Operating Decisions and the Income Statement

Chapter 3

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Understanding the Business

How do business activities affect the income statement?

How are these activities recognized and measured?

How are these activities reported on the income statement?

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The Operating Cycle

Begin
Purchase or manufacture products or supplies on credit.
Receive payment from customers. Deliver product or provide service to customers on credit. Pay suppliers.

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The Operating Cycle

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?

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Elements on the Income Statement

Revenues Increases in assets or settlement of liabilities from ongoing operations. Expenses Decreases in assets or increases in liabilities from ongoing operations. Gains Increases in assets or settlement of liabilities from peripheral transactions. Losses Decreases in assets or increases in liabilities from peripheral transactions.
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Papa Johns Primary Operating Expenses

Cost of sales (used inventory)

Salaries and benefits to employees

Other costs (like advertising, insurance, and depreciation)

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How Are Operating Activities Recognized and Measured?

Cash Basis

Revenue is recorded when cash is received.

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Expenses are recorded when cash is paid.

How Are Operating Activities Recognized and Measured?

Accrual Accounting
Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received.
Required by -

Generally Acceptable Accounting Principles

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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.

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Revenue Principle
Typical liabilities that become revenue when earned include . . .
CASH COLLECTED (Goods or services due to customers) Rent collected in advance Unearned air traffic revenue Deferred subscription revenue REVENUE over time will (Earned when goods become or services provided) Rent revenue Air traffic revenue Subscription revenue

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Revenue Principle
Assets reflecting revenues earned but not yet received in cash include . . .
CASH TO BE COLLECTED (Owed by customers) Interest receivable Rent receivable Royalties receivable REVENUE (Earned when goods or services provided) Interest revenue Rent revenue Royalty revenue

and already earned as

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The Matching Principle

Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid.

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The Matching Principle

Typical assets and their related expense accounts include. . .
CASH PAID FOR Supplies inventory Prepaid insurance Buildings and equipment as used over time becomes EXPENSE Supplies expense Insurance expense Depreciation expense

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A = L + SE
ASSETS Debit Credit for for Increase Decrease LIABILITIES Debit Credit for for Decrease Increase

Next, lets see how Revenues and Expenses affect Retained Earnings.

CONTRIBUTED CAPITAL Debit Credit for for Decrease Increase

RETAINED EARNINGS Debit Credit for for Decrease Increase

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Expanded Transaction Analysis Model

Dividends decrease Retained Earnings.

RETAINED EARNINGS Debit Credit for for Decrease Increase

Net Income increases Retained Earnings.

REVENUES Debit Credit for for Decrease Increase

EXPENSES Debit Credit for for Increase Decrease

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End of Chapter 3

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