3 Operating Decisions and

the Accounting System

ACCT 1101
Introduction to Financial Accounting
2024-2025 Spring Semester

Dr. Lynn Wang

Recap Chapter 2
Questions:
– What is Asset? Liability? Equity?
– Difference between Supplies and Inventory?
– What is unearned revenue?
– What is additional paid-in capital?
– How to understand Debit and Credit?
– What are the steps to analyse investing and
financing transactions?
– What is T-account?
– What is current ratio?
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Takeaways - Transaction Analysis

1. Identify the accounts (by title) affected and make sure at
least two accounts change.

2. Classify them by type of account. Was the account an

asset (A), a liability (L), or a stockholders’ equity (SE)
account?

3. Determine the direction of the effect. Did the account

increase [+] or decrease [−]?

4. Verify: Is the accounting equation in balance?

5. Verify: Is the total dollar value of the debits in the

transaction equal to the total dollar value of credits?
Recap Chapter 2
Learning Objectives
After studying this chapter, you should be able to:
3-1 Describe a typical business operating cycle and explain the
necessity for the time period assumption.

3-2 Explain how business activities affect the elements of the

income statement.

3-3 Explain the accrual basis of accounting and apply the revenue
and expense recognition principles to measure income.

3-4 Apply transaction analysis to examine and record the effects of

operating activities on the financial statements.

3-5 Prepare a classified income statement.

3-6 Compute and interpret the net profit margin ratio.

3-7 Identify operating transactions and demonstrate how they affect

cash flows.
Learning Objective 3-1
3-1 Describe a typical business operating cycle and explain the
necessity for the time period assumption.
What will we do in this lecture?
Accounting Cycle  Conceptual
 Case: Chicken Feet Corporation  Framework

Element of Income Desired

Statement


characteristics

 Revenue Recognition  Principles

Expense Recognition  Assumptions

 Transaction Analysis  Constraints

 To understand
amounts
appearing on a
company’s
income
statement:

How do business How are these

How are these
activities affect activities reported
activities recognized
the income on the income
and measured?
statement? statement?

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The Operating Cycle (1 of 2)
The Operating Cycles – Real life
Company Name Industry Operating Cycle

Yum Brands Inc Restaurant 12 days

Cathay Pacific Airlines 40 days

Walmart Retailer 45 days

Kroger Co Grocery Retailer 45 days

Amazon.com Inc Online Retailer 22 days

General Motors Auto Manufacturer 342 days

Eli Lilly Corp Pharmaceutical 339 days

Hewlett-Packard Co Manufacturer 110 days

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The Operating Cycle (2 of 2)

Accountants follow the time period assumption, which assumes that the
long life of a company can be reported in shorter time period such as:
• months
• quarters
• years

Two issues arise when reporting periodic income:

1) Recognition issues: When should the effects of operating activities
be recognized (recorded)?
2) Measurement issues: What amounts should be recognized?
Learning Objective 3-2
3-2 Explain how business activities affect the elements of the
income statement.
Elements of the Income Statement

Revenues
Increases in assets or settlements of liabilities from
ongoing operations.

Expenses  Revenues
Decreases in assets or increases in liabilities from
ongoing operations.
 - Expenses
 +Gains
Gains  -Losses
Increases in assets or settlements of liabilities from
peripheral transactions.  =NI

Losses
Decreases in assets or increases in liabilities from
peripheral transactions.
Exhibit 3.1 Chipotle Mexican Grill’s Income Statement
*The information
has been adapted
from actual
statements and
simplified for this
chapter.
Operating Revenues

• The amounts earned and recorded from a company’s day-

to-day business activities.
• Amount earned when a company sells products or
provides services to customers or clients.
• Earnings from the central focus of the business. e.g., when
Chipotle sells burritos, it has earned revenue.
Operating Expenses
• Operating expenses are the costs of operating the business that are
incurred to generate revenues during the period.
• Incurred = the resources or services of others that are used
• Many expenses are incurred in making a sale or providing a service.
• Expenses may be incurred before, after, or at the same time as they are
paid in cash.
• Don’t confuse expenditures and expenses! An expenditure is an
outflow of cash for any purpose, whether to buy equipment, pay
off a bank loan, or pay employees their wages.
• Therefore, not all cash expenditures are expenses!

Cash
expenditures

Debt Asset
payments purchases

Expenses
Examples of Chipotle’s Operating Expenses

Depreciation
Repairs expense Supplies
expense expense

Utilities
Wages
expense
expense

Insurance
Rent expense
expense

Losses (gains) General &

on disposal of administrative
assets expense
Other Income Statement Items
Not all activities affecting the income statement are “central to
ongoing operations”.

Revenues, expenses, gains, or losses that result from other

activities that are NOT central to ongoing operations are
categorized as Other Items.

These items are not included in the subtotal “Income from

Operations”.

Other items typically include:

 Interest Revenue (also Investment Revenue, Investment Income,
or Dividend Revenue)
 Interest Expense
 Losses (Gains) on Sale of Investments
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COGS vs Expenses

Cost of goods sold refers to the business expenses

directly tied to the production and sale of a company's
goods and services.
– E.g., coffee shop sells a double espresso, COGS accounts
for the price of the to-go cup, the protective sleeve, the
coffee filter, the water, the processed beans, etc.
Operating expenses refer to expenses that are not
directly tied to the production of goods or services.
– E.g., coffee shop case, operating expense including
advertisement, payrolls for accountants, etc.
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SG&A (Selling, General, and

Administrative expenses)
Selling, general, and administrative expenses
• Has almost the same meaning as operating
expenses, but sometimes companies list SG&A as
a subcategory of operating expenses on income
statements.
• Includes nearly everything that isn't included in
cost of goods sold (COGS).
• Interest expense, research and development costs
are not included in SG&A.
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In-class practice
1) Which of the following costs is most likely to be the largest expense reported on the
income statement of a merchandiser, such as Walmart Stores, Inc.?
• A) Utilities expense.
• B) Cost of goods sold.
• C) Advertising expense.
• D) Income tax expense.

2) Which of the following businesses would most likely not report cost of goods sold
on its income statement?
• A) A law firm.
• B) An automobile dealership.
• C) A pizza restaurant.
• D) A computer chip manufacturer.
Typical Income Statement Format

Operating Revenues
Less Operating Expenses
Income from Operations
Add/Less: Other Items
Income before Income Taxes (or Pretax Income)
Income Tax Expense (or Provision for Income Taxes)
Net Income
Corporations are required to disclose earnings per share (EPS) on the
income statement or in the notes to the financial statements.
 Balance sheet Income statement

Prepaid Rent Expense Revenue

Machine/equipment COGS
Coffee bean Rent expense
Paper cup Supplies expense
Protective sleeve Wage expense
Receipt paper Insurance expense
Cash Depreciation
 How Are Operating Activities Recognized and Measured?
(1 of 2)
Cash Basis Accounting
 Cash basis accounting is used by many sole proprietors
and small partnerships to determine performance.
 It is simple and permitted for tax purposes.
 Cash basis accounting records each cash payment as a
cash outflow and each cash receipt as a cash inflow.
 This produces net cash flow information that is often
quite adequate for organizations that do not need to
report to external users.

CAUTION: Cash basis accounting

may lead to an incorrect Revenue = cash received
interpretation of future company Less: Expenses = cash payments
performance. GAAP does not allow Net Income (cash basis)
the cash basis of accounting.
Cash Basis Accounting

 Revenue is recorded when  Expense is recorded when

cash is received cash is paid
Not
GAAP

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Cash Basis Accounting
Cash Basis Income Statements Year 1 Year 2 Year 3 Total
Sales on credit $60,000 $60,000 $60,000 $180,000

Cash receipts from customers $20,000 $70,000 $90,000 $180,000

Cash disbursements for:
Salaries to employees (30,000) (30,000) (30,000) (90,000)
Insurance for 3 years (12,000) (0) (0) (12,000)
Supplies (3,000) (7,000) (5,000) (15,000)
Net operating cash flows $(25,000) $33,000 $55,000 $63,000

Using cash basis accounting may lead to an incorrect interpretation

of future company performance.

Simply looking at the first year, investors and creditors might

interpret the negative cash flows as a problem with the company’s
ability to generate cash flows in the future.
Learning Objective 3-3
3-3 Explain the accrual basis of accounting and apply the revenue
and expense recognition principles to measure income.
How Are Operating Activities Recognized and Measured?
(2 of 2)
Accrual Basis Accounting
 Accrual basis accounting is required by GAAP and used to report to
external decision makers.
 The accounting principles that determine when revenues and
expenses are recorded are the revenue recognition principle and
the expense recognition principle (also called the matching
principle).
 Revenues are recognized when goods and services are
provided to customers (they are earned)
 Expenses are recognized in the same period as the revenues
to which they relate (resources are used or debts are incurred
to generate revenues), regardless of when cash is received or
paid.
Accrual Basis Accounting
Cash Basis Income Statements Year 1 Year 2 Year 3 Total
Sales on credit $60,000 $60,000 $60,000 $180,000

Cash receipts from customers $20,000 $70,000 $90,000 $180,000

Cash disbursements for:
Salaries to employees (30,000) (30,000) (30,000) (90,000)
Insurance for 3 years (4,000) (4,000) (4,000) (12,000)
Supplies (3,000) (7,000) (5,000) (15,000)
Net operating cash flows $23,000 $19,000 $21,000 $63,000

Using cash basis accounting may lead to an incorrect interpretation

of future company performance.

Simply looking at the first year, investors and creditors might

interpret the negative cash flows as a problem with the company’s
ability to generate cash flows in the future.
Revenue Recognition Principle
The revenue recognition principle specifies the timing and amount of
revenue to be recognized during an accounting period.
Revenue is recognized (1) when the company transfers promised goods or
services to customers (2) in the amount it expects to be entitled to receive.
The five steps to follow for recognizing revenue for complex contracts
are:
1. Identify the contract between the company and the customer.
2. Identify the seller’s performance obligations (promised goods
and services).
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when each performance obligation is satisfied
(or over time if a service is provided over time).

The critical point for revenue recognition under the five-step model is when
goods or services are delivered, not when cash is received from customers.
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Revenue recognition principle

• Revenues should be recognized when

– Earned (services or products are provided), and
– realized or realizable, and
– reliably measurable.
– Discussed in detail in Lecture 6.
Exhibit 3.2 Revenue Revenues versus Cash Receipts

Cash may be received at any of these times:

1. Before the goods or services are delivered.
2. In the same period as the goods or services are delivered.
3. After the goods or services are delivered.

Revenue is always recorded when the goods or services are delivered, not
when the cash is received from customers.
Exhibit 3.2 Revenue Revenues versus Cash Receipts

A company must recognize revenue:

1. When the company transfers promised goods or services to
customers.
2. In the amount it expects to receive.
Exhibit 3.4 Expanded Transaction Analysis Model

Note: As expenses
increase (are debited),
net income, retained
earnings, and
stockholders’ equity
ASSETS = LIABILITIES
(many
+ STOCKHOLDERS’ EQUITY
decrease.
(many Contributed Capital Earned Capital
accounts) accounts)
(2 accounts) (1 account)
+ − – + Common Stock and Retained
Debit Credit Debit Credit Additional Paid-in Earnings
Capital
– + – +
Debit Credit Debit Credit
Issuance of Dividends Net = REVENUES – EXPENSES
(many
(many
Stock declared income accounts) accounts)
+ +
Credit Debit

Note: Instead of reducing Retained Earnings directly when dividends are declared, companies
may use the account Dividends Declared, which has a debit balance.
In summary:

Understand how revenues and expenses impact the balance sheet and
income statement:
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Revenue recognition principle

• When cash is received on the date the revenue is earned, the
following entry is made:

 Company Delivers AND

Cash Received

Accounts Debit Credit

X Cash （+A) X,XXX

Sales Revenue (+R, +SE) X,XXX

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Revenue recognition principle

• If cash is received before the company delivers goods or
services, a liability account UNEARNED REVENUE is
recorded
 Cash Received before  Company Delivers,
revenue is earned Revenue Earned
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Revenue recognition principle

• If cash is received after the company delivers goods or
services, an asset account ACCOUNTS RECEIVABLE is
recorded
• (often called credit sales, sales on credit, sales on account)
 Company Delivers, Revenue  Cash Received AFTER
Earned revenue is earned
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In-class practice

• A company sell products $100 on account, the

cash is expected to collected in three months.
Using cash-based accounting, what is the
revenue in this month? What is the revenue
using accrual-based accounting?
• $0 and $100, respectively.
Expense Recognition Principle
The expense recognition principle (also called the matching
principle) requires that costs incurred to generate revenues be
recognized in the same period—a matching of costs with benefits.

The costs of generating revenue include expenses incurred such as:

• Salaries and wages to employees who worked during the period.
• Utilities for the electricity used during the period.
• Supplies used during the period.
• Facilities rented during the period.
• Equipment used during the period.

Expenses are recorded as incurred, regardless of when cash is paid.

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Expense Recognition - Matching principle

• Determine when expenses should be recognized (recorded in

accounting), and how much?

• Expenses should be matched to the revenues they help

generate
– Directly linked to revenue
• Cost of goods sold (costs of the inventory sold).
• Recognized when the revenue is recognized.
– Indirectly related to the revenue
• Utilities expenses, advertising expenses, etc.
• recognized when incurred.
Exhibit 3.3 Recording Expenses versus Cash Payments

Cash may be paid at any of these times:

1. Before the expense is incurred to generate revenue.
2. In the same period as the expense is incurred to generate revenue.
3. After the cost is incurred to generate revenue.
Expense is always recorded when the cost is incurred, not when the cash is
paid.
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Matching principle
• When cash is paid on the date the expense is incurred, the
following entry is made:
 Expense Incurred AND Cash
Paid

Accounts Debit Credit

X Rent expense （+E, -SE) X,XXX

Cash (-A) X,XXX

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Matching principle
• If cash is paid before the company receives goods or services,
an asset account PREPAID EXPENSE is recorded

 Cash Paid before Expense is  Expense Incurred

incurred
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Matching principle
• If cash is paid after the company receives goods or
services, a liability account PAYABLE is recorded
 Expense Incurred  Cash Paid AFTER Expense is
Paid
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In-class practice
• A company purchased supplies for cash $100, which
will be consumed during future months. Using cash-
based accounting, what is the supplies expense in
this month? What is the supplies expense using
accrual-based accounting?
• $100 and $0, respectively.
Learning Objective 3-4
3-4 Apply transaction analysis to examine and record the effects of
operating activities on the financial statements.
What will we do in this lecture?
Accounting Cycle  Conceptual
 Case: Chicken Feet Corporation  Framework

Element of Income Desired

Statement


characteristics

 Revenue Recognition  Principles

Expense Recognition  Assumptions

 Transaction Analysis  Constraints

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Accounting Cycle
Journalize
transactions

Summarize
transactions Closing entries
(posting)

Adjusting Prepare financial

entries statements

Trial balance
Exhibit 3.4 Expanded Transaction Analysis Model

Note: As expenses
increase (are debited),
net income, retained
earnings, and
stockholders’ equity
ASSETS = LIABILITIES
(many
+ STOCKHOLDERS’ EQUITY
decrease.
(many Contributed Capital Earned Capital
accounts) accounts)
(2 accounts) (1 account)
+ − – + Common Stock and Retained
Debit Credit Debit Credit Additional Paid-in Earnings
Capital
– + – +
Debit Credit Debit Credit
Issuance of Dividends Net = REVENUES – EXPENSES
(many
(many
Stock declared income accounts) accounts)
+ +
Credit Debit

Note: Instead of reducing Retained Earnings directly when dividends are declared, companies
may use the account Dividends Declared, which has a debit balance.
In summary:

Understand how revenues and expenses impact the balance sheet and
income statement:
Exhibit 3.5
Transaction Analysis Steps
Step 1: Ask → Was a revenue earned by delivering goods or services?
If so, debit the account for what was received (+A, -L) and credit the
revenue account (+R, +SE)
OR Was an expense incurred to generate a revenue in the current period?
If so, debit the expense account (+E, -SE) and credit the account for
what was given (-A, +L)
OR If neither a revenue was earned or an expense was incurred, what
was received and given?
debit the account for what was received (+A, -L)
credit the account for what was given (-A, +L)

Step 2: Verify → Is the accounting equation in balance? (A = L + SE)

Do debits = credits?
Analyzing Chipotle’s Transactions (1 of 12)
We will now analyze, record, and post to the T-accounts the
effects of the first quarter’s operating activities for Chipotle.

• The T-accounts begin with the trial balance amounts in Exhibit

2.8.
• All amounts are in millions of dollars, except per share
information.

For each journal entry:

• When a revenue or expense is recorded, we insert (+R, +SE)
for revenues and (+E, −SE) for expenses to emphasize the
effect of the transaction on the accounting equation and to
see that the equation remains in balance.
• Debits equal credits!
Analyzing Chipotle’s Transactions (2 of 12)

(1) Chipotle sold food and beverages to customers for $1,359; $44
was sold to universities on account (to be paid by the universities
next quarter) and the rest was received in cash from customers.
Analyzing Chipotle’s Transactions (3 of 12)

(2) Assume Chipotle purchased food, beverage, and packaging

supplies costing $459 during the quarter, paying $379 in cash, and
owing the rest on account to the suppliers.
Analyzing Chipotle’s Transactions (4 of 12)

(3) At the beginning of January, Chipotle paid $207 cash for rent,
insurance, and advertising to be used in the future (all included in
the account Prepaid Expenses until used).
Analyzing Chipotle’s Transactions (5 of 12)
(4) Chipotle paid $65 as training expense for management during the
quarter.
Analyzing Chipotle’s Transactions (6 of 12)
(5) Chipotle paid employees $342 for work this quarter and $47 for
work last quarter (recorded last quarter as Wages Expense and Wages
Payable for the amount owed to employees who worked then).
Analyzing Chipotle’s Transactions (7 of 12)
(6) Chipotle sold land costing $21 for $12 cash, resulting in a loss of $9
on the disposal of the asset.
Analyzing Chipotle’s Transactions (8 of 12)

(7) Chipotle received $61 cash from customers paying on their

accounts.
Analyzing Chipotle’s Transactions (9 of 12)
(8) During the quarter, assume Chipotle paid $66 on accounts payable
to suppliers and paid $25 on utilities payable (recorded last quarter
as Utilities Expense and Utilities Payable for the amount owed for
utility service used last year).
Analyzing Chipotle’s Transactions (10 of 12)

(9) Chipotle paid $117 for utilities used during the quarter and paid
$35 for repairs of its buildings and equipment during the quarter.
Analyzing Chipotle’s Transactions (11 of 12)

(10) During the quarter, Chipotle sold gift cards to customers for $35
in cash (expected to be redeemed for food next quarter).
Analyzing Chipotle’s Transactions (12 of 12)

(11) Assume Chipotle received $3 cash as interest revenue earned

during the quarter.
Exhibit 3.6 T-Accounts Summary Balance Sheet Accounts
Exhibit 3.6 T-Accounts Summary Income Statement Accounts
Learning Objective 3-5
3-5 Prepare a classified income statement.
How Is the Income Statement Prepared and Analyzed?
Exhibit 3.7 Unadjusted Income Statement

Classified
Income
Statement

Note: Because this statement is

based on unadjusted balances, it
would not be presented to external
users.
Learning Objective 3-6
3-6 Compute and interpret the net profit margin ratio.
 Net Profit Margin Ratio
How effective is management in generating profit on every dollar of sales?

Net Profit = Net Income

Margin Net Sales (or Operating Revenues)

A rising net profit margin signals more efficient management of sales

and expenses.

Note: 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.
Learning Objective 3-7
3-7 Identify operating transactions and demonstrate how they affect
cash flows.
 Effect of Operating Activities on Cash Flows
Only transactions affecting cash are reported on the Statement of Cash
Flows. Cash flows from operating activities are primarily cash received from
customers and cash paid to suppliers and other involved in operations.

Let’s analyze the Cash T-account for Chipotle’s transactions in this chapter:
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In-class practice
Complete the chart below for Monticello Corporation by placing an X in the appropriate
boxes to indicate how the transaction should be recorded.
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In-class Practice
1) Colby Corporation has provided the following information:
•
• • Operating revenues from customers were $199,700.
• • Operating expenses for the store were $111,000.
• • Interest expense was $9,200.
• • Dividend payments to Colby's stockholders were $7,700.
• • Income tax expense was $36,000.
• • Prepaid rent expense was $5,000.
•
• What is the amount of Colby's operating revenues and operating expense?
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In-class practice
2020 2019 2018
Net revenues $3,787.2 $4,232.2 $3,304.5
Cost of goods sold 1,674.0 $1,698.2 1,366.1
Gross profit 2,113.2 2,534.0 1,938.4
Operating expenses 2,217.5 2,206.5 1,613.5
Income (loss) from operations (104.3) 327.5 324.9
Nonoperating income (loss) (121.7) (53.7) (21.4)
Income (loss) before taxes (226.0) 273.8 303.5
Income tax (expense)/benefit 81.4 (84.9) (97.1)
Net income (loss) (144.6) 188.9 206.4

Toy Shop Inc. has provided the following income statements:

(1) Compute net profit margin for each year.
(2) Discuss some of the events that could have caused the changes to the net
profit margin based on the income statement information above.
Thank you!