Operating Decisions and the Accounting System Chapter 3 How Do Business Activities Affect the Income Statement I The Operating Cycle a Long term objective for any business is to turn cash into more cash b Excess cash must be generate from operations not borrowing money or selling long lived assets c Companies acquire inventory and the services of employees and then sell inventory or services to customers d Operating cash to cash cycle begins when a company receives goods to sell pays for them and sells to customers i Ends when customers pay cash to the company ii Length of time for completion of operating cycle depends on nature of business iii Chipotle cycle short because it spends cash for ingredients and preparation and then sells to customers for cash iv Toys R Us however builds inventory for months at a time borrows funds to pay for it repays loans with interest when it receives cash from customers v Some companies receive cash from customers well after a sale takes place 1 Furniture stores and car dealerships e Accountants follow the time period assumptions which assumes that the long life of a company can be reported in shorter time periods such as months quarters and year i Two types of issues arise in reporting periodic income to users 1 Recognition issues a When should the effects of operating activities be recognized recorded 2 Measurement issues a What amounts should be recognized II Elements of the Income Statement a Operating income b c Format is known as multiple step and very common Income before taxes i You can tell if a company uses the multiple step format if you see the Operating Income aka Income from Operations subtotal d Operating Revenues i Revenues are defined as increases in assets or settlements of liabilities from ongoing operations of business ii Result from the sale of goods services iii When revenue is earned assets usually cash or Accounts Receivable increase 1 Sometimes if a customer pays for goods or services in advance a liability account usually Unearned or Deferred Revenue is created a No revenue earned yet iv Restaurant Sales Revenue account 1 Sales of food orders to customers e Operating Expenses Erika Smitten Operating Decisions and the Accounting System Chapter 3 i Expenditure is any outflow of cash for any purpose whether to buy equipment pay off a bank loan or pay employees their wages ii Expenses are outflows or the using up of assets or increase in liabilities from ongoing operations incurred to generate revenues during the period iii Not all cash expenditures are expenses but expenses are necessary to generate revenues iv Cash Expenditures Debt payments or asset purchases or expenses v Restaurant Operating Expenses 1 Food Beverage and Packaging Expense a Food drink ingredients and packaging supplies used to produce and sell meals b Companies with a manufacturing or merchandising focus Cost of Goods Sold cost of Sales representing the cost of inventory used in generating sale is usually the most significant expense vi Salaries and Wages Expense 1 Employees generate sales for chipotle but wages salaries are 2 Service oriented companies incur this expense as their paid later largest usually vii Occupancy Expense 1 Renting facilities insuring property and equipment at the stores and using utilities 2 Paid before occupying but utilities are paid after occupation viii Other Operating Expenses 1 Advertising and marketing costs 2 Repair and maintenance of store facilities f General and Administrative Expenses i Costs of renting headquarters facilities ii Executive salaries iii Training managers iv Not directly related to operating stores g Depreciation Expense i Part of the cost of using buildings and equipment to generate revenues is reported as Depreciation Expenses ii Operating Income is a measure of the profit from central ongoing operations h Other Items 1 Operating revenues operating expenses i Investment Income or Investment Revenue Interest Revenue or Dividend Revenue 1 Using excess cash to purchase stocks or bonds in other companies that isn t a part of the central operation 2 Therefore any interest or dividends earned on investments in other companies are not included in operating revenue ii Interest Expense expense 1 Borrowing money is a financial activity and isn t an operating Erika Smitten Operating Decisions and the Accounting System Chapter 3 2 Incurring interest expense and earning investment income aren t central operations of most businesses 3 We say these are PERIPHERAL normal but not central transactions iii Gain loss on Disposal of Assets 1 Companies sell property plan and equipment to maintain modern facilities and also sell investments as needed 2 Selling for more than original price doesn t result in earning revenue because the transaction isn t the central operating focus for the business 3 Gains result in an increase in assets or decrease in liabilities 4 Losses are decreases in assets or increases in liabilities from from a peripheral transaction peripheral transactions i Income before Income Taxes pretax income 1 Adding and subtracting other items to operating income gives us this subtotal ii Income Tax Expense Provision for Income Taxes 1 Last expense listed on the income statement before determining net income iii All profit making corps required to compute income taxes owed to federal state and foreign govts iv Calculated as a percentage of pretax income determined by applying the tax rates of fed state local and foreign taxing authorities i Income Tax Expense j Earnings per Share i Corps required to disclose earnings per share on the income statement or in the notes to the financial statements ii Ration is used in evaluation the operating performance and profitability of a company iii Net Income Weighted Average Number of Shares of Stock Outstanding Earnings per Share 1 More complicated later Erika Smitten Operating Decisions and the Accounting System Chapter 3 How Are Operating Activities Recognized and Measured I Cash Basis Accounting a Revenues are recorded when cash is received and expenses are recorded wen cash is paid b Produces net operating cash flow information which is often quite adequate for organizations that don t need to report to external users c May lead to an incorrect interpretation of future company performance II i Performance over time seems uneven even when its not Accrual Accounting a Accrual basis accounting is the generally accepted accounting principle that is required for
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