Chapter 03 - Reporting Operating Results on the Income Statement

CHAPTER 3 REPORTING OPERATING RESULTS ON THE INCOME STATEMENT

Summary of Related Video Program Spotlight Video Series

Chapter 3 Time is Money (approximately 4:00) This video program covers time period assumption. In 2000-01, Computer Associates violated the time period assumption to present a picture of smooth steady growth. This video illustrates the effect of shifting sales from one period to another and asks students to discuss its impact.

McGraw-Hill/Irwin Financial Accounting Video Series

Program #2 Transaction Analysis (9:35) This video program may be shown in connection with chapter 2 or chapter 3. The video covers transaction analysis in a lecture replacement format. Platinum Technology is featured during the general discussion of transactions. The video begins by defining and providing examples of assets, liabilities, equity, revenue, and expense. Then, the term, business transaction, is explained. The distinction between what is and what isnt a transaction is stressed. Platinum Technology is a real world company that must determine whether given events should be recorded as transactions. After the accounting equation is illustrated, its similarity to the balance sheet is noted. Then, transaction analysis is performed for a number of transactions. Most, but not all, of the transactions illustrated affect the balance sheet.

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Chapter 03 - Reporting Operating Results on the Income Statement

Chapter Summary
LO 1 Describe common operating transactions and select appropriate income statement account titles. The income statement reports the effects of transactions that affect net income, which includes Revenuesamounts charged to customers for sales of goods or services provided. Expensescosts of business activities undertaken to earn revenues. See Exhibit 3.2 for basic income statement format. The two key concepts underlying accrual basis accounting and the income statement are Revenue principlerecognize revenues when they are earned. Matching principlerecognize expenses when they are incurred in generating revenue.

LO 2 Explain and apply the revenue and matching principles.

LO 3 Analyze, record, and summarize the effects of operating transactions, using the accounting equation, journal entries, and T-accounts. The expanded transaction analysis model includes revenues and expenses as subcategories of Retained Earnings. Increases, decreases, and normal account balances are shown below:

ASSETS
+ dr cr

= LIABILITIES
dr + cr

STOCKHOLDERS EQUITY

Contributed Capital
dr + cr

Retained Earnings
dr

Net Income

+ cr

Revenues (and Gains)

dr + cr

Expenses (and Losses)

+ dr cr

LO 4 Prepare an unadjusted trial balance. The unadjusted trial balance is a list of all accounts and their unadjusted balances, and is used to check on the equality of recorded debits and credits. LO 5 Describe limitations of the income statement. The income statement indicates whether the company is profitable, but this might not explain whether cash increased or decreased. Does not directly measure the change in value of a company during the period. Estimation plays a key role when measuring income.

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Chapter 03 - Reporting Operating Results on the Income Statement

Chapter Outline
I. Understand the Business LO 1 Describe common operating transactions and select appropriate income statement account titles. A. Operating Activities 1. Operating activities The day-to-day functions involved Illustrated in Exhibit 3.1 in running a business. Operating activities include: a. Buying goods and services from suppliers. b. Selling goods and services to customers and then collecting cash from them. 2. Most businesses have the same steps in their operating cycles; the length of time for each step varies from company to company. 3. Operating activities are the primary source of revenues and expenses and, thus, can determine whether a company earns a profit (or incurs a loss). B. Income Statement Accounts 1. Revenues sales of goods or services to customers. Examples provided in 2. Expenses costs of business necessary to earn revenues. Exhibit 3.2 3. Net income the excess of revenues over expenses. C. The time period assumption assumes that the long life of a company can be divided into shorter time periods, such as months, quarters, and years. The Stoplight on Ethics 1. The income statement reports the financial effects of feature notes that some business activities that occurred during just the current managers havent learned the period. They relate only to the current period. time period assumption. 2. Key distinction between the income statement and the balance sheet. a. The revenues and expenses on an income statement report the financial impact of activities in just the current period. b. Items on a balance sheet will continue to have a financial impact beyond the end of the current period. II. Study the Accounting Methods A. Cash Basis Accounting 1. Cash basis accounting reports revenues when cash is received and expenses when cash is paid. 2. Cash basis accounting doesnt measure financial performance very well when transactions are conducted using credit rather than cash. 3. Because most companies use credit for their transactions, cash basis accounting is not likely to correspond to the business activities that actually occur during a given period. 4. This leads to a rather distorted view of the companys financial performance

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Chapter 03 - Reporting Operating Results on the Income Statement

Chapter Outline
B. Accrual Basis Accounting 1. Accrual basis accounting reports revenues when they are earned and expenses when they are incurred, regardless of the timing of cash receipts or payments. a. Accrual basis accounting produces a better measure of the profits arising from the companys activities. b. According to generally accepted accounting principles (GAAP), the accrual basis is the only acceptable method for external reporting of income. c. The cash basis can be used internally by some small companies, but GAAP do not allow it to be used for external reporting. LO 2 Explain and apply the revenue and matching principles. 2. Revenue Principle Revenue Recognition a. Revenue principle requires that revenues be recorded when they are earned, not necessarily when cash is received for them. b. All companies expect to receive cash in exchange for providing goods and services, but the timing of cash receipts does not dictate when revenues are recognized. Instead key factor in recognizing revenue is whether the company has done what it promised. c. Timing of related transactions: i. Cash is received in the same period as the promised acts are performed Company will record the cash received and the revenue earned. ii. Cash is received in a period before the promised acts are performed. The company will record the cash received, but hasnt provided the promised goods/services, so no revenue is recorded yet. The obligation is a liability called Unearned Revenue. Unearned Revenue is recorded as a liability on the balance sheet. iii. Cash is to be received in a period after the promised acts are performed. Situation typically arises when a company sells to a customer on account. Selling on account means the company provides goods or services to a customer not for cash, but instead for the right to collect cash in the future. The right is an asset, Accounts Receivable. As dictated by the revenue principle, the company records revenue when the goods/services are provided.

Spotlight Video Chapter 3

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Chapter 03 - Reporting Operating Results on the Income Statement

Chapter Outline
3. Matching Principle Expense Recognition a. The matching principle requires that expenses be recorded in the same period as the revenues they generate, not necessarily the period in which cash is paid for them. b. If an expense cannot be directly associated with revenues, it is recorded in the period that the underlying business activity occurs. c. Timing of related transactions: i. Cash is paid at the same time as the cost is incurred to generate revenue Company will record the expense incurred and the cash paid ii. Cash is paid before the cost is incurred to generate revenue. The company will record the cash paid, but hasnt used the related goods/services obtained to generate revenues, so no expense is recorded yet. The goods/services paid for in advance represent an asset (typically referred to as prepaid) because they will benefit future periods. When the goods/services are later used to generate revenues, the related expense will be reported on the income statement of that period and the asset originally recorded will decrease. iii. Cash is paid after the cost is incurred to generate revenue. Because the cost of the goods/services obtained relates to revenues earned this month, it represents an expense that will be reported on this months income statement. By using the goods/services, the company has incurred an expense and has the obligation to pa the vendor/supplier. This obligation is a liability. When the company later pays cash to the vendor/ supplier, the liability will decrease and the related liability will decrease. No additional expense is reported at that time.

Timing of reporting revenue versus cash receipts illustrated in Exhibit 3.5

Timing of reporting expenses versus cash payments illustrated in Exhibit 3.6

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Chapter 03 - Reporting Operating Results on the Income Statement

Chapter Outline
LO 3 Analyze, record, and summarize the effects of operating transactions, using the accounting equation, journal entries, and T-accounts. C. The Expanded Accounting Equation 1. Stockholders equity represents the stockholders investment in the company, which comes from either: a. Contributed capital, given to the company by stockholders in exchange for stock or b. Retained earnings, generated by the company itself through profitable operations. 2. Because revenues and expenses as subcategories within retained earnings, they are affected by debits and credits in the same way as all stockholders equity accounts: a. Increases in stockholders equity are on the right. Illustrated in Exhibit 3.7 Revenues increase stockholders equity, so revenues are recorded on the right (credit). b. Decreases in stockholders equity are recorded on the left. Expenses decrease net income and retained earnings, so expenses are recorded on the left (debit). D. Transactions Analysis, Recording, and Summarizing Video Program #2 (a) Provide services for cash In September, Pizza Aroma delivered pizza to customers for $15,000 cash. 1. Analyze: Assets = Liabilities + Stockholders Equity Cash (A) + 15,000; Pizza Revenue (R, SE) + 15,000 2. Record: Refer to illustrations of dr Cash (+A) 15,000 transactions in textbook for cr Pizza Revenue (+R, +SE) 15,000 Step 3 Summarize (which (b) Receive cash for future services Pizza Aroma sold three includes posting to T$100 gift cards at the beginning of September. accounts). 1. Analyze: Assets = Liabilities + Stockholders Equity Cash (A) + 300; Unearned Revenue (L) + 300 2. Record: dr Cash (+A) 300 cr Unearned Revenue (+L) 300 (c) Providing services on credit Pizza Aroma delivers $500 of pizza to a college organization, billing this customer on account. 1. Analyze: Assets = Liabilities + Stockholders Equity Accounts Receivable (A) + 500; Pizza Revenue (R, SE) + 500 2. Record: dr Accounts Receivable (+A) 500 cr Pizza Revenue (+R, +SE) 500

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Chapter 03 - Reporting Operating Results on the Income Statement

Chapter Outline
(d) Receive payment on account Pizza Aroma received a $300 check from the college organization, as partial payment of its account balance. 1. Analyze: Assets = Liabilities + Stockholders Equity Cash (A) + 300; Accounts Receivable (A) 300 2. Record: dr Cash (+A) 300 cr Accounts Receivable (A) 300 (e) Pay cash to employees Pizza Aroma wrote checks to employees, totaling $8,100 for wages related to hours worked in September. 1. Analyze: Assets = Liabilities + Stockholders Equity Cash (A) 8,100; Wages Expense (E) 8,100 2. Record: dr Wages Expense (+E, SE) 8,100 cr Cash (A) 8,100 (f) Pay cash in advance On September 1, Pizza Aroma paid $7,200 in advance for September, October, and November rent. 1. Analyze: Assets = Liabilities + Stockholders Equity Cash (A) 7,200; Prepaid Rent (A) + 7,200 2. Record: dr Prepaid Rent (+A) 7,200 cr Cash (A) 7,200 (g) Pay cash in advance On September 2, Pizza Aroma wrote a check for $1,600 for pizza sauce, dough, cheese, and other toppings. 1. Analyze: Assets = Liabilities + Stockholders Equity Supplies (A) + 1,600; Cash (A) 1,600 2. Record: dr Supplies (+A) 1,600 cr Cash (A) 1,600 (h) Incur cost to be paid later Pizza Aroma received a bill for $400 for running a newspaper ad. The bill will be paid in October. 1. Analyze: Assets = Liabilities + Stockholders Equity Accounts Payable (L) +400; Advertising Expense (E) 400 2. Record: dr Advertising Exp. (+E, SE) 400 cr Accounts Payable (+L) 400

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Chapter 03 - Reporting Operating Results on the Income Statement

Chapter Outline
(i) Pay cash for expenses Pizza Aroma received a bill for $400 for running a newspaper ad. The bill will be paid in October. 1. Analyze: Assets = Liabilities + Stockholders Equity Cash (A) 400; Advertising Expense (E) 400 2. Record: dr Advertising Expense (+E, SE) 400 cr Cash (A) 400 LO 4 Prepare an unadjusted trial balance. E. Unadjusted Trial Balance 1. The best way to ensure accounts are in balance is to prepare a trial balance list of all accounts and their balances, which is used to check on the equality of recorded debits and credits. 2. Ending balances obtained from ledger (T-accounts) are listed in the appropriate debit or credit column. 3. If the trial balance does not balance, look at the difference between total debits and credits. 4. If the trial balance does balance, its still possible that youve made an error. An entry might include the wrong account or have been posted to the wrong account in the general ledger. 5. If title says unadjusted trial balance then several adjustments will have to be made at the end of the accounting period to update the accounts. F. Review of Revenues and Expenses 1. Remember that revenues are recorded when the business fulfills its promise to provide goods or services to customers, which is not necessarily the same time that cash is received. 2. Under accrual accounting, expenses are recorded when incurred (by using up the economic benefits of acquired items). Expenses are not necessarily incurred at the same time that cash is paid. III. Evaluate the Results LO 5 Describe limitations of the income statement. A. Income Statement Limitations 1. One of the most common limitations is that some people think net income equals the amount of cash generated by the business during the period. 2. A second limitation is that net income does not measure the change in the value of a company during a period. While net income is something that analysts consider when valuing a company, its not a measure of it. 3. A third common misconception is that measuring income just involves counting.

Illustrated in Exhibit 3.9

The adjustments will be covered in chapter 4.

The Stoplight on Ethics feature notes that greed is the reason behind recent accounting scandals.

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