Operating Decisions & the Accounting System

Operating Cycle:

• The long-term objective of a company is to turn cash into more cash

  • Must be achieved through operations

  • Operations = activity for which the business was established

• Time it takes for a company to:

  • Pay money to suppliers for goods/services to sell

  • Sell goods/services to customers

  • Collect cash from customers

• The operating cycle repeats continuously and its length depends on the nature of the business

Operating Cycle ≠ Accounting Cycle

Accounting Cycle: Process used by entities to analyze and record transactions, adjust the records at the end of the period, prepare financial statements, and prepare the records for the next cycle

Time Period Assumption: The long life of a company can be reported in shorter time periods

Issues that arise when reporting income periodically:

• Recognition Issues: When should the activity be recognized

• Measurement Issues: What amount should be recognized

Cash vs Accrual Basis:

• Cash Basis: Record revenue when cash is received & expenses when cash is paid

  • Used by small businesses, local retailers, medical offices

  • Postpones/accelerates the recognition of revenue & expenses

  • Does not necessarily reflect all assets & liabilities

• Accrual Basis: Record revenue when earned & expenses when incurred, regardless of the time of cash receipts & payments

  • Required by GAAP/IFRS

  • Revenue is recognized when goods/services are transferred

  • Expenses are recorded to match costs with benefits (ie recorded when incurred)

• In the short run, operating cash flows may inaccurately predict future operating cash flows

• Net income is considered a better indicator

• Problems with Accrual Basis Accounting:

  • Based on estimates of future revenue and expenses

  • Easy to manipulate numbers

Revenues: Increases in assets or decreases in liabilities from ongoing operations of the business

Expenses: Decreases in assets or increases in liabilities from ongoing operations incurred to generate revenues during the same period

Revenues increase Net Income → Increases Retained Earnings → Increases Stockholders’ Equity → Credit

Expenses decrease Net Income  → Decreases Retained Earnings → Decreases Stockholders’ Equity → Debit

Revenue/Expense Recognition Principle:

• Revenues are Recognized:

  • When a company transfers promised goods/services to a customer

  • In the amount expected to receive

• Expenses are Recognized:

  • When incurred in the course of generating revenue (ie resources used)

  • Match costs with benefits

Trial Balance: A list of all accounts with balances to provide a check that debits equals credits

• Used internally to prepare the financial statements

Income Statement:

• Positive Elements:

  • Revenues:

    • Operating Revenues: Results from the sale of goods or the rendering of services as the central focus of the business

    • Other Items: results of peripheral activities (ie Interest Revenue)

  • Gains: Results from the disposal of (primarily) assets form more than the reported book value

• Negative Elements:

  • Expenses:

    • Cost of sales/Cost of goods sold: Cost incurred to make products ready for sale

    • Operating Expenses: Other costs related to the generation of operating revenue

    • Other Items: Results of peripheral activities (ie Interest Expenses)

  • Losses: Results from disposal of (primarily) assets form less than the reported book value

  • Income Tax Expense: Taxes owed to governments

Multi-Step Income Statement:

• Includes multiple subtotals

• Gross Profit = Operating Revenues – Cost of Sales (or Cost of Goods Sold)

• Income from Operations/Operating Income = Gross Profit – Operating Expenses

  • Income from the central focus of business

• Income before Income Taxes = Operating Income +/- Other Items

• Net Income = Income before Income Taxes – Income Tax Expense