Financial Accounting, Second Canadian Edition

1
Chapter 3
Operating Decisions and the Income Statement
2
Business Background
What business activities affect the income
statement?
How are these activities recognized and measured?
How are these activities reported on the income
statement?
3
The Operating Cycle
The operating cycle is the time it takes for a
company to pay cash to suppliers, sell those
goods and services to customers, and collect cash
from customers. Outflow 10,000 Pay
Suppliers Inflow 14,000 Sell Product (received
from customers) Net Cash Inflow 4,000 Use te
4,000 to pay employees, taxes, etc. Or buy more
assets Or pay down debt. Or give back to
investors as Dividend
Begin
Purchase products or supplies on credit.
Receive payment from customers.
Pay suppliers.
Deliver product or provide service to customers
on credit.
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Underlying Accounting Assumptions
Periodicity The long life of a company can be
reported over a series of short time periods.
Investors cant wait 100 years for an income
statement.
Recognition Issues When should the effects of
operating activities be recognized (recorded)?
Measurement Issues What amounts should be
recognized?
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The Periodicity Assumption

• To meet the needs of decision makers, we report
  financial information for relatively short time
  periods (monthly, quarterly, annually).
• Have we actually placed the ad in the newspaper
  yet (are we collecting revenue from the expense?)
  or have we just scheduled it?

Life of the Business
1998
1999
2000
2001
2002
2003
2004
2005
Annual Accounting Periods
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Order of Elements on the Classified Income
Statements
our focus Results of continuing operations
regular operations
Results of discontinued operations ex revenue
of a store that will be closed. Predictive value
Extraordinary items
Earnings per share
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Elements on the Classified Income Statements
Results of continuing operations can be presented
in one of the two formats
Single step format list all revenues follow by
all expense items and then shows the difference
between revenue and expenses revenue expenses
Multiple step format cost of goods sold are
deducted from sale to present gross margin (or
gross profit) as a subtotal. Other operating
expenses are then deducted to show operating
profit as a second subtotal revenue cost of
goods sold gross margin Gross margin pays
salary, property tax, hydro, heat, (operating
expenses Net Income gross margin operating
expenses
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Elements on the Income Statement
Revenue Increases in assets or settlement of
liabilities from ongoing operations.
Expense Decreases in assets or increases in
liabilities to generate revenues during a period.
Gross Profit (Gross Margin) Net sales less cost
of goods sold.
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Elements on the Income Statement
Operating Income Net sales less cost of goods
sold and other operating expenses.
Gains periferal ex. Selling a store Increase in
assets or settlement of liabilities from
peripheral transactions.
Losses periferal ex. Selling a store Decreases
in assets or increases in liabilities from
peripheral transactions.
Income before Income Taxes Revenue minus all
expenses except income tax expense.
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Elements on the Income Statement
Discontinued Operations Result from the disposal
of a major segment of the business and are
reported net of income tax effect. ex. You have
6 stores, only want 5. your going to close one,
it becomes this
Extraordinary Items Gain or losses that are
considered unusual in nature, infrequent in
occurrence, and not dependent primarily on
decisions by management or owners. The are
reported net of tax of income statements RARE
cant happen often. Happen infrequently.
A-Typical. Not dependant on management EX
hurricane damage would be extrodinary here, but
not in texas, or florida
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Asset Turnover Ratio
Sales Revenues Average Total Assets
Asset Turnover Ratio
This ratio measures the sales generated per
dollar of assets. How well are we using assets
to generate revenue? Higher the better
Creditors and analysts used this ratio to assess
a companys effectiveness at controlling current
and noncurrent assets.
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Asset Turnover Ratio
Asset Turnover Ratio
0.94 (here we see Green Mountain is best)
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Cash Basis vs Accrual Accounting

• Cash Basis

Accrual Basis
Assets, liabilities, revenues, and expenses
should be recognized when the transaction that
causes them occurs, not necessarily when cash is
paid or received. Accountants convert from Cash
Basis to Accrural. This is our focus in this
course We care when you actually earned, and
encured the expense.
Revenue is recorded when cash is received.
Expenses are recorded when cash is paid. Typical
of book keeping
Required by GAAP
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Problem 3-6 in Text

• Cash Basis Accrural Basis (our focus)
• Revenues Revenues
• Cash Sales 6,000 ?? Sales To Cust. 10,000
• Customer Deposits 1,000
• Expenses Expenses
• Inventory Purchases 1,000 Cost of Goods Sold
  7,0000
• Wages 600 Wages 600
• Utilities Utilities (April) 200
• --------------------------------------------------
  -------------------------------------------------S
  ummar 5400 Net Income 2,200

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Principles Affecting Income Determination

• Revenue Principle
• Matching Principle
• Cost Principle

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The Revenue Principle

• Recognize revenues when . . .
• The earnings process is complete or nearly
  complete.
• Reasonably sure we can complete the earnings
  process
• An exchange transaction takes place.
• If we call a supplier, asking to order inventory,
  that isnt a transaction.
• When the order is delivered then exchange takes
  place.
• Same with a sale, it cant be recorded until
  purchaser pays you
• Collection is reasonably assured.
• If you order a computer from Dell, they are
  reasonably assured they can collect. Becaues you
  have to first pay for it, or send money order, or
  certified cheque. They dont recognize sale of
  computer until the have been payed.

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The Revenue Principle
Typical liabilities that become revenue when
earned include . . . (this situation occurs when
there is a gap between payment and delivery of
service) Ex. When you book a flight. The
airline May 24 D C Cash 1000 Unearned
Rev. 1000 Aug Unearned Rev. 1000 Fee
Revenue 1000
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The Revenue Principle
Assets reflecting revenues earned but not yet
received in cash include . . . (occurs when
customer pays you after they receive the
service) The intermediate step here will be
Accounts Recievable. There is no liability in
this case because theyve already provided the
service. DR CR Accounts Recievable (A)
1000 Fee Revenue (L) 1000 Cash
(A) 1000 Accounts Recievable (A) 1000
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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.
• Recognize revenue when you take the service so
  you match revenues with your expenses. It also
  has two sides to the equation

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The Matching Principle
Typical assets and their related expense accounts
include. . .
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The Matching Principle
Typical liabilities and their related expense
accounts include . . .
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Return on Assets (ROA)
Net Income Average Total Assets
Returns on Assets
This ratio answers the question How well has
management used the total invested capital
provided by debtholders and shareholders during a
period? How well is management using their
assets to earn more money? How much money is
going to be returned if we invest in this
company. Cash utilization.
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Return on Assets (ROA)
Returns on Assets
0.058 (5.8) (not as good as Starbucks, but
is Starbucks stable?) Higher return on assets,
the better
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A L SE

Next, lets see how Revenues and Expenses affect
Retained Earnings. Normally it is at a credit
balance.
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The Expanded Transaction Analysis Model

Dividends decrease Retained Earnings A revenue
credits retained earnings, expenses debit RE.
Net Income increases Retained Earnings.
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Van Houtte signed contract with new office
service clients and receives 500 cash. The
company earned 400 immediately. The rest will
be earned over several months.
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The company sold coffee products to office
service clients for 35,200 in cash. The cost of
the sales was 19,600. (look at textbok E3-12)
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Focus on Cash Flows
Remember We discussed Investing and Financing
Activities in Chapter 2. Cash is King