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

2. Objectives Income Statement Measurement Principles
Statement of Retained Earnings
Statement of Cash Flows
Relationship among F/S

3. 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.

4. 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

5. 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.

6. 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.

7. 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.

8. 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

9. 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

10. 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.

11. 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.

12. 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

13. 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 ****