The Business Operating Cycle

• The operating cycle begins with the purchase or 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) and ends when customers pay cash to the company. 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 be reported in shorter time periods such as, months, quarters, and years.

Two Main Issues When Reporting Periodic Income

1. Recognition Issues: When should the effects of operating activities be recognized?

2. Measurement Issues: What amounts should be recognized?

Revenue

Revenue Definition and Parameters

• Revenue is defined as inflow of economic benefits arising from the major ordinary operation of a business. Operating revenue result from the sale of goods or rendering of services as the main focus of business

• Different forms of business activities generate different types of revenue

  • Sales of goods

  • Fees for services

  • Subscriptions

  • Interest Received

• Revenue is not earned if a customer pays for something in advance. Revenue is earned only when firms provide the promised good or service to the customer

• When revenue is earned, assets, usually in Cash or Accounts Receivables, increases

Additional Notes

• Selling of fixed assets is not revenue because it is not ordinary operation of business (not daily business)

• Cash accounts will increase when cash is received immediately from customers at the time of sale. Otherwise, accounts receivables increase when sale is on credit and payment form customer will be paid at a later stage.

Revenue Sources

• Many companies generate revenue from various sources

• Many companies do this in order to sustain success

Operating Revenues

• the amounts earned and recorded from a company’s day-to-day business activities

• amount earned when a company sells products or provides services to customers or clients

Sometimes, a customer pays for goods or services in advance. This results in a cash transaction but no services being rendered or goods being sold. We would define this transaction as unearned revenue, which is a liability account, because the cash was received, but we have not earned the revenue yet by performing the service or selling the foods.

Expenses

Expenses Definition and Parameters

• expenses is the opposite of revenue. It represents 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. Some common types of expense include

  • 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

Additional Notes

• Expenditures are different from expenses. Expenditure is ANY outflow of cash for any purpose, whether to buy equipment, pay off a bank loan, or pay employees their wages. Expenses are outflow of economic benefits ONLY from ordinary business activities

• 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.

Operating Expenses

• operating expenses are the costs of operating the business that are incurred to generate revenues during the period

• Incurred = the resources or services of other that are used

• Types of Operating Expenses Include:

  • Depreciation Expenses

  • Supplies Expense

  • Wages Expenses

  • Rent Expenses

  • General and Administrative Expenses

  • Losses (Gains) on Disposal of Assets

  • Insurance Expenses

  • Utilities Expenses

  • Repairs Expenses

• Usually, many expenses are incurred (that is, the resources or services of others that are used) 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, assets such as supplies decrease (are used up) or liabilities such as Wages Payable or Utilities Payable increase.

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, they typically include:

  • Interest Revenue: revenue from investment of bonds in other firms

  • Interest Expense: cost of borrowing money (financing activities)

  • Losses (Gains) on Scale of Investments

Profit in Income Statement

Gross Profit: represents the profit from buying & selling goods, without taking into 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 from other non-operating activities. Profits belong to both debt holders and 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 to only the shareholders

How are Operating Activities Recognized and Measured

Cash Basis Accounting

• Many local retailers and small business 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 is often quite adequate for organizations that do not need to report to external users

• Companies that use cash basis accounting recognize revenue at the time cash is received recognize expenses at the time cash is paid. Financial performance is measured as the difference between the cash balance at the beginning of the period and the cash balance at the end of the period (that is, whether you end up with more or less cash).

CAUTION: Cash basis accounting may lead to an 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 required by GAAP & IFRS and used to report to external decision makers

• The accounting principles that determine when revenues and expenses are recorded are the revenue recognition principle and the expense 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

  • Because the company has not delivered the goods or services at that point, it records no revenue. Instead it creates a liability account, Unearned Revenue (Deferred Revenue), representing the amount owed to the customers. Later, when customers redeem their gift cards and the goods are delivered, the company earns and records the revenue while reducing the liability account because it has satisfied its promise deliver

• In the Same Period as the Goods or Services are Delivered

  • Goods are delivered in exchange for cash, earning revenue in the process.

• After the Goods or Services are Delivered

  • When a business sells goods or services on account (creating Accounts Receivable due from customers), the revenue is earned when the goods or services are delivered, not when cash is received at a later date. Assume goods are ordered by customers and the company bills them at the end of the month, rather than when they receive the goods. When delivered, the company records Sales Revenue and the asset Accounts Receivable, representing the customer’s promise the pay in the future. When the customer pays its monthly bill, the company will increase its cash account and decrease the assets Accounts Receivable

GAAP require accrual basis accounting for financial reporting

Expense Recognition Principle

• Expense recognition principle is more commonly known as matching principle: matching of cost with revenue

• Expenses must be matched to the same accounting period in which the related revenue is generated

• As with revenues and cash receipts, expenses are recorded incurred, regardless of when cash is paid

Cash is King!

• Revenue and profit are important, and a company’s ability to generate positive cash flow is also important

• Need cash 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 it current cash needs

Managers’ Incentive to Violate Accounting Rules

Investors and creditors make relevant decision based on their expectation of firm’s future performance. Companies that fail to meet investors’ expectations often experience decline in share price, affecting their ability to raise funds in the future. Shareholders lose share value, employees may lose their jobs, customers and suppliers may also be affected.

Manager thus have the incentive to report earnings that meet or exceed investors’ expectations to bolster stock price. Greed may lead some managers to make unethical accounting and reporting decision, often involving falsifying revenues and expenses.

Additional Notes

• The recognition of the revenue has nothing to do with cash reception. You cannot count advance payments as revenue, before the customer has received the service

• Items in cash will cause increase in assets and revenue

• In credit, it’s account receivable that increases

• Operating revenues are revenue that are generated from day-to-day activates, and that should be the main revenue focus

• In accrual accounting, you spread the expenses on a monthly basis, per annum. It is recorded in the same time period as other transactions

• When you get a material, but have not generated income from it you would be adding to your inventory, but not to your revenue. And therefore your assets.

• In the balance sheet statements, everything needs to be recorded in the month of operation

• Period of expense of profit is based on the services used or the service provided