Financial Accounting Chapter 3 Financial Accounting Chapter 3. Operating Decisions and the Income Statement

Objectives Income Statement Measurement Principles Statement of Retained Earnings Statement of Cash Flows Relationship among F/S Bookkeeping System

Income Statement Income statement shows the results of a company’s operations over a period of time. Especially, the I/S summarizes the revenues generated and costs incurred (expenses) to generate those revenues.

Operating Cycle The operating cycle The time it takes for a company to pay cash to suppliers, sell goods and services to customers, and collect cash from customers Until a company ceases its activities, the operating cycle is repeated continuously Time period assumption Recognition issues Measurement issues

Structure of Income Statement Main components Revenue is the increase in a company’s resources from the sale of goods or services. Expenses are the amount of assets consumed in the normal course of business to generate revenues. Net income is the difference between revenues and expenses. Gain and loss Gain is the increase in assets or decrease in liabilities due to non-major business (called peripheral business) of the company. Loss is the decrease in assets or increase in liabilities due to non-major business of the company.

Measurement Principles Cash based accounting Revenue is recorded when cash is received Expense are recorded when cash is paid Accrual based accounting (GAAP) Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received. Accrual accounting uses revenue recognition and matching principle to recognize revenue and expense.

Recognition Issue Revenue recognition principle implies that the revenue should be recorded (recognized) when (1) the earning process is substantially completed (= the goods/services are provided to customers) and (2) cash has been either collected or collectibility is reasonably assured. Matching principle is about the recognition of expense. Expense is recognized at the same reporting period when the related revenue is recognized.

Revenue recognition principle Recognize revenues when . . . Delivery has occurred or services have been rendered. There is persuasive evidence of an arrangement for customer payment. The price is fixed or determinable. Collection is reasonably assured

Statement of Retained Earnings Statement of retained earnings reports the changes in retained earnings during a period of time. Beginning RE + revenue – expense – dividend = Ending RE Beginning RE + net income – dividend = Ending RE B/S: Assets = Liabilities + Capital Stock + (Ending) RE

Statement of Cash Flows The Statement of Cash Flows shows the cash inflows and outflows during a period of time The individual cash flow items are classified according to three main activities: operating, investing, and financing activities. Operating activities are the activities that are part of the day-to-day business of a company. Investing activities are activities related to acquiring and disposing long-term assets. Financing activities are activities whereby cash is obtained from or repaid to owners and creditors.

Other Components of F/S Notes to the financial statements are explanatory information on financial statements. Notes include summary of significant accounting policies, additional information about summary totals, disclosure of important information that are not shown in financial statements, and supplementary information.

Relationship Among Financial Statements Income Statement Revenues – Expenses = Net Income Statement of Retained Earnings Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Balance Sheet Assets = Liabilities + Stockholders’ Equity Contributed Capital Retained Earnings Statement of Cash Flows Change in Cash = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities

Journal Entry Journal entry is a recording of a transaction where debits equal credits. The recording is kept in a special book called Journal. Journalizing implies the recording transactions in a journal. Example A typical format of journal entry is: Date Debit entry **** Credit entry ****

Bookkeeping System A ledger is a book of accounts in which data from transactions recorded in journals are posted and summarized. Posting is the process of transferring amounts from the journal to the ledger. In short, the Journal is a book containing all the journal entries and posting is the process to write the journal entries to each accounts (T accounts) in ledger.