Case that can be
graded through Connect.
Ů
New and updated real companies in
end-of-chapter exercises, problems, and
cases.
Ů
&OEPGDIBQUFS
NBUFSJBM
DPNQMFUFMZ

updated to seamlessly match the content
of the chapter.
Chapter 10
Focus Company: Amazon
Ů
New focus company and new contrast
companies.
Ů
$PNQMFUF
SFWJTJPO
PG
DIBQUFS
DPOUFOU
UP

more closely link content to other chap-
ters and to use consistent terminology
throughout the chapter.
Ů
New graphics that visually help students
understand the timing of bond payments
and the accounting for bonds.
Ů
New FINANCIAL ANALYSIS feature
describes bond ratings and bond rating
agencies.
Ů
3FWJTFE
TUSVDUVSF
BMMPXT
JOTUSVDUPST
UP

seamlessly assign accounting for bonds
with or without the use of discount and
premium accounts.
Ů
New GUIDED HELP features walk
students through (1) how to calculate
the present value of a bond issued at a
premium and (2) how to account for the
bond over its life.
Ů
New discussion of accounting for bond
issuance costs.
Ů
New CONTINUING PROBLEM added
to the end-of-chapter problems.
Students are asked to record bond
transactions for Pool Corporation, a
public company.
XIV
Ů
New Annual Report Case that can be
graded through Connect.
Ů
New and updated real companies in
end-of-chapter exercises, problems, and
cases.
Ů
&OEPGDIBQUFS
NBUFSJBM
DPNQMFUFMZ

updated to seamlessly match the content
of the chapter.
Chapter 11
Focus Company: Whole Foods Market
Ů
New focus company and new contrast
companies.
Ů
$PNQMFUF
SFWJTJPO
PG
DIBQUFS
DPOUFOU
UP

more closely link content to other chap-
ters and to use consistent terminology
throughout the chapter.
Ů
New discussion of stock splits effected
in the form of a stock dividend.
Ů
New FINANCIAL ANALYSIS feature on
preferred stock.
Ů
New CONTINUING PROBLEM added to
the end-of-chapter problems. Students
are asked to record transactions that
affect the equity section of the balance
sheet for Pool Corporation, a public
company.
Ů
New Annual Report Case that can be
graded through Connect.
Ů
New and updated real companies in
end-of-chapter exercises, problems, and
cases.
Ů
&OEPGDIBQUFS
NBUFSJBM
DPNQMFUFMZ

updated to seamlessly match the content
of the chapter.
Chapter 12
Focus Company: National Beverage
Corporation
Ů
'PDVT
BOE
DPOUSBTU
DPNQBOZ
EBUB

updated.
Ů
Two New GUIDED HELP features pro-
vide free access to step-by-step video
instruction on (1) preparing the operat-
ing section of the statement of cash
flows using the indirect method and (2)
preparing the investing and financing
sections of the statement of cash flows.
Ů
Supplement C and related problem
material illustrate preparation of the
complete statement of cash flows using
the T-account approach.
Ů
.PSF
BMHPSJUINJD
FYFSDJTFT
JODMVEFE
JO

Connect.
Ů
New CONTINUING PROBLEM added to
the end-of-chapter problems. Students
are asked to prepare a complete state-
ment of cash flows for Pool Corpora-
tion, a public company.
Ů
New Annual Report Case that can be
graded through Connect.
Ů
New and updated real companies in end-
of-chapter exercises, problems, and cases.
Chapter 13
Focus Company: The Home Depot
Ů
'PDVT
DPNQBOZ
EBUB
VQEBUFE
Ů
$PNQMFUF
SFWJTJPO
PG
DIBQUFS
DPOUFOU
UP

more closely link content to other chap-
ters and to use consistent terminology
throughout the chapter.
Ů
New discussion of DuPont analysis.
Ů
3BUJP
GPSNVMBT
JO
DIBQUFS
VQEBUFE
UP
CF

consistent with formulas provided in pre-
vious chapters.
Ů
New CONTINUING PROBLEM added to
the end-of-chapter problems. Students
are asked to download the latest finan-
cial statements for Pool Corporation,
a public company, and compute various
ratios discussed in the chapter.
Ů
New Annual Report Case that can be
graded through Connect.
Ů
New and updated real companies in
end-of-chapter exercises, problems, and
cases.
Ů
&OEPGDIBQUFS
NBUFSJBM
DPNQMFUFMZ

updated to seamlessly match the content
of the chapter.
Appendix A
Focus Company: Graham Holdings
Company
Ů
New focus company, Graham Hold-
ings Company, a company that expands
primarily through investing in other
companies, including Kaplan, Inc. (top
admissions test preparation organiza-
tion). Accounting and reporting are
discussed and illustrated for: (1) debt
securities held to maturity, (2) passive
investments using the fair value method,
(3) investments involving significant
influence using the equity method, and

JOWFTUNFOUT
JO
DPOUSPMMJOH
JOUFSFTUT
Ů
'PDVT
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DPOUSBTU
DPNQBOZ
EBUB

updated.
Ů
GUIDED HELP feature provides free
access to step-by-step video instruction on
accounting for and reporting available-for-
sale securities as investments at fair value.
Ů
New CONTINUING PROBLEM added to
the end-of-chapter problems. Using the
activities of Pool Corporation, students
are asked to record passive investments
as trading securities and as available-for-
sale securities over a three-year period.
Ů
New and updated real companies, as
well as additional exercises on key con-
cepts, in end-of-chapter exercises, prob-
lems, and cases.
Ů
New Annual Report Case that can be
graded through Connect.
XV
 ®

Required=Results

McGraw-Hill Connect®
Learn Without Limits
Connect is a teaching and learning platform
that is proven to deliver better results for
students and instructors.
Connect empowers students by continually
adapting to deliver precisely what they
need, when they need it, and how they need
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Using Connect improves passing rates

by 10.8% and retention by 16.4%.
88% of instructors who use Connect
require it; instructor satisfaction increases
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Analytics
Connect Insight®
Connect Insight is Connect’s new one-of-a-
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performance, which is immediately actionable. By presenting
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results, Connect Insight gives the user the ability to take a just-in-
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Online Assignments
Connect helps students learn more efficiently by providing
feedback and practice material when they need it, where
they need it. Connect grades homework automatically and
gives immediate feedback on any questions students may
have missed. The extensive assignable, gradable end-of-
chapter content includes a general journal application that
looks and feels more like what you would find in a general
ledger software package. Also, select questions have been
redesigned to test students’ knowledge more fully. They
now include tables for students to work through rather than
requiring that all calculations be done offline.
End-of-chapter questions in Connect include:

$)$B3 -$. .

3 -$. .

-*' (. “Students like the flexibility that Connect offers . . . They can complete

*(+- # ).$1
-*' (. their work and catch up on lectures anytime and anywhere.”

*)/$)0$)"
-*' (. —Professor Lisa McKinney, M.T.A., CPA, University of Alabama

NEW! Cases and Projects

NEW! General Ledger Problems

New General Ledger Problems provide a much-improved student experience when working with accounting cycle
questions, offering improved navigation and less scrolling. Students can audit their mistakes by easily linking back
/*
/# $-
*-$"$)'
)/-$ .
)
)
.
#*2
/#
)0( -.
!'*2
/#-*0"#
/#
1-$*0.
!$))$'
.// ( )/.C
)4
 ) -'

Ledger Problems include an analysis tab that allows students to demonstrate their critical thinking skills and a
deeper understanding of accounting concepts.

XVIII
NEW! Interactive
Presentations
The Interactive Presentations provide
engaging narratives of all chapter
learning objectives in an assignable and
interactive online format. They follow the
structure of the text and are organized to
match the specific learning objectives within
each chapter of Financial Accounting. The
interactive presentations provide additional
explanation and enhancement of material
from the text chapter, allowing students
to learn, study, and practice with instant
feedback, at their own pace.

NEW! Excel Simulations

Simulated Excel Questions, assignable within Connect,
allow students to practice their Excel skills—such as basic
formulas and formatting—within the content of financial
accounting. These questions feature animated, narrated Help
and Show Me tutorials (when enabled), as well as automatic
feedback and grading for both students and professors.

Guided Examples
The Guided Examples in Connect provide a narrated,
animated, step-by-step walk-through of select exercises
similar to those assigned. These short presentations can be
turned on or off by instructors and provide reinforcement
when students need it most.

“As a student I need to interact with course material in order to retain it, and Connect
offers a perfect platform for this kind of learning. Rather than just reading through
textbooks, Connect has given me the tools to feel engaged in the learning process.”
—Jennah Epstein Kraus, Student, Bunker Hill Community College

XIX
 ACKNOWLEDGMENTS
Many dedicated instructors have devoted their time and effort to help us make each edition better. We would like to
acknowledge and thank all of our colleagues who have helped guide our development decisions for this and previous
editions. This text would not be the success it is without the help of all of you.
Board of Reviewers
Dawn Addington, Central New Mexico Community
College
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XX
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Allison McLeod, University of North Texas
Michael G. McMillan, Johns Hopkins University
L. Kevin McNelis, New Mexico State University
Tammy Metzke, Milwaukee Area Technical College
Michael J. Meyer, University of Notre Dame
Paulette Miller, Collin County Community College
Tim Mills, Eastern Illinois University
Marilyn Misch, Pepperdine University
Birendra Mishra, University of California at Riverside
Earl Mitchell, Santa Ana College
Dennis P. Moore, Worcester State College
Haim Mozes, Fordham University
Brian Nagle, Duquesne University
Ramesh Narasimhan, Montclair State University
Presha Neidermeyer, Union College
Samir Nissan, California Sate University—Chico
Tom Nunamaker, Washington State University
Peggy O’Kelly, Northeastern University
John O’Shaughnessy, San Francisco State University
Janet L. O’Tousa, University of Notre Dame
Donald Pagach, North Carolina State—Raleigh
Susan Parker,Santa Clara University
Sharon Parrish, Kentucky State University
Kathy Petroni, Michigan State University
Catherine Plante, University of New Hampshire
Kay Poston, Francis Marion University
Grace Pownall, Emory University
Olga Quintanta, University of Miami
Rama Ramamurthy, College of William & Mary
Charles Ransom, Oklahoma State University
Keith Richardson, Bellarmine University
Brenda Richter,Santa Barbara City College
Laura Rickett, Kent State University
Brandi Roberts, Southeastern Louisiana University
Joanne Rockness, University of North Carolina—
Wilmington
Lawrence Roman, Cuyahoga Community College
John Rossi III, Moravian College
John Rude, Bloomsburg University
Joan Ryan, Clackamas Community College
Karen Salmela, University of Minnesota—Duluth
Angela Sandberg, Jacksonville State University
Amy Santos, Manatee Community College
Maggie Schlerman, Central College
Andrew Schmidt, Columbia University
William Schmuhl, University of Notre Dame
Richard Schroeder, University of North Carolina—
Charlotte
Joann Segovia, Minnesota State University Moorhead
Cindy Seipel, New Mexico State University
Ann Selk, University of Wisconsin—Green Bay
Kathleen Sevigny, Bridgewater State College
Howard Shapiro, Eastern Washington University
Warren Smock, Ivy Technical Community College—
Lafayette
Billy Soo, Boston College
Sri Sridhanen, Northwestern University
David Stein, Metropolitan State University
Phillip Stocken, Dartmouth College
Dennis Stovall, Grand Valley State University
Joel Strong, St. Cloud State University
Gina Sturgill, Concord College
Susan Sullivan, University of Massachusetts—
Dartmouth
Martin Taylor, University of Texas—Arlington
Mack Tennyson, College of Charleston
Peter Theuri, Northern Kentucky University
W. Stewart Thomas, University of North Carolina—
Pembroke
Lynda Thompson, Massasoit Community College
Theresa Tiggeman, University of the Incarnate Word
Theodore Tully, DeVry University
Lana Tuss, Chemeketa Community College
Michael Ulinski, Pace University
Ingrid Ulstad, University of Wisconsin—Eau Claire
Marcia Veit, University of Central Florida
Charles Wain, Babson College
Rick Warne, University of Cincinnati
Charles Wasley, University of Rochester
Daniel Weddington, Ohio University—Zanesville
David Weiner, University of San Francisco
Patti Weiss, John Carroll University
Cheryl Westen, Western Illinois University
David Wiest, Washington and Lee University
Patrick Wilkie, University of Virginia
Jefferson Williams, University of Michigan
Wendy Wilson, Southern Methodist University
Peter Woodlock, Youngstown State University
Ron Woods, North Seattle Community College
Darryl Woolley, University of Idaho
Michael Yampuler, University of Houston
Kathryn Yarbrough, University of North Carolina—
Charlotte
Zhang (May) Yue, Northeastern University
Xiao-Jun Zhang, University of California at Berkeley
We are grateful to the following individuals who
helped develop, critique, and shape the extensive
ancillary package: LuAnn Bean, Florida Institute
of Technology; Jeannie Folk, College of DuPage;
Julie Head, Indiana University; Shondra Johnson,
Bradley University; Sara Kern, Gonzaga Univer-
sity; Nancy Lynch, West Virginia University; Mark
McCarthy, East Carolina University; Barbara
Muller, Arizona State University; Kristine Palmer,
Longwood College; Ilene Leopold Persoff, Long
Island University Post; Kevin Smith, Utah Valley
University; Beth Woods, Accuracy Counts; and
Teri Zuccaro, Clarke University.
We also have received invaluable input and sup-
port through the years from present and former
colleagues and students. We also appreciate the
additional comments, suggestions, and support
of our students and our colleagues at Cornell
University, Ithaca College, and University of
Washington.
Last, we applaud the extraordinary efforts of a
talented group of individuals at McGraw-Hill who
made all of this come together. We would espe-
cially like to thank Tim Vertovec, our managing
director; Natalie King, our senior brand manager;
Rebecca Mann, our senior product developer;
Kyle Burdette, our marketing manager; Daryl
Horrocks, our program manager; Lori Koetters
and Angela Norris, our project managers; Debra
Kubiak, our designer; Susan Culbertson, our
buyer; and Melissa Homer and Beth Thole, our
content licensing specialists.
Robert Libby
Patricia A. Libby
Frank Hodge
XXI
 CONTENTS IN BRIEF

Chapter 1 Chapter 10
Financial Statements and Business Decisions 2 Reporting and Interpreting Bond Securities 506
Focus Company: Le-Nature’s Inc. Focus Company: Amazon

Chapter 11
Chapter 2
Reporting and Interpreting Stockholders’ Equity


Investing and Financing Decisions and the Accounting
Focus Company: Whole Foods Market
System


Focus Company: Chipotle Mexican Grill
Chapter 12
Statement of Cash Flows 600
Chapter 3 Focus Company: National Beverage Corp.
Operating Decisions and the Accounting System 102
Focus Company: Chipotle Mexican Grill Chapter 13
Analyzing Financial Statements 658
Chapter 4 Focus Company: The Home Depot
Adjustments, Financial Statements, and the Quality of
Earnings

 Appendix A
Focus Company: Chipotle Mexican Grill Reporting and Interpreting Investments in Other
Corporations A-0
Focus Company: Graham Holdings Company
Chapter 5
Communicating and Interpreting Accounting Information 230 Appendix B
Focus Company: Apple Inc.
American Eagle Outfitters, Inc., Form 10-K Annual Report B-1

Chapter 6 Appendix C
Reporting and Interpreting Sales Revenue, Receivables, and Urban Outfitters, Inc., Form 10-K Annual Report C-1
Cash 282
Focus Company: Deckers Brands
Appendix D
Industry Ratio Report D-0
Chapter 7
Reporting and Interpreting Cost of Goods Sold and Appendix E
Inventory 332 Present and Future Value Tables E-1
Focus Company: Harley-Davidson, Inc.
Glossary G-1
Chapter 8
Reporting and Interpreting Property, Plant, and Equipment; Company Index IND-1
Intangibles; and Natural Resources 388
Focus Company: Southwest Airlines Subject Index IND-5

MBA Companion (Available in McGraw-Hill

Chapter 9 Education’s Create)
Reporting and Interpreting Liabilities

 Leases, Income Taxes, and Retirement Obligations
Focus Company: Starbucks Focus Company: Under Armour

XXII

Preface iv
Chapter 1
Financial Statements and Business Decisions 2
Le-Nature’s Inc. 3
Understanding the Business 3 Chapter 2
The Accounting System 3
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Your Goals for Chapter 1 5
The Four Basic Financial Statements: An Overview
The Balance Sheet 6
FI NANCI AL A NA LYS I S :
Interpreting Assets, Liabilities, and Stockholders’ Equity on the
Balance Sheet 8
Ů
Pause for Feedback and Self-Study Quiz
The Income Statement 9
FI NANCI AL A NA LYS I S :
Analyzing the Income Statement: Beyond the Bottom Line
Ů
Pause for Feedback and Self-Study Quiz
Statement of Stockholders’ Equity 11
FI NANCI AL A NA LYS I S :
Interpreting Retained Earnings 12
Ů
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Statement of Cash Flows 13
FI NANCI AL A NA LYS I S :
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Relationships Among the Statements 15
Notes and Financial Statement Formats 15
Summary of the Four Basic Financial Statements
Responsibilities for the Accounting Communication
Process 16
Generally Accepted Accounting Principles 16
I NT E R NAT I ONA L PE RS PE C T IV E :
The International Accounting Standards Board and Global
Convergence of Accounting Standards 18
Ensuring the Accuracy of Financial Statements
CONTENTS
Demonstration Case 21
C H A P T E R S U P P L E M E N T A : T YPES OF BUSINESS
E N TI T I E S 2 2
C H A P T E R S U P P L E M E N T B : E MPLOYMENT IN THE
AC C O U N TI N G P RO F E S S I O N TO DAY 2 3
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How Do Transactions Affect Accounts? 51
Principles of Transaction Analysis 51
Analyzing Chipotle’s Transactions 53
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How Do Companies Keep Track of Account Balances? 56
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Analytical Tools 59
F I N A N CI A L A N A LYS I S :
Inferring Business Activities from T-Accounts 61
16
Transaction Analysis Illustrated 62
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How Is the Balance Sheet Prepared and Analyzed? 66
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I N TE R N ATI O N A L P E RS P E CT I V E :
Understanding Foreign Financial Statements 68
18 Ratio Analysis in Decision Making 68
XXIII
 XXIV C O N T E N T S

KET R ATI O ANALYS I S : Chapter 4

Current Ratio 69
Adjustments, Financial Statements, and the Quality
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Adjusting Revenues and Expenses 166
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Purpose of Adjustments 166
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Chapter 3
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Elements of the Income Statement 106
FO CU S O N CA S H FLOWS :
I N TERNATI ONAL PE RS PE C T I V E :
Cash Flows from Operations, Net Income, and the Quality of
Income Statement Differences 109 Earnings 183
How are Operating Activities Recognized and Measured? 109
K E Y R ATI O A N A LYS I S :
Accrual Accounting 110
Total Asset Turnover Ratio 185
FI N ANCI AL ANALYS I S :
Closing the Books 185
Revenue Recognition for More Complex Customer Contracts 111
End of the Accounting Cycle 185
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A Q UESTI ON OF E T HI C S : Demonstration Case 188
Management’s Incentives to Violate Accounting Rules 115 End-of-Chapter Material 193
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Transaction Analysis Rules 115
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How Is the Income Statement Prepared Information 230
and Analyzed? 125
Classified Income Statement 126 Apple Inc. 231
KEY R ATI O ANALYS I S : Understanding the Business 231
Net Profit Margin 126 A Q U E ST I O N O F E TH I CS :
The Fraud Triangle 232
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Regulators (SEC, FASB, PCAOB, Stock Exchanges) 233
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Managers (CEO, CFO, and Accounting Staff) 233
Demonstration Case 129 #PBSE
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 C O N T E N TS XXV

Information Intermediaries: Information Services and Financial Motivating Sales and Collections 285
Analysts 235 Credit Card Sales to Consumers 285
FI NANCI AL A NA LYS I S : Sales Discounts to Businesses 285
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That Is the Question 286
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The Disclosure Process 238
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Press Releases 238
FI NANCI AL A NA LYS I S : Ů
Pause for Feedback and Self-Study Quiz 288

How Does the Stock Market React to Earnings Measuring and Reporting Receivables 289
Announcements? 239 Classifying Receivables 289
Annual Reports and Form 10-K 239 I N TE R N ATI O N A L P E RS P E CT I V E :
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Bad Debt Recoveries 291
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Reporting Accounts Receivable and Bad Debts 292
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Estimating Bad Debts 293
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I NT E R NAT I ONA L PE RS PE C T IV E : Reporting and Safeguarding Cash 299
Differences in Accounting Methods Acceptable under IFRS and U.S. Cash and Cash Equivalents Defined 299
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 Cash Management 299
Return on Assets Analysis: A Framework for Evaluating Company Internal Control of Cash 299
Performance 250 A Q U E ST I O N O F E TH I CS :
KE Y R AT I O A NA LYS I S : Ethics and the Need for Internal Control 300
Return on Assets (ROA) 250 Reconciliation of the Cash Accounts and the Bank Statements 300
ROA Profit Driver Analysis and Business Strategy 251 Ů
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Demonstration Case 255 Demonstration Case B 306
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Chapter 6
Chapter 7
Reporting and Interpreting Sales Revenue,
Receivables, and Cash 282 Reporting and Interpreting Cost of Goods Sold
and Inventory 332
Understanding the Business 282
Deckers Brands 283 Harley-Davidson, Inc. 333
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 XXVI C O N T E N T S

Nature of Inventory and Cost of Goods Sold 335 Chapter 8

Items Included in Inventory 335
Costs Included in Inventory Purchases
FI N ANCI AL ANALYS I S :
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in Practice 336
Flow of Inventory Costs 336
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Reporting and Interpreting Property, Plant, and
336
Equipment; Intangibles; and Natural Resources 388
Southwest Airlines 389
Understanding the Business 389
Acquisition and Maintenance of Plant and Equipment 391
Classifying Long-Lived Assets 391
339 Measuring and Recording Acquisition Cost 391
K E Y R ATI O A N A LYS I S :
Fixed Asset Turnover 392
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Repairs, Maintenance, and Improvements 396
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Depreciation Concepts 398
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FI N ANCI AL ANALYS I S :
LIFO and Inventory Turnover Ratio 352
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Control of Inventory 353
Internal Control of Inventory 353
Errors in Measuring Ending Inventory
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Demonstration Case 356
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C HAPTER S UPPLE ME NT A : LI FO L I QU I DAT I O NS 35 8
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C HAPTER S UP P LE ME N T C : A D D I T I O N A L I S S U E S I N F I N A N CI A L A N A LYS I S :
MEAS URI NG PURCHA S E S 360
Research and Development Costs: Not an Intangible Asset under
End-of-Chapter Material 362 64
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 C O N T E N TS XXVII

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Chapter 10
Chapter 9 Reporting and Interpreting Bond Securities 506
Reporting and Interpreting Liabilities 458
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 Bond Terminology 509
Bond Issuance Process 510
KE Y R AT I O A NA LYS I S :
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Bond Information from the Business Press 513
FI NANCI AL A NA LYS I S :
Refinancing Debt: Current or Long-Term Ů
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FOCUS ON CA SH FLOWS: Bonds Issued at a Premium 521

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 XXVIII C O N T E N T S

Early Retirement of Bonds 527 FO CU S O N CA S H FLOWS :

FO CUS ON CASH FLOWS: Financing Activities 572

Bonds Payable 528 Demonstration Case 573
Demonstration Case 529 CH A P TE R S U P P L E M E N T : ACCO U N T I N G FOR OWNERS’
E Q U IT Y FOR SOL E P ROP RI E TO RS HI P S A ND
C HAPTER S UPPLE ME NT : AC C OU NT I NG FO R BO NDS WI T H O U T
PA RT N E RS H IP S 5 7 4
A DIS COUNT ACCOU NT OR PR E MI U M AC C O U NT 5 2 9
End-of-Chapter Material 578
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Pause for Feedback and Self-Study Quiz 531
Comprehensive Problem (Chapters 9–11) 596
Bonds Issued at a Premium 532
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Pause for Feedback and Self-Study Quiz 534
End-of-Chapter Material 535
Chapter 12

Chapter 11 Statement of Cash Flows 600

Reporting and Interpreting Stockholders’ Equity 554

Understanding the Business 554
Whole Foods Market 555
Ownership of a Corporation 557
Benefits of Stock Ownership 557
Authorized, Issued, and Outstanding Shares 558
KEY R ATI O ANALYS I S :
Earnings per Share (EPS) 559
Common Stock Transactions 559
Initial Sale of Stock 560
Sale of Stock in Secondary Markets 560
Stock Issued for Employee Compensation 561
Repurchase of Stock 561
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Pause for Feedback and Self-Study Quiz 562
Dividends on Common Stock 563
KEY R ATI O ANALYS I S :
Dividend Yield 563
Key Dividend Dates 564
FI N ANCI AL ANALYS I S :
Impact of Dividends on Stock Price 565
Ů
Pause for Feedback and Self-Study Quiz 565
Stock Dividends and Stock Splits 566
Stock Dividends 566
Stock Splits 567
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Pause for Feedback and Self-Study Quiz 568
Statement of Stockholders’ Equity 569
Preferred Stock Transactions 570
I N TERNATI ONAL PE RS PE C T I V E :
What’s in a Name? 571
Dividends on Preferred Stock 571
FI N ANCI AL ANALYS I S :
Preferred Stock and Limited Voting Rights
Understanding the Business 600
National Beverage Corporation 601
Classifications of the Statement of Cash Flows 602
Cash Flows from Operating Activities 603
Cash Flows from Investing Activities 604
Cash Flows from Financing Activities 605
Net Increase (Decrease) in Cash 605
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Pause for Feedback and Self-Study Quiz 605
Relationships to the Balance Sheet and Income Statement 606
Preliminary Steps in Preparing the Cash Flow Statement 607
Reporting and Interpreting Cash Flows from Operating
Activities 609
Reporting Cash Flows from Operating Activities—Indirect
Method 609
I N T E R N AT IO N A L P E RS P E CT I VE :
Classification of Interest on the Cash Flow Statement 613
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Pause for Feedback and Self-Study Quiz 614
Interpreting Cash Flows from Operating Activities 614
K E Y R ATI O A N A LYSI S :
Quality of Income Ratio 615
A Q U E STI O N O F E T HI CS :
Fraud and Cash Flows from Operations 616
Reporting and Interpreting Cash Flows from
Investing Activities 616
Reporting Cash Flows from Investing Activities 616
Interpreting Cash Flows from Investing Activities 617
K E Y R ATI O A N A LYSI S :
Capital Acquisitions Ratio 618
F I N A N C IA L A N A LYSI S :
Free Cash Flow 618
Reporting and Interpreting Cash Flows
from Financing Activities 619
572 Reporting Cash Flows from Financing Activities 619
 C O N T E N TS XXIX

Interpreting Cash Flows from Financing Activities 620 Other Financial Information 682
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Pause for Feedback and Self-Study Quiz 621 A Q U E ST I O N O F E TH I CS :
Completing the Statement and Additional Insider Information 683
Disclosures 621 End-of-Chapter Material 683
Statement Structure 621
Supplemental Cash Flow Information 622
Epilogue 623
Appendix A
Demonstration Case 623 Reporting and Interpreting Investments in Other
CH AP T E R S U P P L E M E N T A : R E P O RT I NG C A S H Corporations A-0
FLOWS FROM OPE R AT I NG AC T I VI TI E S — D I R E C T
ME T HOD 625 Graham Holdings Company A-1
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Pause for Feedback and Self-Study Quiz 628
CH AP T E R S U P P L E M E N T B : A D J U STM E NT FO R G A I N S A N D Appendix B
LOS S E S O N S A L E O F LO N G -T E R M A S S E TS — I N D I R E C T
ME T HOD 628 American Eagle Outfitters, Inc., Form 10-K Annual
CH AP T E R S U P P L E M E N T C : T- AC C OU NT A PP ROAC H Report B-1
(I ND I R E CT M E T HOD ) 629
End-of-Chapter Material 631
Appendix C
Urban Outfitters, Inc., Form 10-K Annual Report C-1
Chapter 13
Analyzing Financial Statements 658 Appendix D

The Home Depot 659 Industry Ratio Report D-0

Understanding the Business 659

The Investment Decision 663 Appendix E
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Pause for Feedback and Self-Study Quiz 681 Lease Overview
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Considerations 682 Pensions and Other Postretirement Benefits Overview
 Financial
Accounting
Financial Statements
and Business Decisions

L
e-Nature’s Inc. designed its business strategy to ride the growing wave of interest in
noncarbonated beverages. And apparently its strategy was a huge success: Its financial
statements reported growth in sales from $156 to $275 million in just three years. How
did this small family-run business compete with the likes of Coke and Pepsi in this growing
market? The business press suggested the first key to its success was manufacturing a broad
range of products that fit into the fastest growing “healthy” segments: flavored waters, teas,
and fruit drinks. Founder and CEO Gregory Podlucky said that an obsessive drive for quality
and efficiency was just as critical. Matching customers’ concerns for the environment and
healthy living, Le-Nature’s was praised as one of the first companies to switch to environmen-
tally friendlier PET plastic bottles and to employ safe in-bottle pasteurization. Its 21st-century
manufacturing operation in Latrobe, Pennsylvania, produced everything that goes into its
products, from the injection-molded PET bottles to the final packaging. Complete control over
the whole process assures quality and provides the flexibility to respond quickly to changes
in customers’ demands. When convenience stores moved to larger-sized drinks or school caf-
eterias switched from carbonated beverages to healthier drinks, Le-Nature’s could change its
production to meet the customers’ needs. In August, the company opened a second new state-
of-the-art manufacturing facility in Arizona to meet the apparent growing demand.
But here is the twist: Just three short months later, investigators discovered that Le-Nature’s
phenomenal sales growth was more fiction than fact. How could this seeming success story
portrayed in the financial statements really be one of the most remarkable frauds in history?
Chapter 1 concentrates on the key financial statements that businesspeople rely upon
when they evaluate a company’s performance as well as the importance of accurate financial
statements in making our economic system work. We discuss these issues in the context of
Le-Nature’s rise and fall.
Accounting knowledge will be valuable to you only if you can apply it in the real world.
Learning is also easier when it takes place in real contexts. So at the beginning of each chap-
ter we always provide some background about the business that will provide the context for
the chapter discussion.

Lea r ni ng Obj ec ti ves

After studying this chapter, you should be able to:

1-1 Recognize the information conveyed in each of the four basic financial
statements and the way that it is used by different decision makers
(investors, creditors, and managers).
1-2 Identify the role of generally accepted accounting principles (GAAP) in
determining financial statement content and how companies ensure the
accuracy of their financial statements.
 chapter 1

FOCUS COMPANY:
© James F. Quinn/KRT/Newscom

U N D E RSTA N D I N G T H E B U S I N E S S Le-Nature’s Inc.

Le-Nature’s Inc., our focus company for this chapter, was founded by Gregory
Podlucky and his brother Jonathan, who initially were the sole owners or USING FINANCIAL STATEMENT
stockholders of the company. They were also the managers of the company. INFORMATION TO MANAGE
Using expertise gained working at their parents’ brewery (Stoney’s Beer), the GROWTH
brothers were early believers in the trend toward healthier, noncarbonated bev-
erages. Like most entrepreneurs, their growth ambitions quickly outpaced their
own financial resources. So they turned to banks, including Wells Fargo Bank
and other lenders, to finance additional manufacturing facilities and equipment.
Different units of Wells Fargo continued to arrange lending to Le-Nature’s as the
need arose, becoming its largest lender or creditor. Creditors make money on
the loans by charging interest. The Podluckys also convinced others to buy stock
in Le-Nature’s. These individuals became part owners or stockholders along with
the Podluckys. They hoped to receive a portion of what the company earned in
the form of cash payments called dividends and to eventually sell their share of
the company at a higher price than they paid. Creditors are more willing to lend
and stock prices usually rise when creditors and investors expect the company
to do well in the future. Both groups often judge future performance based on
information in the company’s financial statements.

The Accounting System

Managers (often called internal decision makers) need information about the
company’s business activities to manage the operating, investing, and financing
activities of the firm. Stockholders and creditors (often called external decision
makers) need information about these same business activities to assess whether
 4 CHAPTER 1 Financial Statements and Business Decisions
EXHIBIT 1 .1
The Accounting System
and Decision Makers
ACCOUNTING
A system that collects and
processes (analyzes, measures,
and records) financial information
about an organization and reports
that information to decision
makers.
Accounting System
Financial Accounting Reports Managerial Accounting Reports
Periodic financial statements Detailed plans and
and related disclosures continuous performance reports
provided to
External Decision Makers Internal Decision Makers
Evaluate the company Run the company
Creditors Investors
Managers
the company will be able to pay back its debts with interest and pay dividends. All busi-
nesses must have an accounting system that collects and processes financial information
about an organization’s business activities and reports that information to decision makers.
Le-Nature’s business activities included:

Ů
Financing Activities: borrowing or paying back money to lenders and receiving additional
funds from stockholders or paying them dividends.

Ů
Investing Activities: buying or selling items such as plant and equipment used in the pro-
duction of beverages.

Ů
Operating Activities: the day-to-day process of purchasing raw tea and other ingredients
from suppliers, manufacturing beverages, delivering them to customers, collecting cash
from customers, and paying suppliers.
Exhibit 1.1 outlines the two parts of the accounting system. Internal managers typically
require continuous, detailed information because they must plan and manage the day-to-day
operations of the organization. Developing accounting information for internal decision mak-
ers, called managerial or management accounting, is the subject of a separate accounting
course. The focus of this text is accounting for external decision makers, called financial
accounting, and the four basic financial statements and related disclosures that are periodi-
cally produced by that system.
Why Study Financial Accounting?
No matter what your business career goals, you can’t get away from financial accounting. You
may want to work for an investment firm, a bank, or an accounting firm that would be involved in
the financing of companies like Le-Nature’s. We will focus much of our discussion on the per-
spectives of investors, creditors, and preparers of financial statements. However, you might
not be aware that managers within the firm also make direct use of financial statements. For
example, marketing managers and credit managers use customers’ financial statements to
decide whether to extend credit to their customers. Supply chain managers analyze suppliers’
 CHAPTER 1 Financial Statements and Business Decisions 5

financial statements to see whether the suppliers have the resources to meet demand and invest
in future development. Both the employees’ unions and company human resource managers
use financial statements as a basis for contract negotiations over pay rates. Financial statement
figures even serve as a basis for calculating employee bonuses. Regardless of the functional area
of management in which you are employed, you will use financial statement data.
We begin with a brief but comprehensive overview of the information reported in the four
basic financial statements and the people and organizations involved in their preparation
and use. This overview provides a context in which you can learn the more detailed material
presented in the chapters that follow. Then we will discuss the parties that are responsible
for the accuracy of financial statements as well as the consequences of misstated financial
statements. Le-Nature’s stockholders and creditors used its financial statements to learn
more about the company before making their investment and lending decisions. In doing so,
they assumed that the statements accurately represented Le-Nature’s financial condition.

Your Goals for Chapter 1

To understand the way in which creditors and stockholders used Le-Nature’s financial state-
ments, we must first understand what specific information is presented in the four basic
financial statements for a company such as Le-Nature’s. PLEASE NOTE: Rather than trying
to memorize the definitions of every term used in this chapter, try to focus your attention
on learning the general content, structure, and use of the statements. Specifically:

Ů
Content: the categories of items (often called elements) reported on each of the four
statements.

Ů
Structure: the equation that shows how the elements within the statement are organized
and related.

Ů
Use: how the information is used by stockholders and creditors to make investment and
lending decisions.
The Pause for Feedback–Self-Study Quizzes at key points in the chapter will help you
assess whether you have reached these goals. Remember that since this chapter is an over-
view, each concept discussed here will be discussed again in Chapters 2 through 5.

OR G AN I Z ATI ON of the Chapter

Responsibilities for the

The Four Basic Financial Accounting Communication
Statements: An Overview Process

Ů
Balance Sheet Ů
Generally Accepted Accounting

Ů
Income Statement Principles
Ů
Statement of Stockholders’ Equity Ů
Ensuring the Accuracy of
Ů
Statement of Cash Flows Financial Statements
Ů
Relationships Among the
Statements
Ů
Notes and Financial Statement
Formats
 6 CHAPTER 1 Financial Statements and Business Decisions

L EAR NING OB JEC T IVE 1-1
Recognize the information
conveyed in each of the four
basic financial statements
and the way that it is used
by different decision makers
(investors, creditors, and
managers).
T H E FO U R BA S I C F I N A N C I A L STAT E M E N TS :
AN OVERVIEW
Four financial statements are normally prepared by profit-making organizations for use by
investors, creditors, and other external decision makers.
1. On its balance sheet, Le-Nature’s reports the economic resources it owns and the sources
of financing for those resources.
2. On its income statement, Le-Nature’s reports its ability to sell goods for more than their
cost to produce and sell.
3. On its statement of stockholders’ equity, Le-Nature’s reports additional contributions or
payments to investors and the amount of income the company reinvested for future growth.
4. On its statement of cash flows, Le-Nature’s reports its ability to generate cash and how it
was used.
The four basic statements can be prepared at any point in time (such as the end of the year,
quarter, or month) and can apply to any time span (such as one year, one quarter, or one month).
Like most companies, Le-Nature’s prepared financial statements for external users (investors
and creditors) at the end of each quarter (known as quarterly reports) and at the end of the
year (known as annual reports).

The Balance Sheet

BALANCE SHEET The purpose of the balance sheet is to report the financial position (amount of assets, liabili-
(STATEMENT OF FINANCIAL ties, and stockholders’ equity) of an accounting entity at a particular point in time. We can learn
POSITION) a great deal about what the balance sheet reports just by reading the statement from the top. The
Reports the amount of assets, balance sheet Le-Nature’s Inc. presented to creditors and stockholders is shown in Exhibit 1.2.
liabilities, and stockholders’
equity of an accounting entity at a Structure
point in time.
Notice that the heading specifically identifies four significant items related to the statement:
Balance 1. Name of the entity, Le-Nature’s Inc.
Sheet
Assets
2. Title of the statement, Balance Sheet.
= 3. Specific date of the statement, At December 31, 2012.
Liabilities 4. Unit of measure, (in millions of dollars).
+
Stockholders’ The organization for which financial data are to be collected, called an accounting entity, must
Equity
be precisely defined. On the balance sheet, the business entity itself, not the business owners,
is viewed as owning the resources it uses and being responsible for its debts. The heading of
each statement indicates the time dimension of the report. The balance sheet is like a finan-
cial snapshot indicating the entity’s financial position at a specific point in time—in this case,
ACCOUNTING ENTITY December 31, 2012—which is stated clearly on the balance sheet. Financial reports are nor-
The organization for which
mally denominated in the currency of the country in which they are located. U.S. companies
financial data are to be collected.
report in U.S. dollars, Canadian companies in Canadian dollars, and Mexican companies in
Mexican pesos. Le-Nature’s statements report in millions of dollars. That is, they round the last
six digits to the nearest million dollars. The listing of Cash $10.6 on Le-Nature’s balance sheet
actually means $10,600,000.
Notice that Le-Nature’s balance sheet has three major captions: assets, liabilities, and stock-
BASIC ACCOUNTING holders’ equity. The basic accounting equation, often called the balance sheet equation,
EQUATION (BALANCE explains their relationship:
SHEET EQUATION)
Assets = Liabilities + Assets = Liabilities + Stockholders’ Equity
Stockholders’ Equity.
Economic resources Financing from creditors Financing from stockholders
(e.g., cash, inventory, buildings) (e.g., amounts owed to (e.g., common stock,
suppliers, employees, banks) retained earnings)
 CHAPTER 1 Financial Statements and Business Decisions 7

EXPLANATION
LE-NATURE’S INC.* Name of the entity EXHIBIT 1.2
Balance Sheet Title of the statement
At December 31, 2012 Specific date of the statement
(in millions of dollars) Unit of measure
Balance Sheet

Assets: Resources controlled by the company

Cash $ 10.6 Amount of cash in the company’s bank accounts
Accounts receivable 6.6 Amounts owed by customers from prior sales
Inventories 51.2 Ingredients and beverages ready for sale
Property, plant, and equipment 459.0 Factories, production equipment, and land
Total assets $527.4 Total amount of company’s resources
Liabilities and stockholders’ equity: Sources of financing for company’s resources
Liabilities Financing supplied by creditors
Accounts payable $ 26.0 Amounts owed to suppliers for prior purchases
Notes payable to banks 381.7 Amounts owed to banks on written debt contracts
Total liabilities 407.7
Stockholders’ equity Financing provided by stockholders
Common stock 55.7 Amounts invested in the business by stockholders
Retained earnings 64.0 Past earnings not distributed to stockholders
Total stockholders’ equity 119.7
Total liabilities and stockholders’ equity $527.4 Total sources of financing for company’s resources

The notes are an integral part of these financial statements.

The basic accounting equation shows what we mean when we refer to a company’s financial
position: the economic resources that the company owns and the sources of financing for those
resources.

Elements
Assets are the economic resources owned by the entity. Le-Nature’s lists four items under
the category Assets. The exact items listed as assets on a company’s balance sheet depend
on the nature of its operations. But these are common names used by many companies.
The four items listed by Le-Nature’s are the economic resources needed to manufacture
and sell beverages to retailers and vending companies. Each of these economic resources
is expected to provide future benefits to the firm. To prepare to manufacture the bever-
ages, Le-Nature’s first needed cash to purchase land on which to build factories and
install production machinery (property, plant, and equipment). Le-Nature’s then began
purchasing ingredients and producing beverages, which led to the balance assigned to
inventories. When Le-Nature’s sells its beverages to grocery stores and others, it sells
them on credit and receives promises to pay called accounts receivable, which are col-
lected in cash later.
Every asset on the balance sheet is initially measured at the total cost incurred to acquire
it. Balance sheets do not generally show the amounts for which the assets could currently
be sold.
Liabilities and stockholders’ equity are the sources of financing for the compa-
ny’s economic resources. Liabilities indicate the amount of financing provided by
creditors. They are the company’s debts or obligations. Under the category Liabilities,
Le-Nature’s lists two items. The accounts payable arise from the purchase of goods © Adrian Bradshaw/EPA/Newscom

*Le-Nature’s statements have been simplified for purposes of our discussion.

8 CHAPTER 1 Financial Statements and Business Decisions

or services from suppliers on credit without a formal written contract (or a note). The
notes payable to banks result from cash borrowings based on a formal written debt con-
tract with banks.
Stockholders’ equity indicates the amount of financing provided by owners of the busi-
ness and reinvested earnings.1 The investment of cash and other assets in the business by
the stockholders is called common stock. The amount of earnings (profits) reinvested in the
business (and thus not distributed to stockholders in the form of dividends) is called retained
earnings.
In Exhibit 1.2, the Stockholders’ Equity section reports two items. The founders and other
stockholders’ investment of $55.7 million is reported as common stock. Le-Nature’s total earn-
ings (or losses incurred) less all dividends paid to the stockholders since formation of the cor-
poration equals $64 million and is reported as retained earnings. Total stockholders’ equity is
the sum of the common stock plus the retained earnings.

FINANCIAL Interpreting Assets, Liabilities, and Stockholders’

A N A LY S I S Equity on the Balance Sheet
Assessment of Le-Nature’s assets was important to its creditors, Wells Fargo Bank and others, and its
stockholders because assets provide a basis for judging whether the company has sufficient resources
available to operate. Assets are also important because they could be sold for cash in the event that
Le-Nature’s went out of business.
Le-Nature’s debts are important because creditors and stockholders are concerned about whether the
company has sufficient sources of cash to pay its debts. Le-Nature’s debts were also relevant to Wells
Fargo Bank’s decision to lend money to the company because existing creditors share its claim against
Le-Nature’s assets. If a business does not pay its creditors, the creditors may force the sale of assets suf-
ficient to meet their claims. The sale of assets often fails to cover all of a company’s debts, and some
creditors may take a loss.
Le-Nature’s stockholders’ equity is important to Wells Fargo Bank because creditors’ claims legally
come before those of owners. If Le-Nature’s goes out of business and its assets are sold, the proceeds of
that sale must be used to pay back creditors before the stockholders receive any money. Thus, creditors
consider stockholders’ equity a protective “cushion.”

PAU S E F O R F E E D B AC K

We just learned the balance sheet is a statement of financial position that reports dollar amounts for
a company’s assets, liabilities, and stockholders’ equity at a specific point in time. These elements are
related in the basic accounting equation: Assets = Liabilities + Stockholders’ Equity. Before you
move on, complete the following questions to test your understanding of these concepts.

SELF-STUDY QUIZ

1. Le-Nature’s assets are listed in one section and liabilities and stockholders’ equity in
another. Notice that the two sections balance in conformity with the basic accounting

1
A corporation is a business that is incorporated under the laws of a particular state. The owners are called
stockholders or shareholders. Ownership is represented by shares of capital stock that usually can be bought and
sold freely. The corporation operates as a separate legal entity, separate and apart from its owners. The stockholders
enjoy limited liability; they are liable for the debts of the corporation only to the extent of their investments. Chapter
Supplement A discusses forms of ownership in more detail.
 CHAPTER 1 Financial Statements and Business Decisions 9

equation. In the following chapters, you will learn that the basic accounting equation is the
basic building block for the entire accounting process. Your task here is to verify that total
assets ($527.4 million) is correct using the numbers for liabilities and stockholders’ equity
presented in Exhibit 1.2.
2. Learning which items belong in each of the balance sheet categories is an important first
step in understanding their meaning. Without referring to Exhibit 1.2, mark each balance
sheet item in the following list as an asset (A), a liability (L), or a stockholders’ equity (SE)
item.
_____ Accounts payable _____ Property, plant, and equipment
_____ Accounts receivable _____ Inventories
_____ Cash _____ Notes payable
_____ Common stock _____ Retained earnings

After you have completed your answers, check them below.

The Income Statement

Structure
The income statement (statement of income, statement of earnings, statement of operations, INCOME STATEMENT
statement of comprehensive income2) reports the accountant’s primary measure of perfor- (STATEMENT OF
mance of a business, revenues less expenses during the accounting period. While the term INCOME, STATEMENT OF
profit is used widely for this measure of performance, accountants prefer to use the technical EARNINGS, STATEMENT OF
terms net income or net earnings. Le-Nature’s net income measures its success in selling bev- OPERATIONS, STATEMENT
erages for more than the cost to generate those sales. OF COMPREHENSIVE
INCOME)
A quick reading of Le-Nature’s income statement (Exhibit 1.3) indicates a great deal about
Reports the revenues less the
its purpose and content. The heading identifies the name of the entity, the title of the report, expenses of the accounting
and the unit of measure used in the statement. Unlike the balance sheet, however, which reports period.
as of a certain date, the income statement reports for a specified period of time (for the year
ended December 31, 2012). The time period covered by the financial statements (one year
in this case) is called an accounting period. Notice that Le-Nature’s income statement has ACCOUNTING PERIOD
three major captions: revenues, expenses, and net income. The income statement equation that The time period covered by the
describes their relationship is: financial statements.

Revenues − Expenses = Net Income

(Cash and promises received from (Resources used to earn (Revenues earned minus
delivery of goods and services) period’s revenues) expenses incurred) Income
Statement

Elements Revenues
- Expenses
Companies earn revenues from the sale of goods or services to customers (in Le-Nature’s
Net Income
case, from the sale of beverages). Revenues normally are amounts expected to be received for
goods or services that have been delivered to a customer, whether or not the customer has
paid for the goods or services. Retail stores such as Walmart and McDonald’s often receive
cash from consumers at the time of sale. However, when Le-Nature’s delivers its beverages to
retail stores, it receives a promise of future payment called an account receivable, which later is

Solutions to
1. Assets ($527.4) = Liabilities ($407.7) + Stockholders’ Equity ($119.7) (in millions).
2. L, A, A, SE, A, A, L, SE (reading down the columns). SELF-STUDY QUIZ

2
Comprehensive income is sometimes presented in a separate statement. This advanced topic is discussed in Chapter 5.
 10 CHAPTER 1 Financial Statements and Business Decisions

EXPLANATION
EXHIBIT 1.3 LE-NATURE’S INC. Name of the entity
Income Statement Title of the statement
For the Year Ended December 31, 2012 Accounting period
Income Statement (in millions of dollars) Unit of measure

Revenues
Sales revenue $275.1 Cash and promises received from sale of beverages
Expenses
Cost of goods sold 140.8 Cost to produce beverages sold
Selling, general, and administrative Other operating expenses (utilities, delivery
expenses 77.1 costs, etc.)
Interest expense 17.2 Cost of using borrowed funds
Income before income taxes 40.0
Income tax expense 17.1 Income taxes on period’s income before income taxes
Net income $ 22.9 Revenues earned minus expenses incurred

The notes are an integral part of these financial statements.

collected in cash. In either case, the business recognizes total sales (cash and credit) as revenue
for the period. Various terms are used in income statements to describe different sources of rev-
enue (e.g., provision of services, sale of goods, rental of property). Le-Nature’s lists only one,
sales revenue, in its income statement.
Expenses represent the dollar amount of resources the entity used to earn revenues during the
period. Expenses reported in one accounting period may actually be paid for in another accounting
period. Some expenses require the payment of cash immediately while others require payment at
a later date. Some may also require the use of another resource, such as an inventory item, which
may have been paid for in a prior period. Le-Nature’s lists four types of expenses on its income
statement, which are described in Exhibit 1.3. These expenses include income tax expense, which,
as a corporation, Le-Nature’s must pay on the subtotal income before income taxes.
Net income or net earnings (often called “the bottom line”) is the excess of total revenues
over total expenses. If total expenses exceed total revenues, a net loss is reported.3 We noted
earlier that revenues are not necessarily the same as collections from customers and expenses
are not necessarily the same as payments to suppliers. As a result, net income normally does
not equal the net cash generated by operations. This latter amount is reported on the cash flow
statement discussed later in this chapter.

FINANCIAL
Analyzing the Income Statement: Beyond the Bottom Line
A N A LY S I S

Investors and creditors such as Wells Fargo Bank closely monitor a firm’s net income because it indi-
cates the firm’s ability to sell goods and services for more than they cost to produce and deliver. Investors
buy stock when they believe that future earnings will improve and lead to dividends and the ability to
sell their stock for more than they paid. Lenders also rely on future earnings to provide the resources to
repay loans. The details of the statement also are important. For example, Le-Nature’s had to sell more
than $275 million worth of beverages to make just under $23 million. If a competitor were to lower prices
just 10 percent, forcing Le-Nature’s to do the same, its net income could easily turn into a net loss. These
factors and others help investors and creditors estimate the company’s future earnings.

3
Net losses are normally noted by parentheses around the income figure.
 CHAPTER 1 Financial Statements and Business Decisions 11

PAU S E F O R F E E D B AC K

As noted above, the income statement is a statement of operations that reports revenues, expenses,
and net income for a stated period of time. To practice your understanding of these concepts, complete
the following questions.

SELF-STUDY QUIZ

1. Learning which items belong in each of the income statement categories is an important first
step in understanding their meaning. Without referring to Exhibit 1.3, mark each income
statement item in the following list as a revenue (R) or an expense (E).

_____ Cost of goods sold _____ Sales revenue

_____ Income tax _____ Selling, general, and administrative

2. During the period 2012, Le-Nature’s delivered beverages for which customers paid or
promised to pay amounts totaling $275.1 million. During the same period, it collected
$250.0 million in cash from its customers. Without referring to Exhibit 1.3, indicate which
AP Photo/Keith Srakocic
of these two amounts will be shown on Le-Nature’s income statement as sales revenue for
2012. Why did you select your answer?
3. During the period 2012, Le-Nature’s produced beverages with a total cost of production of
$142.1 million. During the same period, it delivered to customers beverages that cost a total
of $140.8 million to produce. Without referring to Exhibit 1.3, indicate which of the two
numbers will be shown on Le-Nature’s income statement as cost of goods sold expense for
2012. Why did you select your answer?
After you have completed your answers, check them below.

Statement of Stockholders’ Equity

Structure
Le-Nature’s prepares a separate statement of stockholders’ equity, shown in Exhibit 1.4. STATEMENT OF
The heading identifies the name of the entity, the title of the report, and the unit of measure STOCKHOLDERS’ EQUITY
used in the statement. Like the income statement, the statement of stockholders’ equity cov- Reports the way that net income
ers a specified period of time (the accounting period), which in this case is one year. The and the distribution of dividends
statement reports the changes in each of the company’s stockholders’ equity accounts during affected the financial position
of the company during the
that period. accounting period.
Le-Nature’s had no changes in common stock during the period. Had it issued or repur-
chased common stock during the year, the transactions would be reported on separate lines.
The retained earnings column reports the way that net income and the distribution of div-
idends affected the company’s financial position during the accounting period. Net income
earned during the year increases the balance of retained earnings, showing the relationship of

Solutions to
1. E, E, R, E (reading down the columns).
2. Sales revenue in the amount of $275.1 million is recognized. Sales revenue is normally reported on the SELF-STUDY QUIZ
income statement when goods or services have been delivered to customers who have either paid or promised
to pay for them in the future.
3. Cost of goods sold expense is $140.8. Expenses are the dollar amount of resources used up to earn
revenues during the period. Only those beverages that have been delivered to customers have been used up.
 12 CHAPTER 1 Financial Statements and Business Decisions

EXPLANATION
EXHIBIT 1.4 LE-NATURE’S INC. Name of the entity
Statement of Stockholders’ Equity Title of the statement
For the Year Ended December 31, 2012 Accounting period
Statement of Stockholders’ (in millions of dollars) Unit of measure
Equity
Common Retained
Stock Earnings
Balance December 31, 2011 $55.7 $43.1 Last period’s ending balances
Net income for 2012 22.9 Net income reported on the income statement
Dividends for 2012 (2.0) Dividends declared during the period
Balance December 31, 2012 $55.7 $64.0 Ending balances on the balance sheet

The notes are an integral part of these financial statements.

the income statement to the balance sheet.4 Declaring dividends to the stockholders decreases
Statement of retained earnings.
Stockholders’ The retained earnings equation that describes these relationships is:
Equity
Beginning balance Beginning Retained Earnings + Net Income − Dividends = Ending Retained Earnings
+ Increases
- Decreases
Ending balance Elements
The statement starts with the beginning balances in the stockholders’ equity accounts,
lists the increases and decreases, and reports the resulting ending balances. The retained
earnings portion of the statement in Exhibit 1.4 begins with Le-Nature’s beginning-of-
the-year retained earnings. The current year’s net income reported on the income state-
ment is added and the current year’s dividends are subtracted from this amount. During
2012, Le-Nature earned $22.9 million, as shown on the income statement (Exhibit 1.3).
This amount was added to the beginning-of-the-year retained earnings. Also, during 2012,
Le-Nature’s declared and paid a total of $2.0 million in dividends to its stockholders. This
amount was subtracted in computing end-of-the-year retained earnings on the balance
sheet. Note that retained earnings increased by the portion of income reinvested in the
business ($22.9 million − $2.0 million = $20.9 million). The ending retained earnings
amount of $64.0 million is the same as that reported in Exhibit 1.2 on Le-Nature’s balance
sheet. Thus, the retained earnings portion of the statement indicates the relationship of the
income statement to the balance sheet.

FINANCIAL
Interpreting Retained Earnings
A N A LY S I S

Reinvestment of earnings, or retained earnings, is an important source of financing for Le-Nature’s,

representing more than 12 percent of its financing. Creditors such as Wells Fargo Bank closely monitor
a firm’s statement of stockholders’ equity because the firm’s policy on dividend payments to the stock-
holders affects its ability to repay its debts. Every dollar Le-Nature’s pays to stockholders as a dividend
is not available for use in paying back its debt to Wells Fargo. Investors examine retained earnings to
determine whether the company is reinvesting a sufficient portion of earnings to support future growth.

4
Net losses are subtracted.
 CHAPTER 1 Financial Statements and Business Decisions 13

PAU S E F O R F E E D B AC K

The statement of stockholders’ equity explains changes in stockholders’ equity accounts, including
the change in the retained earnings balance caused by net income and dividends during the reporting
period. Check your understanding of these relationships by completing the following question.

SELF-STUDY QUIZ

1. Assume that a company’s financial statements reported the following amounts: beginning
retained earnings, $5,510; total assets, $20,450; dividends, $900; cost of goods sold expense,
$19,475; and net income, $1,780. Without referring to Exhibit 1.4, compute ending retained
earnings.
After you have completed your answer, check it below.

GUIDED HELP 1-1

For additional step-by-step video instruction on preparing the balance sheet, income statement, and
statement of stockholders’ equity, go to www.mhhe.com/libby9e_gh1.

Statement of Cash Flows

Structure
Le-Nature’s statement of cash flows is presented in Exhibit 1.5. The statement of cash flows STATEMENT OF CASH
(cash flow statement) divides Le-Nature’s cash inflows and outflows (receipts and payments) FLOWS (CASH FLOW
into the three primary categories of cash flows in a typical business: cash flows from operat- STATEMENT)
ing, investing, and financing activities. The heading identifies the name of the entity, the title Reports inflows and outflows of
of the report, and the unit of measure used in the statement. Like the income statement, the cash during the accounting period
cash flow statement covers a specified period of time (the accounting period), which in this in the categories of operating,
investing, and financing.
case is one year.
As discussed earlier in this chapter, reported revenues do not always equal cash collected
from customers because some sales may be on credit. Also, expenses reported on the income Statement of
statement may not be equal to the cash paid out during the period because expenses may be Cash Flows
incurred in one period and paid for in another. Because the income statement does not pro- +/- CFO
vide information concerning cash flows, accountants prepare the statement of cash flows to +/- CFI
report inflows and outflows of cash. The cash flow statement equation describes the causes +/- CFF
of the change in cash reported on the balance sheet from the end of the last period to the end Change in Cash
of the current period:
+/− Cash Flows from Operating Activities (CFO)
+/− Cash Flows from Investing Activities (CFI)
+/− Cash Flows from Financing Activities (CFF)
!Change in Cash
+ Beginning Cash Balance
Ending Cash Balance

Note that each of the three cash flow sources can be positive or negative.

Solutions to
1. Beginning Retained Earnings ($5,510) + Net Income ($1,780) − Dividends ($900) = Ending Retained
Earnings ($6,390). SELF-STUDY QUIZ
 14 CHAPTER 1 Financial Statements and Business Decisions

EXPLANATION
EXHIBIT 1.5 LE-NATURE’S INC. Name of the entity
Statement of Cash Flows (Summary) Title of the statement
For the Year Ended December 31, 2012 Accounting period
Statement of Cash Flows (in millions of dollars) Unit of measure

Cash flows from operating activities $ 87.5 Cash flows directly related to earning income
Cash flows from investing activities (125.5) Cash flows from purchase/sale of plant, equipment, & investments
Cash flows from financing activities 47.0 Cash flows from investors and creditors
Net increase (decrease) in cash 9.0 Change in cash during the period
Cash balance December 31, 2011 1.6 Last period’s cash on the balance sheet
Cash balance December 31, 2012 $ 10.6 Ending cash on the balance sheet

The notes are an integral part of these financial statements.

Elements
Cash flows from operating activities are cash flows that are directly related to earning
income. For example, when customers pay Le-Nature’s for the beverages it has delivered to
them, it lists the amounts collected as cash collected from customers. When Le-Nature’s pays
salaries to its production employees or pays bills received from its tea suppliers, it includes the
amounts in cash paid to suppliers and employees.
Cash flows from investing activities include cash flows related to the acquisition or sale of
the company’s plant and equipment and investments. This year, Le-Nature’s had only one cash
outflow from investing activities, the purchase of additional manufacturing equipment to meet
growing demand for its products.
Cash flows from financing activities are cash flows directly related to the financing of
the enterprise itself. They involve the receipt or payment of money to investors and creditors
(except for suppliers). This year, Le-Nature’s borrowed additional money from the bank to pur-
chase most of the new manufacturing equipment. It also paid out dividends to the stockholders.5

FINANCIAL
Interpreting the Cash Flow Statement
A N A LY S I S

Bankers often consider the Operating Activities section to be most important because it indicates the
company’s ability to generate cash from sales to meet its current cash needs. Any amount left over can be
used to pay back the bank debt or expand the company. Stockholders will invest in a company only if they
believe that it will eventually generate more cash from operations than it uses so that cash will become
available to pay dividends and expand.

PAU S E F O R F E E D B AC K

The statement of cash flows reports inflows and outflows of cash for a stated period of time classified
into three categories: operating, investing, and financing activities. Answer the following questions to
test your understanding of the concepts involved.

5
The complete statement of cash flows is discussed in Chapter 13.
 CHAPTER 1 Financial Statements and Business Decisions 15

SELF-STUDY QUIZ

1. During the period 2012, Le-Nature’s delivered beverages to customers who paid or prom-
ised to pay a total of $275.1 million. During the same period, it collected $250.0 million in
cash from customers. Which of the two amounts will be shown on Le-Nature’s cash flow
statement for 2012?
2. Your task here is to verify that Le-Nature’s cash balance increased by $9.0 million during
the year using the totals for cash flows from operating, investing, and financing activities
presented in Exhibit 1.5. Recall the cash flow statement equation:

+/− Cash Flows from Operating Activities (CFO)

+/− Cash Flows from Investing Activities (CFI)
+/− Cash Flows from Financing Activities (CFF)
Change in Cash
After you have completed your answers, check them below.

Relationships Among the Statements

Our discussion of the four basic financial statements has focused on what elements are reported
in each statement, how the elements are related by the equation for each statement, and how
the information is important to the decisions of investors, creditors, and others. We have also
discovered how the statements, all of which are outputs from the same system, are related to
one another. In particular, we learned:
Net income from the income statement results in an increase in ending retained earnings on
the statement of stockholders’ equity.
Ending retained earnings from the statement of stockholders’ equity is one of the two com-
ponents of stockholders’ equity on the balance sheet.
The change in cash on the cash flow statement added to the beginning-of-the-year balance
in cash equals the end-of-year balance in cash on the balance sheet.
Thus, we can think of the income statement as explaining, through the statement of stockhold-
ers’ equity, how the operations of the company improved or harmed the financial position of
the company during the year. The cash flow statement explains how the operating, invest-
ing, and financing activities of the company affected the cash balance on the balance sheet
during the year. These relationships are illustrated in Exhibit 1.6 for Le-Nature’s financial
statements.

Notes and Financial Statement Formats

At the bottom of each of Le-Nature’s four basic financial statements is this statement: “The
notes are an integral part of these financial statements.” This is the accounting equivalent
of the Surgeon General’s warning on a package of cigarettes. It warns users that failure to

Solutions to
1. The firm recognizes $250.0 million on the cash flow statement because this number represents the actual
cash collected from customers related to current and prior years’ sales. SELF-STUDY QUIZ
2. +/− Cash Flows from Operating Activities (CFO) $ 87.5
+/− Cash Flows from Investing Activities (CFI) (125.5)
+/− Cash Flows from Financing Activities (CFF) 47.0

Change in Cash $ 9.0

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 the Court of Madrid the project of acquisition of the two Floridas. Then
perhaps the Emperor might think that this country is less suited to
Spain now that it is separated from her other colonies, and that it is
better suited to the United States because a part of their Western
rivers cross the Floridas before flowing into the Gulf of Mexico; and
finally, that Spain may see in her actual situation, and in the expenses
entailed on her by the war, some motives for listening to the offers of
the Federal government.”
Talleyrand had great need to insist on “the forms of civility and
decorum from which governments should never depart”! Perhaps
Talleyrand already foresaw the scene, said to have occurred some
two years later, when Napoleon violently denounced him to his face
as “a silk stocking stuffed with filth,” and the minister coldly retaliated
by the famous phrase, “Pity that so great a man should be so ill
brought up!” The task of teaching manners to Jefferson was not
Napoleon’s view of his own functions in the world. He probably gave
more attention to the concluding lines of the report, which suggested
that he should decide whether a Spanish colony, made worthless by
an arbitrary act of his own, could be usefully employed in sustaining
his wars.
This report, dated Nov. 19, 1804, lay some weeks in the
Emperor’s hands. Monroe left Paris for Madrid December 8, and still
no answer had been sent to his note. He wrote from Bordeaux,
December 16, a long and interesting letter to Madison, and resumed
his journey. He could hardly have crossed the Bidassoa when
Armstrong received from Talleyrand, December 21, the long-
expected answer,[225] which by declaring the claim to West Florida
emphatically unfounded struck the ground from under Monroe’s feet,
and left him to repent at leisure his defiance of Talleyrand’s advice.
Under the forms of perfect courtesy, this letter contained both
sarcasm and menace. Talleyrand expressed curiosity to learn the
result of Monroe’s negotiation:—
“This result his Imperial Majesty will learn with real interest. He
saw with pain the United States commence their difficulties with Spain
in an unusual manner, and conduct themselves toward the Floridas by
acts of violence which, not being founded in right, could have no other
effect but to injure the lawful owner. Such an aggression gave the
 more surprise to his Majesty because the United States seemed in
this measure to avail themselves of their treaty with France as an
authority for their proceedings, and because he could scarcely
reconcile with the just opinion which he entertains of the wisdom and
fidelity of the Federal government a course of proceedings which
nothing can authorize toward a Power which has long occupied, and
still occupies, one of the first ranks in Europe.”
Madison and Monroe, as well as Jefferson, in the course of their
diplomacy had many mortifications to suffer; but they rarely received
a reprimand more keen than this. Yet its sharpness was so delicately
covered by the habitual forms of Talleyrand’s diplomacy that
Americans, who were accustomed to hear and to use strong
language, hardly felt the wound it was intended to inflict. After
hearing Yrujo denounce an act of their government as an “atrocious
libel,” they were not shocked to hear Talleyrand denounce the same
act as one of violence which nothing could authorize. The force of
Talleyrand’s language was more apparent to Godoy than to Madison,
for it bore out every expression of Yrujo and Cevallos. The Prince of
Peace received a copy of Talleyrand’s note at the moment when
Monroe, after almost a month of weary winter travel, joined
Pinckney, who had for six months been employed only in writing
letter after letter begging for succor and support. Don Pedro
Cevallos, with this public pledge in his hand, and with secret French
pledges covering every point of the negotiation in his desk, could
afford to meet with good humor the first visit of the new American
plenipotentiary.
Pinckney’s humiliation was extreme. After breaking off relations
with Cevallos and pledging himself to demand his passports and to
leave Spain, he had been reduced to admit that his Government
disavowed him; and not only was he obliged to remain at Madrid, but
also to sue for permission to resume relations with Cevallos. The
Spanish government good-naturedly and somewhat contemptuously
permitted him to do so; and he was only distressed by the fear that
Monroe might refuse to let him take part in the new negotiation, for
he was with reason confident that Monroe would be obliged to follow
in his own footsteps,—that the United States could save its dignity
and influence only by war.
 At the beginning of the new year, Jan. 2, 1805, Monroe entered
Madrid to snatch Florida from the grasp of Spain and France. The
negotiation fell chiefly within Jefferson’s second term, upon which it
had serious results. But while Monroe, busy at Madrid with a quarrel
which could lead only to disappointment or war, thus left the legation
at London for eight months to take care of itself, events were
occurring which warned President Jefferson that the supreme test of
his principles was near at hand, and that a storm was threatening
from the shores of Great Britain compared with which all other
dangers were trivial.
 CHAPTER XIV.
For eighteen years after 1783 William Pitt guided England
through peace and war with authority almost as absolute as that of
Don Carlos IV. or Napoleon himself. From him and from his country
President Jefferson had much to fear and nothing to gain beyond a
continuance of the good relations which President Washington, with
extreme difficulty, had succeeded in establishing between the two
peoples. So far as England was concerned, this understanding had
been the work of Pitt and Lord Grenville, who rather imposed it on
their party than accepted it as the result of any public will. The
extreme perils in which England then stood inspired caution; and of
this caution the treaty of 1794 was one happy result. So long as the
British government remained in a cautious spirit, America was safe;
but should Pitt or his successors throw off the self-imposed restraints
on England’s power, America could at the utmost, even by a
successful war, gain nothing materially better than a return to the
arrangements of 1794.
The War of Independence, which ended in the definitive treaty of
1783, naturally left the English people in a state of irritation and
disgust toward America; and the long interregnum of the
Confederation, from 1783 to 1789, allowed this disgust to ripen into
contempt. When at length the Constitution of 1789 restored order in
the American chaos, England felt little faith in the success of the
experiment. She waited for time to throw light on her interests.
This delay was natural; for American independence had
shattered into fragments the commercial system of Great Britain, and
powerful interests were combined to resist further concession.
Before 1776 the colonies of England stretched from the St.
Lawrence to the Mississippi, and across the Gulf of Mexico to the
coast of South America, mutually supporting and strengthening each
other. Jamaica and the other British islands of the West Indies drew
their most necessary supplies from the Delaware and the Hudson.
Boston and New York were in some respects more important to them
than London itself. The timber, live-stock, and provisions which came
from the neighboring continent were essential to the existence of the
West Indian planters and negroes. When war cut off these supplies,
famine and pestilence followed. After the peace of 1783 even the
most conservative English statesmen were obliged to admit that the
strictness of their old colonial system could not be maintained, and
that the United States, though independent, must be admitted to
some of the privileges of a British colony. The government unwillingly
conceded what could not be refused, and the West Indian colonists
compelled Parliament to relax the colonial system so far as to allow
a restricted intercourse between their islands and the ports of the
United States. The relaxation was not a favor to the United States,—
it was a condition of existence to the West Indies; not a boon, but a
right which the colonists claimed and an Act of Parliament defined.
[226]

The right was dearly paid for. The islands might buy American
timber and grain, but they were allowed to make return only in
molasses and rum. Payment in sugar would have been cheaper for
the colonists, and the planters wished for nothing more earnestly
than to be allowed this privilege; but as often as they raised the
prayer, English shipowners cried that the navigation laws were in
peril, and a chorus of familiar phrases filled the air, all carrying a
deep meaning to the English people. “Nursery of seamen” was one
favorite expression; “Neutral frauds” another; and all agreed in
assuming that at whatever cost, and by means however extravagant,
the navy must be fed and strengthened. Under the cover of
supporting the navy any absurdity could be defended; and in the
case of the West Indian trade, the British shipowner enjoyed the right
to absurdities sanctioned by a century and a half of law and custom.
The freight on British sugars belonged of right to British shippers,
who could not be expected to surrender of their own accord, in
obedience to any laws of political economy, a property which was the
source of their incomes. The colonists asked permission to refine
their own sugar; but their request not only roused strong opposition
from the shipowners who wanted the bulkier freight, but started the
home sugar-refiners to their feet, who proved by Acts of Parliament
that sugar-refining was a British and not a colonial right. The colonist
then begged a reduction of the heavy duty on sugar; but English
country gentlemen cried against a measure which might lead to an
increase of the income-tax or the imposition of some new burden on
agriculture. In this dilemma the colonists frankly said that only their
weakness, not their will, prevented them from declaring themselves
independent, like their neighbors at Charleston and Philadelphia.
Even when the qualified right of trade was conceded, the
colonists were not satisfied; and the concession itself laid the
foundation of more serious changes. From the moment that
American produce was admitted to be a necessity for the colonists, it
was clear that the Americans must be allowed a voice in the British
system. Discussion whether the Americans had or had not a right to
the colonial trade was already a long step toward revolution. One
British minister after another resented the idea that the Americans
had any rights in the matter; yet when they came to practical
arrangements the British statesmen were obliged to concede that
they were mistaken. From the necessity of the case, the Americans
had rights which never could be successfully denied. Parliament
struggled to prevent the rebel Americans from sharing in the
advantages of the colonial system from which they had rebelled; but
unreasonable as it was that the United States should be rewarded
for rebellion by retaining the privileges of subjects, this was the
inevitable result. Geography and Nature were stronger than
Parliament and the British navy.
At first Pitt hoped that the concession to the colonists might entail
no concession to the United States; while admitting a certain hiatus
in the colonial system, he tried to maintain the navigation laws in
their integrity. The admission of American produce into the West
Indies was no doubt an infraction of the protectionist principle on
which all the civilized world, except America, founded its economical
ideas; but in itself it was not serious. To allow the flour, potatoes,
tobacco, timber, and horses of the American continent to enter the
harbors of Barbadoes and Jamaica; to allow in turn the molasses
and rum of the islands to be sent directly to New York and Boston,—
harmed no one, and was advantageous to all parties, so long as
British ships were employed to carry on the trade. At first this was
the case. The Act of Parliament allowed only British subjects, in
British-built ships, to enter colonial ports with American produce.
Whether the United States government would long tolerate such
legislation without countervailing measures was a question which
remained open for a time, while the system itself had a chance to
prove its own weakness. The British shipping did not answer colonial
objects. Again and again the colonists found themselves on the
verge of starvation; and always in this emergency the colonial
governors threw open their ports by proclamation to American
shipping, while with equal regularity Parliament protected the
governors by Acts of Indemnity. To this extent the navigation system
suffered together with the colonial system, but in theory it was intact.
Ministry, Parliament, and people clung to the navigation laws as their
ark of safety; and even the colonists conceded that although they
had a right to eat American wheat and potatoes, they had no right to
eat those which came to them in the hold of a Marblehead schooner.
Such a principle, however convenient to Great Britain, was not
suited to the interests of New England shippers. In peace their
chances were comparatively few, and the chief diplomatic difficulties
between European governments and the United States had their
source in the American attempt to obtain legal recognition of trade
which America wished to maintain with the colonies; but in war the
situation changed, and more serious disputes occurred. Then the
French and Spanish West Indian ports were necessarily thrown open
to neutral commerce, because their own ships were driven from the
ocean by the superiority of the British navy. Besides the standing
controversy about the admission of American produce to British
islands, the British government found itself harassed by doubts to
what extent it might safely admit the Americans into the French or
Spanish West Indies, and allow them to carry French property, as
though their flag were competent to protect whatever was under it.
Granting that an article like French sugar might be carried in a
neutral vessel, there were still other articles, called contraband,
which ought not to be made objects of neutral commerce; and
England was obliged to define the nature of contraband. She was
also forced to make free use of the right of blockade. These delicate
questions were embittered by another and more serious quarrel. The
European belligerents claimed the right to the military service of their
subjects, and there was no doubt that their right was perfect. In
pursuance of the claim they insisted upon taking their seamen from
American merchant-vessels wherever met on the high seas. So far
as France was concerned, the annoyance was slight; but the identity
of race made the practice extremely troublesome as concerned
England.
At the outbreak of the French wars, Nov. 6, 1793, the British
government issued instructions directing all British armed vessels to
seize every neutral ship they should meet, loaded with the produce
of a French colony or carrying supplies for its use.[227] These orders
were kept secret for several weeks, until the whole American
commerce with the Antilles, and all American ships found on the
ocean, laden in whole or in part with articles of French colonial
produce or for French colonial use, were surprised and swept into
British harbors, where they were condemned by British admiralty
courts, on the ground known as the “Rule of the War of 1756,”—that
because trade between the French colonies and the United States
was illegal in peace, it was illegal in war. From the point of view in
which European Powers regarded their colonies, much could be said
in support of this rule. A colony was almost as much the property of
its home government as a dockyard or a military station. France and
Spain could hardly complain if England chose to treat the commerce
of such governmentstations as contraband; but a rule which might
perhaps be applied by European governments to each other worked
with great injustice when applied to the United States, who had no
colonies, and made no attempt to build up a navy or support an army
by such means. Taken in its broadest sense, the European colonial
system might be defined by the description which the best of British
commentators gave to that of England,[228]—a “policy pursued for
rendering the foreign trade of the whole world subservient to the
increase of her shipping and navigation.” American Independence
was a protest against this practice; and the first great task of the
United States was to overthrow and destroy the principle, in order to
substitute freedom of trade. America naturally objected to becoming
a martyr to the rules of a system which she was trying to
revolutionize.
When these British instructions of Nov. 26, 1793, became known
in the United States, the Government of President Washington
imposed an embargo, threatened retaliation, and sent Chief-Justice
Jay to London as a last chance of maintaining peace. On arriving
there, Jay found that Pitt had already voluntarily retreated from his
ground, and that new Orders, dated Jan. 8, 1794, had been issued,
exempting from seizure American vessels engaged in the direct
trade from the United States to the French West Indies. In the end,
the British government paid the value of the confiscated vessels. The
trade from the United States to Europe was not interfered with; and
thus American ships were allowed to carry French colonial produce
through an American port to France, while Russian or Danish ships
were forbidden by England to carry such produce to Europe at all,
although their flags and harbors were as neutral as those of the
United States. America became suddenly a much favored nation,
and the enemies of England attributed this unexpected kindness to
fear. In truth it was due to a natural mistake. The British Treasury
calculated that the expense and trouble of carrying sugar and coffee
from Martinique or St. Domingo to Boston, of landing it, paying
duties, re-embarking it, receiving the drawback, and then carrying it
to Bordeaux or Brest, would be such as to give ample advantages to
English vessels which could transship more conveniently at London.
The mistake soon became apparent. The Americans quickly proved
that they could under these restrictions carry West Indian produce to
Europe not only more cheaply than British ships could do it, but
almost as quickly; while it was a positive advantage on the return
voyage to make double freight by stopping at an American port. The
consequence of this discovery was seen in the sudden increase of
American shipping, and was largely due to the aid of British seamen,
who found in the new service better pay, food, and treatment than in
their own, and comparative safety from the press-gang and the lash.
At the close of the century the British flag seemed in danger of
complete exclusion from the harbors of the United States. In 1790
more than 550 British ships, with a capacity of more than 115,000
tons, had entered inward and outward, representing about half that
number of actual vessels; in 1799 the custom-house returns showed
not 100 entries, and in 1800 about 140, representing a capacity of
40,000 tons. In the three years 1790–1792, the returns showed an
average of some 280 outward and inward entries of American ships
with a capacity of 54,000 tons; in 1800 the entries were 1,057, with a
capacity of 236,000 tons. The Americans were not only beginning to
engross the direct trade between their own ports and Europe, but
were also rapidly obtaining the indirect carrying-trade between the
West Indies and the European continent, and even between one
European country and another. The British government began to feel
seriously uneasy. At a frightful cost the people of England were
striving to crush the navies and commerce of France and Spain, only
to build up the power of a dangerous rival beyond the ocean.
Doubtless the British government would have taken measures to
correct its mistake, if the political situation had not hampered its
energies. Chief-Justice Jay, in 1794, negotiated a treaty with Lord
Grenville which was in some respects very hard upon the United
States, but was inestimably valuable to them, because it tied Pitt’s
hands and gave time for the new American Constitution to acquire
strength. Ten years of steady progress were well worth any
temporary concessions, even though these concessions
exasperated France, and roused irritation between her and the
United States which in 1798 became actual hostility. The prospect
that the United States would become the ally of England was so fair
that Pitt dared not disturb it. His government was in a manner forced
to give American interests free play, and to let American shipping
gain a sudden and unnatural enlargement. His liberality was well
paid. For a moment France drove the United States to reprisals; and
as the immediate consequence, St. Domingo became practically
independent, owing to the support given by the United States to
Toussaint. Even the reconciliation of France with America effected by
Bonaparte and Talleyrand in 1800 did not at first redress the
balance. Not till the Peace of Amiens, in 1802, did France recover
her colonies; and not till a year later did Bonaparte succeed, by the
sacrifice of Louisiana, in bringing the United States back to their old
attitude of jealousy toward England.
 Nevertheless, indications had not been wanting that England was
aware of the advantage she had given to American commerce, and
still better of the advantages which had been given it by Nature. All
the Acts of Parliament on the statute-book could not prevent the
West Indies from being largely dependent on the United States; yet
the United States need not be allowed the right to carry West Indian
produce to France,—a right which depended only on so-called
international law, and was worthless unless supported by the
stronger force. A new Order was issued, Jan. 25, 1798, which
admitted European neutrals to enemies’ colonies, and allowed them
to bring French colonial produce to England or to their own ports.
This Order was looked upon as a side-blow at American shipping,
which was not allowed the same privilege of sailing direct from the
Antilles to Europe. The new Order was justified on the ground that
the old rule discriminated in favor of American merchants, whose
competition might be injurious to the commercial interests of
England.[229]
Further than this the British government did not then go; on the
contrary, it officially confirmed the existing arrangement. The British
courts of admiralty conformed closely to the rules of their political
chiefs. Sir William Scott, better known as Lord Stowell, whose great
reputation as a judge was due to the remarkable series of judgments
in which he created a new system of admiralty law, announced with
his usual clearness the rules by which he meant to be guided. In the
case of the “Emmanuel,” in November, 1799, he explained the
principle on which the law permitted neutrals to carry French
produce from their own country to France. “By importation,” he said,
“the produce became part of the national stock of the neutral
country; the inconveniences of aggravated delay and expense were
a safeguard against this right becoming a special convenience to
France or a serious abridgement of belligerent rights.” Soon
afterward, in the case of the “Polly,” April 29, 1800, he took occasion
to define what he meant by importation into a neutral country. He
said it was not his business to decide what was universally the test
of a bona fide importation; but he was strongly disposed to hold that
it would be sufficient if the goods were proved to have been landed
and the duties paid; and he did accordingly rule that such proof was
sufficient to answer the fair demands of his court.
Rufus King, then American minister in London, succeeded in
obtaining from Pitt an express acceptance of this rule as binding on
the government. On the strength of a report[230] from the King’s
Advocate, dated March 16, 1801, the British Secretary of State
notified the American minister that what Great Britain considered as
the general principle of colonial trade had been relaxed in a certain
degree in consideration of the present state of commerce. Neutrals
might import French colonial produce, and convey it by re-
exportation to France. Landing the goods and paying the duties in
America legalized the trade, even though these goods were at once
re-shipped and forwarded to France on account of the same owners.
With this double guaranty Jefferson began his administration, and
the American merchants continued their profitable business. Not only
did they build and buy large numbers of vessels, and borrow all the
capital they could obtain, but doubtless some French and Spanish
merchants, besides a much greater number of English, made use of
the convenient American flag. The Yankees exulted loudly over the
decline of British shipping in their harbors; the British masters
groaned to see themselves sacrificed by their own government; and
the British admirals complained bitterly that their prize-money was
cut off, and that they were wearing out their lives in the hardest
service, in order to foster a commerce of smugglers and perjurers,
whose only protection was the flag of a country that had not a single
line-of-battle ship to fly it.
Yet President Jefferson had reason to weigh long and soberly the
pointed remark with which the King’s Advocate began his report,—
that the general principle with respect to the colonial trade had been
to a certain extent relaxed in consideration of the present state of
commerce. No doubt the British pretension, as a matter of
international law, was outrageous. The so-called rule of 1756 was
neither more nor less than a rule of force; but when was international
law itself anything more than a law of force? The moment a nation
found itself unable to show some kind of physical defence for its
protection, the wisdom of Grotius and Bynkershoek could not
prevent it from being plundered; and how could President Jefferson
complain merely because American ships were forbidden by
England to carry French sugars to France, when he looked on
without a protest while England and France committed much greater
outrages on every other country within their reach?
President Jefferson believed that the United States had ample
means to resist any British pretension. As his letters to Paine and
Logan showed, he felt that European Powers could be controlled
through the interests of commerce.[231] He was the more firmly
convinced by the extraordinary concessions which Pitt had made,
and by the steady encouragement he gave to the American
merchant. Jefferson felt sure that England could not afford to
sacrifice a trade of some forty million dollars, and that her colonies
could not exist without access to the American market. What need to
spend millions on a navy, when Congress, as Jefferson believed,
already grasped England by the throat, and could suffocate her by a
mere turn of the wrist!
This reasoning had much in its favor. To Pitt the value of the
American trade at a time of war with France and Spain was
immense; and when taken in connection with the dependence of the
West Indian colonies on America, it made a combination of British
interests centring in the United States which much exceeded the
entire value of all England’s other branches of foreign commerce. Its
prospective value was still greater if things should remain as they
were, and if England should continue to undersell all rivals in articles
of general manufacture. England could well afford to lose great sums
of money in the form of neutral freights rather than drive Congress to
a protective system which should create manufactures of cotton,
woollen, and iron. These were motives which had their share in the
civility with which England treated America; and year by year their
influence should naturally have increased.
Of all British markets the American was the most valuable; but
next to the American market was that of the West Indies. In some
respects the West Indian was of the two the better worth preserving.
From head to foot the planters and their half-million negroes were
always clad in cottons or linens made by the clothiers of Yorkshire,
Wiltshire, or Belfast. Every cask and hoop, every implement and
utensil, was supplied from the British Islands. The sailing of a West
Indian convoy was “an epoch in the diary of every shop and
warehouse throughout the Kingdom.”[232] The West Indian colonies
employed, including the fisheries, above a thousand sail of shipping
and twenty-five thousand seamen. While America might, and one
day certainly would, manufacture for herself, the West Indies could
not even dream of it; there the only profitable or practicable industry
was cultivation of the soil, and the chief article of cultivation was the
sugar-cane. Rival industries to those of Great Britain were
impossible; the only danger that threatened British control was the
loss of naval supremacy or the revolt of the negroes.
A great majority of British electors would certainly have felt no
hesitation in deciding, as between the markets of the United States
and of the West Indies, that if a choice must be made, good policy
required the government to save at all hazards the West Indies. Both
as a permanent market for manufactures and as a steady support for
shipping, the West Indian commerce held the first place in British
interests. This fact needed to be taken into account by the United
States government before relying with certainty on the extent to
which Great Britain could be controlled by the interests involved in
the American trade. At the most critical moment all Jefferson’s
calculations might be upset by the growth of a conviction in England
that the colonial system was in serious danger; and to make this
chance stronger, another anxiety was so closely connected with it as
to cause incessant alarm in the British mind.
The carrying-trade between the French West Indies and Europe
which had thus fallen into American hands, added to the natural
increase of national exports and imports, required a large amount of
additional shipping; and what was more directly hostile to English
interests, it drew great numbers of British sailors into the American
merchant-service. The desertion of British seamen and the
systematic encouragement offered to deserters in every seaport of
the Union were serious annoyances, which the American
government was unable to excuse or correct. Between 1793 and
1801 they reached the proportions of a grave danger to the British
service. Every British government packet which entered the port of
New York during the winter before Jefferson’s accession to power
lost almost every seaman in its crew; and neither people nor
magistrates often lent help to recover them. At Norfolk the crew of a
British ship deserted to an American sloop-of-war, whose
commander, while admitting the fact, refused to restore the men,
alleging his construction of official orders in his excuse.[233] In most
American harbors such protection as the British shipmaster obtained
sprang from the personal good-will of magistrates, who without strict
legal authority consented to apply, for the benefit of the foreign
master, the merchant-shipping law of the United States; but in one
serious case even this voluntary assistance was stopped by the
authority of a State government.
This interference was due to the once famous dispute over
Jonathan Robbins, which convulsed party politics in America during
the heated election of 1800. Thomas Nash, a boatswain on the
British frigate “Hermione,” having been ringleader in conspiracy and
murder on the high seas, was afterward identified in the United
States under the name and with the papers of Jonathan Robbins of
Danbury, in Connecticut. On a requisition from the British minister,
dated June 3, 1799, he was delivered under the extradition clause of
Jay’s treaty, and was hung. The Republican party, then in opposition,
declared that Robbins, or Nash, was in their belief an American
citizen whose surrender was an act of base subservience to Great
Britain. An effigy of Robbins hanging to a gibbet was a favorite
electioneering device at public meetings. The State of Virginia,
having a similar grievance of its own, went so far as to enact a
law[234] which forbade, under the severest penalties, any magistrate
who acted under authority of the State to be instrumental in
transporting any person out of its jurisdiction. As citizens of the
Union, sworn to support the Constitution, such magistrates were
equally bound with the Federal judges to grant warrants of
commitment, under the Twenty-seventh Article of Jay’s treaty,
against persons accused of specified crimes. The Virginia Act
directly contravened the treaty; while indirectly it prevented
magistrates from granting warrants against deserters and holding
them in custody, so that every English vessel which entered a
Virginia port was at once abandoned by her crew, who hastened to
enter the public or private ships of the United States.[235]
The captain of any British frigate which might happen to run into
the harbor of New York, if he went ashore, was likely to meet on his
return to the wharf some of his boat’s crew strolling about the town,
every man supplied with papers of American citizenship. This was
the more annoying, because American agents in British ports
habitually claimed and received the benefit of the British law; while
so far as American papers were concerned, no pretence was made
of concealing the fraud, but they were issued in any required
quantity, and were transferred for a few dollars from hand to hand.
Not only had the encouragement to desertion a share in the
decline of British shipping in American harbors, but it also warranted,
and seemed almost to render necessary, the only countervailing
measure the British government could employ. Whatever happened
to the merchant-service, the British navy could not be allowed to
suffer. England knew no conscription for her armies, because for
centuries she had felt no need of general military service; but at any
moment she might compel her subjects to bear arms, if
circumstances required it. Her necessities were greater on the
ocean. There, from time immemorial, a barbarous sort of
conscription, known as impressment, had been the ordinary means
of supplying the royal navy in emergencies; and every seafaring man
was liable to be dragged at any moment from his beer-cellar or
coasting-vessel to man the guns of a frigate on its way to a three-
years’ cruise in the West Indies or the Mediterranean. Mere
engagement in a foreign merchant-service did not release the British
sailor from his duty. When the captain of a British frigate overhauled
an American merchant-vessel for enemy’s property or contraband of
war, he sent an officer on board who mustered the crew, and took
out any seamen whom he believed to be British. The measure, as
the British navy regarded it, was one of self-protection. If the
American government could not or would not discourage desertion,
the naval commander would recover his men in the only way he
could. Thus a circle of grievances was established on each side.
Pitt’s concessions to the United States irritated the British navy and
merchant-marine, while they gave great profits to American shipping;
the growth of American shipping stimulated desertions from the
British service to the extent of injuring its efficiency; and these
desertions in their turn led to a rigorous exercise of the right of
impressment. To find some point at which this vicious circle could be
broken was a matter of serious consequence to both countries, but
most so to the one which avowed that it did not mean to protect its
interests by force.
Great Britain could have broken the circle by increasing the pay
and improving the condition of her seamen; but she was excessively
conservative, and the burdens already imposed on her commerce
were so great that she could afford to risk nothing. In the face of a
combined navy like that of Spain and France, her control of the seas
at any given point, such as the West Indies, was still doubtful; and in
the face of American competition, her huge convoys suffered under
great disadvantage. Conscious of her own power, she thought that
the United States should be first to give way. Had the American
government been willing to perform its neutral obligations strictly, the
circle might have been broken without much trouble; but the United
States wished to retain their advantage, and preferred to risk
whatever England might do rather than discourage desertion, or
enact and enforce a strict naturalization law, or punish fraud. The
national government was too weak to compel the States to respect
neutral obligations, even if it had been disposed to make the attempt.
The practice of impressment brought the two governments to a
deadlock on an issue of law. No one denied that every government
had the right to command the services of its native subjects, and as
yet no one ventured to maintain that a merchant-ship on the high
seas could lawfully resist the exercise of this right; but the law had
done nothing to define the rights of naturalized subjects or citizens.
The British government might, no doubt, impress its own subjects;
but almost every British sailor in the American service carried papers
of American citizenship, and although some of these were
fraudulent, many were genuine. The law of England, as declared
from time out of mind by every generation of her judges, held that
the allegiance of a subject was indefeasible, and therefore that
naturalization was worthless. The law of the United States, as
declared by Chief-Justice Ellsworth in 1799, was in effect the same;
[236] he held that no citizen could dissolve the compact of protection
and defence between himself and society without the consent or
default of the community. On both sides the law was emphatic to the
point that naturalization could not bind the government which did not
consent to it; and the United States could hardly require England to
respect naturalization papers which the Supreme Court of the United
States declared itself unable to respect in a similar case.
Nevertheless, while courts and judges declare what the law is or
ought to be, they bind only themselves, and their decisions have no
necessary effect on the co-ordinate branches of government. While
the judges laid down one doctrine in Westminster Hall, Parliament
laid down another in St. Stephen’s chapel; and no one could say
whether the law or the statute was final. The British statute-book
contained Acts of Parliament as old as the reign of Queen Anne[237]
to encourage the admission of foreign seamen into the British navy,
offering them naturalization as an inducement. American legislation
went not quite so far, but by making naturalization easy it produced
worse results. A little perjury, in no wise unsafe, was alone required
in order to transform British seamen into American citizens; and
perjury was the commonest commodity in a seaport. The British
government was forced to decide whether papers so easily obtained
and transferred should be allowed to bar its claims on the services of
its subjects, and whether it could afford to become a party to the
destruction of its own marine, even though the United States should
join with France and carry on endless war.
That there were some points which not even the loss of American
trade would bring England to concede was well known to Jefferson;
and on these points he did not mean to insist. Setting the matter of
impressment aside, the relations between England and America had
never been better than when the new President took office March 4,
1801. The British government seemed earnest in conciliation, and
lost no opportunity of showing its good-will. Under the Sixth Article of
Jay’s treaty, a commission had been appointed to settle long-
standing debts due to British subjects, but held in abeyance by State
legislation in contravention of the treaty of 1783. After long delays
the commission met at Philadelphia and set to work, but had made
little progress when the two American commissioners, with the
President’s approval, in the teeth of the treaty which created the
Board, refused to accept its decisions, and seceded. This violent
measure was not taken by the Administration without uneasiness, for
England might reasonably have resented it; but after some further
delay the British government consented to negotiate again, and at
last accepted a round sum of three million dollars in full discharge of
the British claim. This was a case in which England was the
aggrieved party; she behaved equally well in other cases where the
United States were aggrieved. Rufus King complained that her
admiralty courts in the West Indies and at Halifax were a scandal; in
deference to his remonstrances these courts were thoroughly
reformed by Act of Parliament. The vice-admiralty court at Nassau
condemned the American brigantine “Leopard,” engaged in carrying
Malaga wine from the United States to the Spanish West Indies. The
American minister complained of the decision, and within three days
the King’s Advocate reported in his favor.[238] The report was itself
founded on Sir William Scott’s favorable decision in the case of the
“Polly.” Soon afterward the American minister complained that
Captain Pellew, of the “Cleopatra,” and Admiral Parker had not
effectually restrained their subordinates on the American station;
both officers were promptly recalled. Although the Ministry had not
yet consented to make any arrangement on the practice of
impressment, Rufus King felt much hope that they might consent
even to this reform; meanwhile Lord Grenville checked the practice,
and professed a strong wish to find some expedient that should take
its place.
There was no reason to doubt the sincerity of the British Foreign
Office in wishing friendship. Its policy was well expressed in a
despatch written from Philadelphia by Robert Liston, the British
minister, shortly before he left the United States to return home:[239]
—