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CHAPTER 3Operating Decisions

& the Income Statement

Acct 2301, Fall 2009

Cox School of Business, SMU

Zining Li

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Elements of the Income Statement

Revenues

Cost of goods sold

Gross Profit

Operating costs and expenses

Operating Income

Other gains and losses

Pretax Net Income

Income tax expense

Net Income

–

=

–

=

–

=–

=

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• Time period assumption

• Revenue principle: Criteria for revenue recognition• Delivery of goods has occurred or services have been

rendered• Evidence of arrangement for customer payment• Price is fixed or determinable• Collection is reasonably assured

• Matching principle: Outlines expense recognition• Costs incurred to generate revenues recognized in the same

period as revenues

Assumptions & Principles of Accounting

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Accrual Accounting

• Required by GAAP

• Revenues are recognized when earned under the revenue principle, regardless of when cash is received

• Expenses are recognized when incurred under the matching principle, regardless of when cash is paid

• Prepaid expenses, unearned revenue

• Accrual vs. cash-basis accounting

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Examples: Recording revenues and expenses

1. Company employees earned $420 in wages during the month of December and will receive their paychecks in January. How much salary expense should the company record in December?

2. The company purchased a one-year insurance policy on January 1 for $1,200. At the end of January, what should the company record as insurance expense?

3. On December 1 the company makes a one year loan to one of its employees for $12,000. The loan carries an interest rate of 10%. Should the company record any revenues or expenses in December related to the loan?

4. At the beginning of the year a company has $200 of supplies in storage. During the year, $600 of additional supplies are purchased. At December 31, $250 of supplies are left. How much supplies expense should the company record for the year?

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Exercise: Revenue & expense recognition under accrual accounting

The Mozart Music Co. operates a retail store that sells musical instruments. The company had the following transactions in July. For each of following transactions, identify the amount of revenue or expense that should be recognized for July under accrual accounting.

1. Sold instruments to customers for $10,000. The company received $6,000 cash and the rest was charged on account. The cost of the instruments was $7,000.

2. Purchased $4,000 of new instruments inventory with cash.3. Paid $600 in wages to employees who worked during July.4. Received a $200 telephone bill for July that will be paid in August.5. Received $1,000 from customers as deposits on orders of new

instruments that will be delivered to customers in August.

Under accrual accounting what is the company’s net income for July?

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The type of account determines how increases and decreases are recorded in it:

DR CR + -

CRDR +- +

CRDR -

Rules of Debit and

Credit

Rules of Debit and

Credit

Assets

Stockholder’s

EquityLiabilitiesAccounting Equation

Accounting Equation

= +

Transaction Analysis

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CRDR +-

Stockholder’s

Equity

Expanded Transaction Analysis Contributed

Capital

CRDR +-

= Retained

EarningsEND

CRDR +-

+

Retained

EarningsBEGIN

CRDR +-

+ Revenues

CRDR +-

– Expenses

DR

+

CR

–

– Dividends

+

DR CR

–

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1. Determine whether event is recordable

2. Identify specific accounts affected (at least two accounts per transaction)

3. Determine direction and $ amount of each effect

4. Record journal entry

5. Verify that the total debits = total credits

6. Verify that the accounting equation is in balance

Accounting for Business Transactions

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Examples: Recording revenue and expense transactions with journal entries

1. Company performs services for customers in exchange for $500 cash (e.g., Landscaping business).

2. Employees worked and earned wages of $200, the company paid cash.

3. Company declares and pays dividends to its shareholders totaling $1,000.

4. Company performs services worth $300 for customers on account.

5. Company receives payment in full from customer in item 4 above.

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Exercise: Recording transactions with journal entries College Caps, Inc. operates a small retail store in the mall that sells

baseball caps. The following transactions occurred during the first month of operations:

May 1 Sold 1,000 shares of stock to investors for $30 per share

May 1 Purchased a supply of UT, SMU, and A&M baseball caps for $7,800 in cash.

May 1 Paid $1,200 for the current month’s rent and another $1,200 for next month’s rent.

May 21 Paid employee salaries of $300 for first three weeks of May.

May 24 Received $300 utilities bill for first two weeks of May. The bill was paid that day with check no. 7005.

May 31 Monthly sales totaled $12,200, half of which was charged on account. The cost of the caps sold was $5,400.

May 31 Salaries due to employees for the last week of May is $100. These salaries will be paid June 7.

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Effect of transactions on cash flow

Statement of Cash Flows

Beginning cash balance

+ inflows of cash – outflows of cash

= Ending cash balance

Cash Inflows & Outflows:• Operating activities

• Investing activities

• Financing activities

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Exercise: Identifying cash flow effects

Identify the cash flow effect of each transaction as either an operating, investing, or financing activity. Indicate if there is no cash effect.

May 1 Sold 1,000 shares of stock to investors for $30 per share

May 1 Purchased a supply of UT, SMU, and A&M baseball caps for $7,800 in cash.

May 1 Paid $1,200 for the current month’s rent and another $1,200 for next month’s rent.

May 21 Paid employee salaries of $300 for first three weeks of May.

May 24 Received $300 utilities bill for first two weeks of May. The bill was paid that day with check no. 7005.

May 31 Monthly sales totaled $12,200, half of which was charged on account. The cost of the caps sold was $5,400.

May 31 Salaries due to employees for the last week of May is $100. These salaries will be paid June 7.

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Ratio Analysis

Asset Sales (or Operating) Revenues

Turnover Ratio = Average Total Assets

Earnings per Net Income

Share = # of Shares Outstanding

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Flow of Accounting Data

1. Identify recordable financial transactions2. Record the journal entries3. Post journal entry amounts to T-accounts4. Prepare the unadjusted trial balance5. Record adjusting journal entries6. Prepare the adjusted trial balance7. Prepare the financial statements8. Record the closing entries