Chapter 3 Operating Decisions and the Income Statement Prof. Yu Gao What do we hope to learn? ? Business Processes ? Cash basis vs. Accrual Basis Accounting ? Revenue Recognition ? Expense Recognition ? Asset Turnover Ratio What are Business Processes? ? Series of activities that a company performs to achieve its goals ? Operating cycle: time used for ? ACQUISITION / PAYMENT: acquire, maintain, and pay for the resources needed by the organization. (INPUTS) ? CONVERSION: convert the resources acquired intogoods and/or services. (VALUE ADDED) ? SALES / COLLECTIONS: sell and deliver goodsand/or services to customers and to collect payment. (OUTPUTS) The Operating Cycle (cash to cash) Purchase orPurchase or manufacturemanufacture products orproducts or supplies onsupplies on creditcredit.. Deliver productDeliver product or provide serviceor provide service to customers onto customers on credit.credit. PayPay suppliers.suppliers. Receive paymentReceive payment from customers.from customers. Purchase orPurchase or manufacturemanufacture products orproducts or supplies onsupplies on creditcredit.. Deliver productDeliver product or provide serviceor provide service to customers onto customers on credit.credit. PayPay suppliers.suppliers. Receive paymentReceive payment from customers.from customers. Elements on the Income Statement ? Revenue -Increases in assets or settlement of liabilities from ongoing operations ? Expense -Decreases in assets or increases in liabilities from ongoing operations ? Gains -Increase in assets or settlement of liabilities from peripheral transactions ? Losses -Decreases in assets or increases in liabilities from peripheral transactions The Time Period Assumption ? To meet the needs of decision makers, we report financial information for relati relatirelativ vve eel lly yy sh shshort time periods ort time periodsort time periods (monthly, quarterly, annually). Life of Life ofLife of the Business the Businessthe Business 1996 1997 1998 1999 2000 2001 2002 2003 Annual Accounting Periods The Time Period Assumption ? Time Period: The long life of a company can be reported over a series of shorter time periods ? Recognition Issues : When should the effects of operating activities be recognized (recorded)? ? Measurement Issues: What amounts should be recognized? Cash Basis Accounting Revenue is recordedRevenue is recorded when cashis receivedwhen cash is received.. Expenses are recordedExpenses are recorded when cashis paid.when cash is paid. NOTNOT GAAP!GAAP! Accrual Accounting ? The way GAAP recognizes revenues and expenses ? Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received. Accrual Accounting ? Based on the economic substance of a transaction ? Recognize revenue when it?s earned (revenue principle) & expenses when they are incurred (matching principle) ? Doesn?t rely on receipt or payment of cash to determine recognition When to recognize revenue ? Revenue Principle ? Recognize revenues when . . . ? Delivery has occurred or services have been rendered ? There is persuasive evidence of an arrangement for customer payment ? The price is fixed or determinable ? Collection is reasonably assured Revenue Principle If cash is received before the companyIf cash is received before the company delivers goods or services, thedelivers goods or services, the liabilityliabilityaccountaccount UNEARNEDUNEARNED REVENUEREVENUE is recorded.is recorded. Cash received before revenue is earned - $ Received Company Delivers Unearned Revenue (-L) x,xxx Revenue (+R) x,xxx No revenue recognition until earnings process is complete Cash (+A) x,xxx Unearned revenue (+L) x,xxx Revenue Principle Liabilities occur when cash is received but Liabilities occur when cash is received butLiabilities occur when cash is received but reven revenrevenue is n ue is nue is no oot earned. Include . . . t earned. Include . . .t earned. Include . . . CASH COLLECTED (Goods or services due to customers) over time will become REVENUE (Earned when goods or services provided) Rent collected in advance Rent revenue Unearned air traffic revenue Air traffic revenue Deferred subscription revenue Subscription revenue Revenue Principle When cash is received on the dateWhen cash is received on the date the revenue is earned,thethe revenue is earned, the following entry is made:following entry is made: $ Received Company Delivers Cash (+A) x,xxx Revenue (+R) x,xxx AND Revenue Principle $ Received Cash (+A) x,xxx Accounts receivable (-A) x,xxx Accounts receivable (+A) x,xxx Revenue (+R) x,xxx Cash received after revenue is earned - Company Delivers If cash is received after the companyIf cash is received after the company delivers goods or services, andelivers goods or services, an assetasset ACCOUNTS RECEIVABLEACCOUNTS RECEIVABLE is recorded.is recorded. Recognize revenue when earnings process is complete Revenue Principle CASH TO BE COLLECTED (Owed by customers) and already earned as REVENUE (Earned when goods or services provided) Interest receivable Interest revenue Rent receivable Rent revenue Royalties receivable Royalty revenue Assets occur when revenue is earnedAssets occur when revenue is earned but cash is not yet received. Include . . .but cash is not yet received. Include . . . Assets occur when revenue is earnedAssets occur when revenue is earned but cash is not yet received. Include . . .but cash is not yet received. Include . . . Revenue Principle -Examples ? On Dec. 31, 2008, the Business Week received $6,000 subscription fees from customers for their 2009 issues. ? On Jan. 5, 2009, HomFurniture sold a bedroom set worth of $2,000 on account. The payment will be collected in 3 months. When to recognize expenses ? Matching Principle ? Expenses are recognized when the revenue they were incurred to generate is recognized ? Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid. Matching Principle ? Product costs ? Remain on the balance sheet until goods sold ? Period costs ? Difficult to associate with particular production ? e.g., Marketing and admin costs typically period expenses ? Microsoft?s $220 million campaign to launch Windows 95 Matching Principle Expense Incurred If cash is paidbefore the company receivesIf cash is paid before the company receives goods or services, angoods or services, an assetassetaccountaccount PREPAID EXPENSEPREPAID EXPENSE is recorded.is recorded. Cash is paid before expense is incurred - $ Paid No expense is recorded until the asset is used up to generate revenue Prepaid rent expense (+A) x,xxx Cash (-A) x,xxx Rent expense (+E) x,xxx Prepaid rent expense (-A) x,xxx Matching Principle Assets occu Assets occuAssets occur when ca r when car when cash shsh is paid but is paid butis paid but expense is expense isexpense is not yet not yetnot yet incurred. Include. . incurred. Include. .incurred. Include. . . .. CASH PAID FOR as used over time becomes EXPENSE Supplies (inventory) Supplies expense Prepaid insurance Insurance expense Buildings and equipment Depreciation expense Matching Principle When cash is paid on t When cash is paid on tWhen cash is paid on th hhe da e dae dat tte ee t tth hhe ee expe expeexpense i nse inse is ss i iin nncurred, th curred, thcurred, the fol e fole foll llo oow wwi iing ngng en enent ttr rry is made: y is made:y is made: Expense Incurred AND $ Paid Rent expense (+E) Cash (-A) x,xxx x,xxx Matching Principle $ Paid Wages payable(-L) x,xxxCash(-A) x,xxxIf cash is paid after the company receivesIf cash is paid after the company receives goods or services, angoods or services, an liabilityliabilityaccountaccount PAYABLEPAYABLE is recorded.is recorded. Cash paid after expense is incurred - Wages expense(+E) x,xxxWages payable(+L) x,xxxExpense Incurred An expense is recorded when it is incurred. Wages expense (+E) x,xxx Wages payable (+L) x,xxx Wages payable (-L) x,xxx Cash (-A) x,xxx Matching Principle Liabilities occur when expense is incurred Liabilities occur when expense is incurredLiabilities occur when expense is incurred but cash is but cash isbut cash is not yet paid. Include . . not yet paid. Include . .not yet paid. Include . . . .. CASH TO BE PAID and already incurred as EXPENSE Salaries payable Salaries expense Interest payable Interest expense Property taxes payable Property tax expense Matching Principle ? Examples ? On Dec. 11, 2008, Walmart purchased 5,000 DVD players from an overseas manufacturer for $20 each (miscellaneous costs included). According to the contract, Walmart will pay the full amount on Mar. 11, 2009. All these DVD players were sold out in December 2008 at $32 each. Prepare the journal entries (Aggregate all December sales of the DVD players into one journal entry.) Accrual vs. Cash basis accounting Accrual basis Cash basis Recognize Revenue 1. Performed 2. Cash collection can be estimated When cash is received Recognize expense Match with revenue When cash is paid Accepted under GAAP for listed firms? Yes NO (However, info is provided in Statement of Cash Flows) Accrual vs. Cash basis ? Adverse incentives can arise under cash accounting ? Under-invest ? Penalize growth ? Delay payment of accounts ? Accrual accounting provides a more accurate picture of a company?s financial position and operating results than does cash-basis accounting Revenue and Expense Accounts ? Revenue and expense accounts are not considered ?owners? equity? even though they increase and decrease equity ? They are called income statement accounts, nominal or temporary accounts ? Revenue (expense) accounts are increased or decreased the same (opposite) way as equity accounts A AA = == L LL + ++ SE SESE Co CoCont ntntri riribut butbuted eded Ret RetReta aai iin nne eed dd A AAsse ssesset tts ss Dr: Inc. Cr: Dec. L LLi iia aab bbilitie ilitieilities ss Dr: Dec. Cr: Inc. Ca CaCapi pipit tta aal ll Ear EarEarn nni iin nng ggs ss Dr: Dec. Dr: Dec. Cr: Inc. Cr: Inc. Div DivDivi iidends dendsdends Net NetNet In InInc cco oom mme ee Ex ExExpe pepense nsenses ss an anand L d Ld Lo ooss sssses eses Debit for Increase Credit for Decrease Re ReReve vevenue nuenues an s ans and G d Gd Ga aai iin nns ss Debit for Decrease Credit for Increase Accruals & Deferrals ? Transactions where the exchange of cashdoes not coincide with the economic substance ? Accrual ? Recognition (revenue or expense) before the exchange of cash ? Deferral ? Recognition after the exchange of cash Unadjusted Financial Statements ? Several expenses, including income tax expense, have not determined at this point in the accounting process. ? Adjustments discussed in Chapter 4 The Accounting Process 1. Journalizing on the Journal ? 2. Posting on T-Accts ? 3. Prepare an unadjusted trial balance ? 4. Corrections and adjustments ? 5. Prepare an adjusted trial balance ? 6. Prepare financial statements ? 7. Closing entries if the end of the year ? 8. Prepare a post-closing trial balance Asset Turnover Ratio Asset Turnover Ratio Sales (or Operating) Revenues AverageTotal Assets = Measures the sales generated per dollar of assets Creditors and analysts use this ratio to assess a company?s effectiveness at controlling current and noncurrent assets What to take home with? ? Business Processes ? When should revenue be recognized? ? When should expense be recognized? ? What are the differences between cash basis and accrual basis accounting? ? Why is accrual basis better than cash basis accounting? ? What is Asset Turnover Ratio?
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