CHAPTER 3

OPERATING DECISIONS AND THE STATEMENT OF EARNINGS

HOW DO BUSINESS ACTIVITIES AFFECT THE STATEMENT OF EARNINGS?

A. The Operating Cycle

1. The operating cycle applies to merchandising and manufacturing companies as well as
service companies. The length of time for a company’s operating cycle depends on the
nature of its business.
2. The operating cycle is not the same as the accounting cycle. These cycles do not coincide
in terms of time. Cash payments and receipts often do not coincide with the accounting
cycle recognition rules.

B. Classified Statement of Earnings

1. Three main sections:

-Continuing operations
 Reflects the results from ongoing operations
i Operating revenues
ii Operating expenses
iii Non-operating items known as other revenues and expenses
 Investment income, financing costs, and gains and losses on disposal of assets
are ancillary to the operations of the business and are reported as other income
and expenses
iv Income tax expense
 Based on a percentage of an entity’s taxable income in accordance with the
Income Tax Act (later courses will discuss the differences between accounting
income and taxable income)
The above represents Continued Operations
-Results from discontinued operations
 As entities evolve, it may be determined that certain units of the business no
longer fit into the plans of the entity and as such are sold or closed down. The
identification of these business units provides users with insights on what
should be included in future projections for an entity’s operations.
 The net earnings or loss from the component to be disposed of (revenue,
expenses, gains, and losses) and any gains or losses from the disposal of assets
or settlement of obligations are presented as one figure on the statement of
earnings (net of tax) and disclosed separately in the notes to the financial
statements.
-Earnings per share
 by dividing net earnings available to common shareholders by the weighted
average number of common shares. Earnings per share (EPS) is a required ratio
that must be reported on a statement of earnings at any reporting date.
 Operating Non-operating
Rent expense Gain or loss on sale of investments
Salaries expense Gain or loss on sale of land
Supplies expense Interest expense
Insurance expense Interest revenue
Advertising expense Financing costs ►
Depreciation expense ► Vending machine revenue from breakroom ►
Bad debt expense (covered in Chapter 6) ► Interest on bank account balance ►
Impairment expense (covered in Chapter 8) ► Dividend income ►
Neither Operating nor non-operating
Cost of sales – reported between “net sales” and “gross profit” at top of Statement of Earnings.
Income tax expense – reported between “earnings before tax” and “net earnings.”
Discontinue operations – reported between “Earnings from Continuous Operations” and “Net
earnings” ►
III HOW ARE OPERATING ACTIVITIES RECOGNIZED AND
MEASURED?

Cash basis accounting records revenues and expenses based on the receipt and payment of
cash. Cash basis accounting is inappropriate for the preparation of financial statements.

A. Accrual Accounting

1. The statement of cash flows breaks down accrual based financial statements to a cash basis.
2. Accrual basis accounting requires reporting of revenues when earned and expenses when
incurred, regardless of the timing of cash receipts and cash payments.
3. Accrual based accounting is part of the conceptual framework under IFRS and ASPE.

B. The Revenue Recognition Principle

1. The revenue principle requires that certain criteria be met for revenue recognition. To
recognize revenue in the period, all the criteria must be satisfied.
a. The entity has transferred to the buyer the significant risks and rewards of ownership
of the goods.
b. One deals with a good client , collecting the money is reasonably assured.

The entity’s revenue recognition policy is generally disclosed in the notes to the financial
statements.
2. Revenue is normally recognized when earned regardless of when cash is actually received.

C. The Matching Process

1. The matching process requires that expenses be recorded when incurred in earning
revenues. This recognition is required regardless of when cash is actually paid. Expenses are
resources used up to generate revenues.
2. When a transaction occurs, ask the following questions:
 Is a revenue earned?
 Is an expense incurred?
 If revenue was not earned or an expense was not incurred, what was received
and what was given?

Key Ratio Analysis

Total Asset Turnover Ratio = Sales revenues / Average total assets

Indicates how well the company uses its assets

Return on Assets = Net earnings / Average total assets

It indicates how much profitability is earned based on total assets
Exercise 3–19

Req. 1

Bianca Corp. 2024 2023 2022 2021

Total assets $ 40,000 $ 50,000 $ 60,000 $ 65,000
Revenue 130,000 144,000 154,000 150,000
Net earnings 25,000 3,800 5,000 4,800
Average total assets 45,000 55,000 62,500
Total asset turnover ratio 2.89 2.62 2.46
Return on assets 55.6% 6.9% 8.0%

Uzma Inc.
Total assets $ 65,000 $ 60,000 $ 50,000 $ 40,000
Revenue 150,000 154,000 144,000 130,000
Net earnings 4,800 5,000 3,800 25,000
Average total assets 62,500 55,000 45,000
Total asset turnover ratio 2.40 2.80 3.20
Return on assets 7.7% 9.1% 8.4%

Total Asset Turnover Ratio = Sales revenues / Average total assets

Indicates how well the company uses its assets

Return on Assets = Net earnings / Average total assets

It indicates how much profitability is earned based on total assets

Req. 2

Based on the total asset turnover ratios:

Bianca outperformed Uzma in 2024 only.
With respect to the ROA, Bianca outperformed Uzma in 2024 but not in 2023 or 2022.

The total assets of Bianca have declined since 2021, which means its assets are shrinking, while
for Uzma the reverse is true; its assets are increasing.
The growth in this company’s assets takes time to be reflected in revenue, which may explain
why Uzma’s asset turnover ratio is lower than Bianca’s in 2024. Nevertheless, Uzma’s revenues
have grown since 2021, but not as quickly as its assets.
The dramatic increase in net earnings for Bianca in 2024 may be due to a gain in the sale of
assets and this highlights the importance of seeking further information by inspecting the
statement of earnings closely.

If true, then Bianca’s ROA of 55.6% may not be repeated in the future. Uzma’s ROA has been
fairly steady, despite its growth in assets, which suggests that Uzma’s management is
controlling the growing operations well.

Overall, Uzma Inc. appears to be more efficient in managing its resources.

Exercise 3-6
3–6
Req. 1
Amount of Revenue Earned or Expense
Cash Incurred in October
Received OR
Accounts Affected and Type of (Paid) in Why a Revenue or an Expense Is Not
Account October Recognized
(a) Cash (+A) No revenue earned in October; earnings
$2,600
Deferred revenue (+L) process is not yet complete.
(b) Cash (+A) No revenue earned in October; collections in
2,500
Accounts receivable (A) October related to earnings in September.
(c) Accounts payable (+L)
Cash (A) (1,900)
Utilities expense (+E, SE) $(2,200) incurred in October
(d) Cash (+A) 3,000
Accounts receivable (+A)
Equipment sales revenue (+R, +SE) 7,000
Cost of sales (+E, SE) (4,200)
Inventory (A)
(e) Cash (+A) 13,000
Game fees revenue (+R, +SE) 13,000
(f) Repairs and maintenance expense (1,400)
(+E, SE)
Cash (A) (1,400)
(g) Wages expense (+E, SE) (4,700)
Cash (A) (4,700)
(h) Prepaid expense (+A)
Insurance expense (+E, SE) $(600) incurred in October; 1/3 of the
insurance has been used up in October.
Cash (A) (1,800)
Totals $11,300 $6,900

Req. 2

The net cash flow from these transactions is $11,300, but the difference between revenues and
expenses is $6,900.
The reason for the difference of $4,400 is that some cash receipts in October relate to sales
made in September, and other cash receipts in October relate to revenue to be earned in the
future. Some revenue earned in October will be made in future months.
Ratios

Total Asset Turnover Ratio = Sales revenues / Average total assets

Indicates how well the company uses its assets

Return on Assets = Net earnings / Average total assets

It indicates how much profitability is earned based on total assets

Exercise 3 12
Transaction Analysis Model

Assets (A) = Liabilities (L) + Equity (E)

Increase Decrease Decrease Increase Decrease Increase
Debit Credit Debit Credit Debit Credit

Retained Earnings
Revenues Expenses
Decrease Increase Increase Decrease
Debit Credit Debit Credit

Beg. Bal. Beg. Bal.

End. Bal. End. Bal.

CLASS EXERCISES

Amounts are in millions as given in the text.

a. Buildings (+A) ................................................................................ 432

Equipment (+A) ............................................................................. 254
Cash (–A) ................................................................................... 686

b. Cash (+A) ....................................................................................... 119

Notes payable (+L) .................................................................... 119
 c. Cash (+A) ....................................................................................... 26,813
Accounts receivable (+A) .............................................................. 28,558
Service revenue (+R, +SE) .......................................................... 55,371

d. Accounts payable (–L) ................................................................... 32,074

Cash (–A) ................................................................................... 32,074

e. Inventory (+A) ............................................................................... 41,683

Accounts payable (+L) ............................................................... 41,683

f. Salaries expense (+E, SE) ............................................................. 6,540

Cash (A) ................................................................................... 6,540

g. Cash (+A) ....................................................................................... 22,043

Accounts receivable (A) .......................................................... 22,043

h. Fuel expense (+E, –SE) .................................................................. 1,750

Cash (A).................................................................................... 1,750

i. Dividends declared (or Retained earnings) (SE) .......................... 698

Dividends payable (+L) .............................................................. 698

j. Utilities expense (+E, SE) ............................................................. 121

Cash (A) ................................................................................... 110
Accounts payable (+L) ............................................................... 11

Exercise 3 13 The instructor will ask you to do an entry in teams , we will do one entry at a
time. Then she will ask a team to explain it to the class

Requirement 1 HINT for For A, the shareholders are inputting cash PLUS every other asset ,
in exchange for Contributed capital.

Dr all the assets credit contributed capital

Requirement 2

Operating, Investing, or Direction and Amount of

Transaction Financing Effect the Effect
(a)*
(b)*
(c)
(d)
(e)*
(f)
(g)
(h)
(i)
(j)

Requirement 3

Effect on Net
Transaction Earnings Effect on Cash
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.