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The Business Operating Cycle
Begins with the purchase of manufacture of a product for sale
When products are purchased from suppliers, those suppliers must be paid
After a sale has been made, the company must deliver the product or service to the customer
Many business sales are made on credit. If credit is extended, payment must be received from customers
Once the cash has been collected from customers, the business cycle begins all over again
There is a difference between the business operating cycle and the accounting cycle
The Accounting Cycle
First companies acquire inventory and the services of employees
Then they sell inventories or services to customers
The operating (or cash-to-cash) cycle begins when a company receives goods to sell (or, in case of a service company, has employees work to provide services to customers)
The length of time for the completion of the operating cycle depends on the nature of the business
Reporting Periodic Income
accountants follow the time period assumption, which assumes that the long life of a company can reported in shorter time periods such as months, quarters, and years
Two Main Issues When Reporting Periodic Income
Recognition Issues: When should the effects of operating activities be recognized?
Measurement Issues: What amounts should be recognized?
Revenue
inflow of economic benefits arising from the major ordinary operating of a business. operating Revenue result from the sale of goods or rendering of services as the main focus of business
revenue is not earned if a customer pays for something in advance. revenue is earned only when firms provide the promised good or service
when revenue is earned assets increase
selling of fixed assets is not revenue because it is not ordinary day-to-day operations
Forms of Business Activity that Generates Different Types of Revenue
Sales of Goods
Fees for Services
Subscriptions
Interest Received
Many companies generate revenue from various sources in order to sustain success
Expense
represent the outflows of economic benefits arising from the major ordinary operations incurred to generate revenues during the period.
the nature of business will again determine the type of expenses that will be incurred
Common Types of Expenses
Cost of Goods Sold or Cost of Sales (the cost of making or buying the goods that are sold during the period)
Salaries and Wages
Rent Expense, Insurance Expense, Utilities
General and Administrative Expenses: cost of training employees and managers, advertising & other expenses which are not directly related to operating stores
Depreciation Expenses
In purely-service oriented firms where no products are produced or sold, the cost of hiring employees to provide services is usually the largest expense
Difference Between Expenditure and Expense
Expenditure is ANY outflow of cash for any purpose, whether to but equipment, pay off a loan, or pay wages. Expenses are outflows of economic benefits ONLY from ordinary business activities
Operating Expenses
the costs of operating the business that are incurred to generate revenue during the period
incurred = the resources or services of others that are used
Usually, many expenses are incurred in making a sale or providing a service. Expenses may be incurred before, after, or at the same time as they are paid in cash. When an expense is incurred, the appropriate assets account decrease and liabilities increase.
Types of Operating Expenses
Includes:
Depreciation Expense
Supplies Expense
Wages Expense
Rent Expense
General and Administrative Expenses
Losses (Gains) on Disposal of Assets
Insurance Expenses
Utilities Expenses
Repairs Expenses
Other Items
not all activities affecting income statement belongs to operation activities
any revenue, expenses, gains or losses that are due to these other activities are not included as part of operating income but are instead categorized as Other Items
Types of “Other Items”
Interest Revenue: revenue from investment of bonds in other firms
Interest Expense: cost of borrowing money (financing activities)
Losses (Gains) on Scale of Investments
Elements of Profit in Income Statement
Gross Profit, Operating Profit, Net Income
Gross Profit
represents the profit from buying & selling goods, without taking into consideration any other revenues/expenses associated with the business
Operating Profit
Operating revenue less operating expenses. represents the profit generated from the major operation activities of the business. Does not take into account profit from other non-operating activities. Profit belong to only the shareholders
Net Income
represent the final wealth attributed to the owners and will be added to the equity (retained earnings) figure in the balance sheet. Profits belong only to shareholders
Cash Basis Accounting
Many local retailers and small businesses often use this method. It is only adequate for organizations that do not need to report to external users
It is simple and permitted for tax purposes
Cash basis accounting records each cash payment as a cash outflow and each cash receipt as a cash inflow
This produces net cash flow information that if often adequate for organizations that do not need to report to external users
Limitations of Cash Basis Accounting
Cash Basis Accounting may lead to incorrect interpretation of future company performance. Profits are less stable and unpredictable, with big variation. GAAP & IFRS does not allow the cash basis of accounting
Accrual Basis Accounting
Accrual Basis Accounting is require by GAAP & IFRS and used to report external decision makers
The accounting principles that determine when revenues and expenses are recorded are the revenue recognition and the expenses recognition principle (also called the matching principle)
Revenues are recognized when goods and services are provided to customers (they are earned)
Expenses are recognized in the same period as the revenues to which they relate (resources are used or debts are incurred to generate revenues), regardless of when cash is received or paid
Revenue versus Cash Receipts
Cash may be received at any of these times:
Before the goods and services are delivered
In the same period as the goods or services are delivered
After the goods or services are delivered
GAAP require accrual basis accounting for financial reporting
Expense Recognition Principle
Expenses recognition principle is more commonly know as the matching principle: matching of cost with revenue
Expenses must be matched to the same accounting period in which the related revenue is generate
As with revenues and cash receipts, expenses are recorded incurred, regardless of when cash is pair
Importance of Cash
a company’s ability to generate positive cash flow is important
Cash is needed to:
pay employees, suppliers, rent in order to continue as a going concern
determine the company’s ability to meet future obligations
be flexible in funding needs for investment
Interpreting the cash flow statement: creditors consider the cash flow from operating activities as it indicates firm’s ability to generate cash from sales to meet its current cash needs
Managers’ Incentive to Violate Accounting Rules
Investors and creditors make relevant decisions based on their expectation of a firm’s future performance. Managers thus have the incentive to report earnings that meet or exceed investors’ expectation to bolster stock price, when their firm is in the red. Greed may lead some managers to make unethical accounting and reporting decisions, often involving falsifying revenues and expenses.
