Operating Decisions and the Income Statement Chapter 3 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Slide 2 McGraw-Hill/Irwin Slide 2 Cash Basis Accounting Revenue is recorded when cash is received. Revenue is recorded when cash is received. Expenses are recorded when cash is paid. Expenses are recorded when cash is paid.

McGraw-Hill/Irwin Slide 3 Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received. Required by - G enerally A cceptable A ccounting P rinciples Accrual Accounting

McGraw-Hill/Irwin Slide 4 McGraw-Hill/Irwin Slide 4 Revenue Principle Recognize revenues when... Delivery has occurred or services have been rendered. Delivery has occurred or services have been rendered. There is persuasive evidence of an arrangement for customer payment. There is persuasive evidence of an arrangement for customer payment. The price is fixed or determinable. The price is fixed or determinable. Collection is reasonably assured. Collection is reasonably assured. Recognize revenues when... Delivery has occurred or services have been rendered. Delivery has occurred or services have been rendered. There is persuasive evidence of an arrangement for customer payment. There is persuasive evidence of an arrangement for customer payment. The price is fixed or determinable. The price is fixed or determinable. Collection is reasonably assured. Collection is reasonably assured.

McGraw-Hill/Irwin Slide 5 McGraw-Hill/Irwin Slide 5 Revenue Principle Sometimes cash is received before the good or service is delivered

McGraw-Hill/Irwin Slide 6 McGraw-Hill/Irwin Slide 6 Revenue Principle If cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE is recorded. Cash received before revenue is earned - Cash Received Cash (+A) xxx Unearned revenue (+L) xxx

McGraw-Hill/Irwin Slide 7 McGraw-Hill/Irwin Slide 7 Revenue Principle When the company delivers the goods or services UNEARNED REVENUE is reduced and REVENUE is recorded. Cash received before revenue is earned - Cash Received Company Delivers Cash (+A) xxx Unearned revenue (+L) xxx Revenue will be recorded when earned. Unearned revenue (-L) xxx Service revenue (+R) xxx

McGraw-Hill/Irwin Slide 8 McGraw-Hill/Irwin Slide 8 Revenue Principle When cash is received on the date the revenue is earned, the following entry is made: Cash Received Company Delivers Cash (+A) xxx Revenue (+R) xxx AND

McGraw-Hill/Irwin Slide 9 McGraw-Hill/Irwin Slide 9 Revenue Principle Sometimes cash is received after the good or service is delivered

McGraw-Hill/Irwin Slide 10 McGraw-Hill/Irwin Slide 10 Revenue Principle If cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded. Cash received after revenue is earned - Accounts receivable (+A) xxx Revenue (+R) xxx Company Delivers

McGraw-Hill/Irwin Slide 11 McGraw-Hill/Irwin Slide 11 Revenue Principle Cash Received Accounts receivable (+A) xxx Revenue (+R) xxx Cash received after revenue is earned - Company Delivers When the cash is received the ACCOUNTS RECEIVABLE is reduced. Cash will be collected. Cash (+A) xxx Accounts receivable (-A) xxx

McGraw-Hill/Irwin Slide 12 McGraw-Hill/Irwin Slide 12 The Matching Principle Resources consumed to earn revenues (i.e.expenses) in an accounting period should be recorded in that period, regardless of when cash is paid.

McGraw-Hill/Irwin Slide 13 McGraw-Hill/Irwin Slide 13 The Matching Principle Sometimes cash is paid before the expense is incurred

McGraw-Hill/Irwin Slide 14 McGraw-Hill/Irwin Slide 14 The Matching Principle If cash is paid before the company receives goods or services, an asset account, PREPAID EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Prepaid expense (+A) xxx Cash (-A) xxx

McGraw-Hill/Irwin Slide 15 McGraw-Hill/Irwin Slide 15 The Matching Principle Expense Incurred When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Prepaid expense (+A) xxx Cash (-A) xxx Expense will be recorded when incurred. Expense (+E) xxx Prepaid expense (-A) xxx

McGraw-Hill/Irwin Slide 16 McGraw-Hill/Irwin Slide 16 The Matching Principle When cash is paid on the date the expense is incurred, the following entry is made: Cash Paid Expense Incurred Expense (+E) xxx Cash (-A) xxx AND

McGraw-Hill/Irwin Slide 17 McGraw-Hill/Irwin Slide 17 The Matching Principle Sometimes cash is paid after the expense is incurred

McGraw-Hill/Irwin Slide 18 McGraw-Hill/Irwin Slide 18 The Matching Principle If cash is paid after the company receives goods or services, a liability PAYABLE is recorded. Cash paid after expense is incurred - Expense (+E) xxx Payable (+L) xxx Expense Incurred

McGraw-Hill/Irwin Slide 19 McGraw-Hill/Irwin Slide 19 The Matching Principle Cash Paid When cash is paid the PAYABLE is reduced. Cash paid after expense is incurred - Expense Incurred Expense (+E) xxx Payable (+L) xxx Cash will be paid. Payable (-L) xxx Cash (-A) xxx

McGraw-Hill/Irwin Slide 20 McGraw-Hill/Irwin Slide 20 A = L + SE ASSETS Debit for Increase Credit for Decrease LIABILITIES Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase CONTRIBUTED CAPITAL Debit for Decrease Credit for Increase Next, let’s see how Revenues and Expenses affect Retained Earnings.

McGraw-Hill/Irwin Slide 21 McGraw-Hill/Irwin Slide 21 EXPENSES Debit for Increase Credit for Decrease REVENUES Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase Expanded Transaction Analysis Model Dividends decrease Retained Earnings. Net Income increases Retained Earnings.

McGraw-Hill/Irwin Slide 22 McGraw-Hill/Irwin Slide 22 Trial Balance 3-22 Debits and credits are equal after preparing the unadjusted trial balance.

McGraw-Hill/Irwin Slide 23 McGraw-Hill/Irwin Slide 23 Finding Accounting Errors Determine the out-of-balance amount. Divide the out-of-balance amount by 2 (a debit treated as a credit or vice versa). Divide the out-of-balance amount by 9, which may indicate a slide or a transposition.

McGraw-Hill/Irwin Slide 24 McGraw-Hill/Irwin Slide 24 Net Profit Margin Net Income Net Sales (or Operating Revenues)* = 3-24 * Net sales is sales revenue less any returns from customers and other reductions. For companies in the service industry, total operating revenues is equivalent to net sales. The 2011 ratio for Chipotle using actual reported amounts is (dollars in thousands):

McGraw-Hill/Irwin Slide 25 McGraw-Hill/Irwin Slide 25 Focus on cash flows Companies report cash inflows and outflows over a period of time in their statement of cash flows that is divided into three categories: O - Operating activities primarily with customers and suppliers, and interest payments and earnings on investments. I - Investing activities include buying and selling noncurrent assets and investments. F - Financing activities include borrowing and repaying debt, including short-term bank loans, issuing and repurchasing stock, and paying dividends. 3-25

McGraw-Hill/Irwin Slide 26 McGraw-Hill/Irwin Slide 26 International Perspective 3-26

© 2008 The McGraw-Hill Companies, Inc. End of Chapter 3