Operating Decisions and the Income Statement

Chapter 3

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2009 The McGraw-Hill Companies, Inc.

The Operating Cycle

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

Receive payment from customers.

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Slide 2

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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Slide 3

Cash Basis Accounting

Revenue is recorded when cash is received.

Expenses are recorded when cash is paid.

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Slide 4

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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Slide 5

Revenue Principle
When the company delivers the goods or services UNEARNED REVENUE is reduced and REVENUE is recorded.
Cash received before revenue is earned Cash Received Cash (+A) Unearned revenue (+L) xxx Company Delivers

xxx Revenue will be recorded when earned.

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Slide 6

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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Slide 7

Revenue Principle
When the cash is received the ACCOUNTS RECEIVABLE is reduced.
Cash received after revenue is earned Company Delivers Cash Received

Accounts receivable (+A) Revenue (+R)

xxx

xxx Cash will be collected.

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Slide 8

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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Slide 9

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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Slide 10

The Matching Principle

When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded.
Cash is paid before expense is incurred $ Paid Prepaid expense (+A) Cash (-A) xxx Expense Incurred

xxx Expense will be recorded when incurred.

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Slide 11

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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Slide 12

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

Slide 13

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How are Financial Statements Prepared?

Income Statement Statement of Retained Earnings Balance Sheet Revenues Expenses = Net Income Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Assets = Liabilities + Stockholders Equity Contributed Capital Retained Earnings Change = Cash from Operating Activities in + Cash from Investing Activities Cash + Cash from Financing Activities
Slide 14

Statement of Cash Flows

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End of Chapter 3

2009 The McGraw-Hill Companies, Inc.