Financial Accounting The Operating Cycle Chapter 3 Operating Decisions and the Income Statement Objective of a business to turn cash into more cash Operating cash to cash Cycle o Begins when a company receives good to sell o Pays for them o Sells to customers o Ends when customers pay cash to the company Shortening the cycle means higher profit Time Period Assumption o Indicates that the long life of a company can be reported in shorter time periods o 2 types of issues arise in reporting periodic income to users Recognition issues WHEN should the effects of operating activities be recognized recorded Measurement issues WHAT AMOUNTS should be recognized Elements of the Income Statement Operating Revenues o Result from the sells of goods and services o Revenues increases in assets or settlements of liabilities from ongoing operations of the business o If a customer pays for goods and services in advance a liability account usually unearned revenue is create No revenue is earned Operating Expenses o Expenditure any outflow of cash for any purpose whether to buy equipment pay off a bank loan or pay employees their wages o Expenses decreases in assets or increases in liabilities from ongoing operations incurred to generate revenues during the period o Expenses are necessary to generate revenues o Operating expenses consist of Cash of sales All other operating expenses Salaries expenses Other Items o Any revenues expenses gains loses that result from these other activities are not included as part of operating income but are instead categorized as other items o Include Investment income or Investment Interest or Dividend revenue Using excess cash to purchase stocks or bonds in other companies Interest Expense Using money that was borrowed is not an operating expense Gains or Loses on Sales of Assets Gains Increases in assets or settlement of liabilities from peripheral transactions Loses Decreases in Assets or increases in liabilities from peripheral transactions Income Tax Expense o Also called Provision for Income Taxes or Pretax Income is the last expense listed on the Income Statement before determining Net Income o Income before tax expense Subtotal of all revenues minus all expenses except taxes Earning per Share o This ratio is widely used in evaluating the operating performance and profitability of a company o Net income average of shares of stock outstanding How Are Operating Activities Recognized and Measured Cash Basis Accounting o Records revenues when cash is received and expenses when cash is paid o Cash basis Income Statement Accrual Accounting income Revenues cash receipts Expenses cash payments net o Required by GAAP o In Accrual Accounting revenues and expenses are recognized when the transaction that causes them occurs not necessarily when cash is received or paid o Records revenues when earned and expenses when incurred regardless of the timing of cash receipts or payments o The two basic accounting principles that determine when revenues and expenses are recorded under accrual basis accounting are the revenue principle and the matching principle Revenue Principle States that 4 criteria or conditions must normally be met for revenue to be recognized if not met revenue is not recognized 1 Delivery has occurred or services have been rendered 2 There is persuasive evidence of an arrangement for customer payment 3 The price is fixed or determinable 4 Collection is reasonably assured Cases of Revenue Principle 1 Cash is received before the goods or services are delivered a If cash is received before the company delivers goods or services the liability account UNEARNED REVENUE is recorded Cash A xxx Unearned revenue L xxx b When the company delivers the goods or services UNEARNED REVENUE is reduced and REVENUE is recorded Unearned revenue L xxx Service revenue R xxx 2 Cash is received in the same period as the goods or services are delivered Cash A xxx Revenue R xxx 3 Cash is received after the goods or services are delivered a If cash is received after the company delivers goods or services an asset ACCOUNTS RECEIVABLE is recorded Accounts receivable A xxx Revenue R xxx b When the cash is received the ACCOUNTS RECEIVABLE is reduced Cash A xxx Accounts receivable A xxx Matching Principle Requires that expenses be recorded when incurred in earning revenue Resources consumed to earn revenues in an accounting period should be recorded in that period regardless of when cash is paid The costs of generating the revenue include expenses incurred such as these o Wages to employees who worked during the period wages expense o Utilities for the electricity used during the period o Food and paper products used during the period utilities expense cost of sales o Facilities rental during the period rent expense o The use of ovens and other equipment during the period depreciation expense Cases of Matching Principle 1 Cash is paid before the expense is incurred to generate revenue a If cash is paid before the company receives goods or services an asset account PREPAID EXPENSE is recorded Prepaid expense A xxx Cash A xxx b When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded i Expense is recorded when incurred Expense E xxxPrepaid expense A xxx 2 Cash is paid in the same period as the expense is incurred to generate revenue a When cash is paid on the date the expense is incurred the following entry is made Expense E xxx Cash A xxx 3 Cash is paid after the cost is incurred to generate revenue a If cash is paid after the company receives goods or services a liability PAYABLE is recorded Expense E xxx Payable L xxx b When cash is paid the PAYABLE is reduced Payable L xxx Cash A xxx The Expanded Transaction Analysis Model Transaction Analysis Rules o Includes all 5 elements A L SE RE EX o A L SE CONSIST OF NET INCOME R E SE ASSETS LIABILITIES CONT CAP RET EARN D C D C Invest Dividend Net by declared Income C C D D owners Rev Exp D C D C Questions to ask yourself 1 Is revenue earned a If yes then revenue account is increased credited 2 Is an expense incurred a If yes then expense account is increased debited Analyzing Papa John s Transactions 1 Papa John s restaurants sold pizza to customers for 36 000 cash and sold 30 000 in supplies to franchised restaurants receiving 21 000 cash with the rest due on account a Cash A 36 000 21 000 Accounts Receivable A Restaurant Sales Revenue R SE Debit 57 000 9 000 Credit 66 000 Assets Liabilities Stockholders Equity
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