Chapter 03 – Operating Decisions and the Accounting System
3-1
CHAPTER 3
OPERATING DECISIONS AND THE ACCOUNTING SYSTEM
Learning Objectives and Related Assignment Materials
Learning Objectives
Mini-
Exercises
Exercises
Problems
Alternate
Problems
Cases and
Projects
Continuing
Case
1. Describe a typical
business operating cycle
and explain the necessity
for the time period
assumption.
1
1
2. Explain how business
activities affect the
elements of the income
statement.
1, 3, 4
1, 3, 4,
15, 16
1, 2, 3, 8
3. Explain the accrual basis
of accounting and apply
the revenue realization
and matching principles to
measure income.
1, 2, 3, 4
1, 2, 3, 4,
10, 15,
16
5, 7, 6, 8
4. Apply transaction analysis
to examine and record the
effects of operating
activities on the financial
statements.
5, 6, 7, 8
5, 6, 7, 8,
9, 10, 13,
15, 16,
17
1, 2, 3, 4,
6, 7
1, 2, 3, 4,
6
1, 2, 3, 6
1
5. Prepare a classified
income statement.
9, 10
11, 12,
15, 18
4, 5, 6
4, 5, 6
6
1
6. Compute and interpret the
net profit margin ratio.
11
16, 18
4, 6
4, 6
1, 2, 3, 4,
8
1
Synopsis of Chapter Revisions
Focus Company: Chipotle Mexican Grill
▪ New focus company Chipotle Mexican Grill
▪ Update of the conceptual framework to reflect the new definitions from the FASB.
▪ The key ratio in this chapter was changed to the Net Profit Margin ratio (replacing coverage of the
Total Asset Turnover ratio in the 7e).
▪ Trial balance updated as needed as part of the continuing illustration of Chipotle Mexican Grill’s
quarterly transactions.
▪ T-accounts added after each transaction to illustrate posting the effects.
▪ New GUIDED HELP feature provides free access to step-by-step video instruction on transaction
analysis and recording, posting, and classifying accounts for operating activities.
▪ New CONTINUING CASE where students prepare journal entries for operating activities, prepare a
classified income statement, and compute and analyze the net profit margin based on the income
statement for Penny’s Pool Service.
Chapter 03 – Operating Decisions and the Accounting System
Synopsis of Chapter Revisions, continued
▪ New and updated real companies, as well as modified accounts, names, and amounts for fictional
companies in end-of-chapter exercises, problems, and cases with requirements reflecting the changes
in topics emphasized in each chapter.
PowerPoint Slides
Learning Objectives
PowerPoint® Slides
1. Describe a typical business operating cycle and explain the necessity for the
time period assumption.
3-1 through 3-4
2. Explain how business activities affect the elements of the income
statement.
3-5 through 3-9
3. Explain the accrual basis of accounting and apply the revenue realization
and matching principles to measure income.
3-10 through 3-26
4. Apply transaction analysis to examine and record the effects of operating
activities on the financial statements.
3-27 through 3-47
5. Prepare a classified income statement.
3-48 through 3-51
6. Compute and interpret the net profit margin ratio.
3-52
Related Video Program
Chapter 03 – Operating Decisions and the Accounting System
3-3
Chapter Take-Aways
2. Explain how business activities affect the elements of the income statement.
▪ Elements on the income statement:
a. Revenues—increases in assets or settlements of liabilities from ongoing operations.
b. Expenses—decreases in assets or increases in liabilities from ongoing operations.
c. Gains—increases in assets or settlements of liabilities from peripheral activities.
d. Losses—decreases in assets or increases in liabilities from peripheral activities.
3. Explain the accrual basis of accounting and apply the revenue realization and matching
principles to measure income.
In accrual basis accounting, revenues are recognized when earned and expenses are recognized when
incurred.
▪ Revenue principle—recognize revenues when (1) delivery has occurred, (2) there is persuasive
evidence of an arrangement for customer payment, (3) the price is fixed or determinable, and (4)
collection is reasonably assured.
▪ Matching principle—recognize expenses when they are incurred in generating revenue.
4. Apply transaction analysis to examine and record the effects of operating activities on the
financial statements.
The expanded transaction analysis model includes revenues and expenses:
ASSETS
(many accounts)
=
LIABILITIES
(many accounts)
+
STOCKHOLDERS’ EQUITY
(two accounts)
+
debit
–
credit
–
debit
+
credit
Common Stock
and Additional
Paid-in Capital
Retained
Earnings
–
debit
+
credit
Investments
by owners
–
debit
Dividends
declared
+
credit
Net income
REVENUES
(many accounts)
–
EXPENSES
(many accounts)
+
credit
+
debit
5. Prepare a classified income statement.
Until the accounts have been updated to include all revenues earned and expenses incurred in the
period (due to a difference in the time when cash is received or paid), the financial statements are
unadjusted:
▪ Classified income statement––net income is needed to determine ending Retained Earnings;
classifications include Operating Revenues, Operating Expenses (to determine Operating
Income), Other Items (to determine Pretax Income) Income Tax Expense, Net Income, and
Earnings per Share.
Chapter 03 – Operating Decisions and the Accounting System
3-4
Chapter Take-Aways , continued
6. Compute and interpret the net profit margin.
The net profit margin ratio (Net Income ÷ Net Sales) measures the profit generated per dollar of sales
(operating revenues). The higher the ratio, the more effective the company is at generating revenues
and/or controlling costs.
Key Ratio
Net profit margin measures the profit generated per dollar of sales (operating revenues). A high ratio
suggests that a company is generating revenues and/or controlling expenses effectively. The ratio is
computed as follows:
Net Profit Margin = Net Income Net Sales (or Operating Revenues)
Finding Financial Information
BALANCE SHEET
INCOME STATEMENT
Current Assets
Cash
Short-term investments
Accounts and notes
receivable
Inventory (goods to be
sold)
Prepaid expenses
Noncurrent Assets
Long-term
investments
Property and
equipment
Intangibles
Current Liabilities
Accounts payable
Notes payable
Accrued expenses
payable
Unearned revenue
Noncurrent
Liabilities
Long-term debt
Stockholders’ Equity
Common stock
Additional Paid-in
Capital
Retained earnings
Revenues (operating)
Sales (from various operating
activities)
Expenses (operating)
Cost of sales (used inventory)
Rent, wages, interest, depreciation,
insurance, etc.
Operating Income
Other Items
Interest expense
Investment income
Gains on sale of assets
Losses on sale of assets
Pretax Income
Income tax expense
Net Income
Earnings per Share
STATEMENT OF CASH FLOWS
NOTES
Under operating activities
+ Cash from customers
+ Cash from interest and dividends
− Cash to suppliers
− Cash to employees
− Interest paid
− Income taxes paid
Under summary of significant
accounting policies
Description of the company’s revenue
recognition policy.
Chapter 03 – Operating Decisions and the Accounting System
3-5
Chapter Outline
Teaching Notes
LO 1 – Describe a typical business operating cycle and explain the necessity for the time period
assumption.
I. How do Business Activities Affect the Income Statement
A. 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
1. To stay in business, excess cash must be generated from
operations rather than from borrowing money or selling
long-lived assets
2. Operating (or cash-to-cash) cycle – begins when a
company receives goods to sell (or, in the case of a
service company, has employees work), pays for them,
and sells to customers; it ends when customers pay cash
to the company
a. Length of time for completion of the operating cycle
depends on the nature of the business
b. Reducing the time needed to turn cash into more cash
(that is, shortening the operating cycle) means higher
profit and faster growth
c. Until a company ceases its activities, the operating
cycle is repeated continuously
B. Time Period Assumption
1. Time period assumption – indicates that the long life of a
company can be reported in shorter time periods.
2. Two types of issues arise in reporting periodic income to
users:
a. Recognition issues: When should the effects of
operating activities be recognized (recorded)?
b. Measurement issues: What amounts should be
recognized?
LO 2 – Explain how business activities affect the elements of the income statement.
C. Elements on the Income Statement
1. Multi-step income statement has multiple subtotals, such
as Operating Income and Income before Income Taxes.
Illustrated in Exhibit 3.1
2. Operating Revenues – result from the sale of goods or
services
a. Revenues – increases in assets or settlements of
liabilities from ongoing operations of the business;
when revenue is earned, assets, usually Cash or
Accounts Receivables, often increase
b. If a customer pays for goods or services in advance, a
liability account, usually Unearned (or Deferred)
Revenue, is created
i. At this point, no revenue has been earned; there is
simply a receipt of cash in exchange for a promise
to provide a good or service in the future.
Chapter 03 – Operating Decisions and the Accounting System
3-6
ii. When the company provides the promised goods or
services to the customer, the revenue is recognized
and the liability settled
3. Operating Expenses
a. Expenses are the outflows or using up of assets or
increases in liabilities from ongoing operations
incurred to generate revenues during the period
b. Not all cash expenditures are expenses, but expenses
are necessary to generate revenues
4. Operating Income (also called Income from Operations)
a. Operating revenues – operating expenses = operating
income
b. A measure of the profit from central ongoing
operations
5. Other Items
a. Activities affecting an income statement that are not
central to ongoing operations are not considered part
of operating income, but are instead categorized as
Other Items.
b. Typically include:
i. Investment Income (or Investment Revenue,
Interest Revenue , or Dividend Revenue )
ii. Interest Expense – cost of using money that is
borrowed
iii. Gains on Sales of Assets – Increases in assets or
decreases in liabilities from peripheral transactions
iv. Losses on Sales of Assets – Decreases in assets or
increases in liabilities from peripheral transactions
6. Operating Income +/– Other Items = Income before
Income Taxes (or pretax income)
7. Income Tax Expense ( also called Provision for Income
Taxes) – Calculated as a percentage of pretax income
determined by applying the tax rates of the federal, state,
local, and foreign taxing authorities
8. Income before Income Taxes – Income Tax Expense =
Net Income
9. Earnings per Share (EPS)
a. Must be disclosed on the income statement or in the
notes to the financial statements of corporations
b. Widely used in evaluating the operating performance
and profitability of a company
See International Perspective
c. EPS = Net Income ÷ Average Number of Shares of
Stock Outstanding
feature “Income Statement
Differences”
Chapter 03 – Operating Decisions and the Accounting System
3-7
LO 3 – Explain the accrual basis of accounting and apply the revenue realization and matching
principles to measure income.
II. How are Operating Activities Recognized and Measured?
A. Cash Basis Accounting
1. Revenues are recorded when cash is received, and
expenses are recorded when cash is paid, regardless of
when the revenues were earned or the expenses incurred
2. Cash basis is often quite adequate for organizations that
do not need to report to external users
a. Financial statements created under cash basis
accounting normally postpone or accelerate
recognition of revenues and expenses long before or
after goods and services are produced and delivered
(when cash is received or paid).
b. They also do not necessarily reflect all assets or
liabilities of a company on a particular date.
B. Accrual Accounting
1. Records revenues when earned and expenses when
incurred, regardless of the timing of cash receipts or
payments
2. Revenue principle
a. Four criteria must be met for revenue to be recognized
(If any of the four criteria are not met, revenue is not
recognized and cannot be recorded):
i. Delivery has occurred or services have been
rendered
ii. There is persuasive evidence of an arrangement for
customer payment
iii. The price is fixed or determinable, and
iv. Collection is reasonably assured
b. These conditions normally occur when the title, risks,
and rewards of ownership have transferred to the
customers.
c. For most businesses, these conditions are met at the
point of delivery of goods or services, regardless of
when cash is received.
d. Timing of cash receipts from customers does not
dictate when businesses report revenues
Illustrated in Exhibit 3.2
i. Cash is received before the goods or services are
delivered – Revenue is not recorded; instead, a
liability account (Unearned Restaurant Sales
Revenue) is created representing the amount of
services or goods owed to the customers
ii. Cash is received in the same period as the goods or
services are delivered – Revenue is recorded
Chapter 03 – Operating Decisions and the Accounting System
3-8
iii. Cash is received after the goods or services are
delivered – When delivered, revenue is recorded as
is the asset Accounts Receivable, representing the
customer’s promise to pay in the future for past
deliveries
Refer students to Pause for
Feedback – Self-Study Quiz
e. Companies usually disclose their revenue recognition
practices in a note to the financial statements
3. Expense matching principle
See A Question of Ethics
feature “Management’s
Incentives to Violate
Accounting Rules”
Illustrated in Exhibit 3.3
a. Requires that costs incurred to generate revenues be
recognized in the same period (a matching of costs
with benefits)
b. Timing of cash payments does not dictate when
businesses report expenses
i. Cash is paid before the expense is incurred to
generate revenue – An asset (called Supplies or
Prepaid Expenses) is recorded because they will
benefit future periods; when used, an expense is
recorded and the asset is reduced to the amount yet
to be used
ii. Cash is paid in the same period as the expense is
incurred to generate revenue – Expense is recorded
iii. Cash is paid after the cost is incurred to generate
revenue – Expense is recorded as is a liability (a
Payable), representing the amount that is owed
Refer students to Pause for
Feedback – Self-Study Quiz
LO 4 – Apply transaction analysis to examine and record the effects of operating activities on the
financial statements.
III. The Expanded Transaction Analysis Model
Show Video Program #2
A. Transaction Analysis Rules
Illustrated in Exhibit 3.4
1. All accounts can increase or decrease, although revenues
and expenses tend to increase throughout a period
Steps listed in Exhibit 3.5
2. Revenues increase stockholders’ equity through the
account Retained Earnings and therefore have credit
balances
3. Expenses decrease net income and, as such, decrease
Retained Earnings and stockholders’ equity and therefore
have debit balances (opposite of the balance in Retained
Earnings)
B. Analyzing Chipotle’s Transactions
1. Transaction (g) Chipotle purchased food, beverage, and
packaging supplies costing $207,700, paying $167,700 in
cash and owing the rest on account.
Use Supplemental
Enrichment Activity #1
dr Supplies (+A)
207,700
cr Cash (–A)
167,700
cr Accounts Payable (+L)
40,000
Use Supplemental
Enrichment Activity #2
Assets = Liabilities + Stockholders’ Equity
Supplies (A) + 207,700 + Cash (A) – 167,700 = Accounts
Payable (L) + 40,000
Chapter 03 – Operating Decisions and the Accounting System
3-9
2. Transaction (h) At the beginning of January, Chipotle
paid in advance $36,000 for six months of rent, $32,000
for insurance coverage for all of 2012, and $18,000 for
advertising over several upcoming months. All of these
are Prepaid Expenses.
dr Prepaid Expenses (+A)
86,000
cr Cash (–A)
86,000
Assets = Liabilities + Stockholders’ Equity
Prepaid Expenses (A) + 86,000 + Cash (A) – 86,000 = No
change
3. Transaction (i) During the first quarter, Chipotle sold
food to customers for $619,300; $4,000 was sold to
universities on account (to be paid next quarter) and the
rest was received in cash in the stores. Note: To measure
revenues and expenses in a period, these accounts begin
with a $0 balance; notice they are not listed on the trial
balance on page 113 because they have no balance yet.
dr Cash (+A)
615,300
cr Accounts Receivable (+A)
4,000
cr Restaurant Sales Revenue (+R)
619,300
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 615,300 + Accounts Receivable (A) + 4,000 =
= Restaurant Sales Revenue (+R) (+SE) +619,300
4. Transaction (j) Chipotle paid $49,300 for management
training expenses (part of General and Administrative
Expenses).
dr General & Administrative
Expense (+E, –SE)
49,300
cr Cash (–A)
49,300
Assets = Liabilities + Stockholders’ Equity
Cash (A) – 49,300 = General & Administrative Expense
(E) – 49.300
5. Transaction (k) Chipotle paid employees who worked this
quarter for $138,600 and last quarter for $91,500
(recorded last quarter as a liability in Accrued Expenses
Payable).
dr Salaries & Wages Expense (+E)
(–SE)
138,600
dr Accrued Expenses Payable (–L)
91,500
cr Cash (–A)
230,100
Assets = Liabilities + Stockholders’ Equity
Cash (A) – 230,100 = Accrued Expenses Payable (L) –
91,500 + Salaries & Wages Expense (E) + 138,600
Chapter 03 – Operating Decisions and the Accounting System
3-10
6. Transaction (l) Chipotle sold for cash land (included in
Property and Equipment) costing $11,900 at a loss of
$1,300.
dr Cash (+A)
10,600
Dr Gain (Loss) on Disposal of
Assets (+E) (–SE)
1,300
cr Property & Equipment (–A)
11,900
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 10,600 + Property & Equipment (A) – 11,900
= Gain (Loss) on Disposal of Assets (E) – 1,300
7. Transaction (m) Chipotle received $3,300 cash from
customers paying on their accounts.
dr Cash (+A)
3,300
cr Accounts Receivable (–A)
3,300
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 3,300 + Accounts Receivable (A) – 3,300 =
No change
8. Transaction (n) During the quarter, Chipotle paid
suppliers $37,200 on account.
dr Accounts Payable (–L)
37,200
cr Cash (–A)
37,200
Assets = Liabilities + Stockholders’ Equity
Cash (A) – 37,200 = Accounts Payable (L) – 37,200
9. Transaction (o) During the quarter, Chipotle incurred and
paid $10,000 for utilities (part of Occupancy Expense)
and $48,600 in the maintenance of its facilities (part of
Other Operating Expenses).
dr Occupancy Expense (+E)
(–SE)
10,000
dr Other Operating Expenses (+E)
(–SE)
48,600
cr Cash (–A)
58,600
Assets = Liabilities + Stockholders’ Equity
Cash (A) – 58,600 = Occupancy Expense (E) – 10,000 +
Other Operating Expenses (E) – 48,600
10. Transaction (p) Chipotle received $4,700 cash as
investment income earned during the quarter.
dr Cash (+A)
4,700
cr Investment Income (+R) (+SE)
4,700
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 4,700 = Investment Income (R) + 4,700
11. Transaction (q) During the quarter, Chipotle sold gift
cards to customers for $15,400 in cash (expected to be
redeemed for food next quarter).
Refer students to Pause for
Feedback – Self-Study Quiz
dr Cash (+A)
15,400
cr Unearned Revenue (+L)
15,400
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 15,400 = Unearned Revenue (L) + 15,400
12. Posting to T-accounts illustrated in Exhibit 3.6
Chapter 03 – Operating Decisions and the Accounting System
3-11
LO 5 – Prepare a classified income statement.
IV. How is the Income Statement Prepared and Analyzed?
A. Unadjusted Trial Balance
See illustration in text
1. Before preparing any statements, we must first determine
that the debits equal credits by generating a trial balance.
2. Accounts are listed in financial statement order: assets,
liabilities, stockholders’ equity, revenues/gains, and
expenses/losses.
Use Supplemental
Enrichment Activity #3
3. Trial balance is unadjusted because no end-of-period
adjustments have been made yet to reflect all revenues
earned and expenses incurred during the period.
Adjustments are covered in
Chapter 4
B. Classified Income Statement
1. Classified income statement is presented to highlight the
structure.
Use Supplemental
Enrichment Activity #4
2. Because it is based on unadjusted balances, it would not
be presented to external users.
LO 6 – Compute and interpret the net profit margin ratio.
C. Net Profit Margin Ratio
1. Net Profit Margin Ratio = Net Income ÷ Net Sales (or
Operating Revenues )
2. Net profit margin measures how much of every sales
dollar generated during the period is profit
Use Supplemental
Enrichment Activity #5
3. A rising net profit margin signals more efficient
management of sales and expenses
4. Differences among industries result from the nature of the
products or services provided and the intensity of
competition
5. Differences among competitors in the same industry
reflect how each company responds to changes in
competition (and demand for the product or service) and
changes in managing sales volume, sales price, and costs
See Financial Analysis
feature “New Revenue
Recognition Standard”
D. Focus on Cash Flows: Operating Activities
1. The statement of cash flows divides all transactions that
affect cash into three categories:
a. Operating activities (covered in this chapter)
b. Investing activities include buying and selling
noncurrent assets and investments (covered in Chapter
2)
c. Financing activities include borrowing and repaying
debt, including short-term bank loans, issuing and
repurchasing stock, and paying dividends (covered in
Chapter 2)
Refer students to Pause for
Feedback – Self-Study Quiz
2. Accounts associated with operating activities are current
assets, such as Accounts Receivable, Inventories, and
Prepaid Expenses, and current liabilities, such as
Accounts Payable, Wages Payable, and Unearned
Revenue.
Chapter 03 – Operating Decisions and the Accounting System
3-12
Supplemental Enrichment Activities
Note: These activities would be suitable for individual or group activities.
1. Handout 3-1
Use this handout for an in-class activity designed to review transaction analysis (preparation of
journal entries and impact on the accounting equation). The solution follows the handout master.
2. Handout 3-2
Use this handout for an in-class activity designed to the posting to T-accounts. This activity is a
continuation of Activity #1; it should be assigned only if that activity was assigned. The solution
follows the handout master.
3. Handout 3-3
Use this handout for an in-class activity designed to review the preparation of a trial balance. This
activity is a continuation of Activity #5; it should be assigned only if that activity was assigned. The
solution follows the handout master.
4. Handout 3-4
Use this handout for an in-class activity designed to review the preparation of an income statement.
This activity is a continuation of Activities #3; it should be assigned only if that activity was assigned.
The solution follows the handout master.
5. Use Handout 3-5
Use this handout for an in-class activity designed to review the calculation and interpretation of the
total asset turnover ratio. This activity is a continuation of Activity #4; it should be assigned only if
that activity was assigned. The solution follows the handout master.
Chapter 03 – Operating Decisions and the Accounting System
3-13
HANDOUT 3 – 1
TRANSACTION ANALYSIS
Tabor Hill Designers entered into the following transactions during February 2014. Analyze each of the
following transactions and prepare the journal entry required to record the related transaction.
(a) Provide website design services for $40,000.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets
=
Liabilities
+
Stockholders’ Equity
(b) Provide website design services to Acme Company, for $20,000 on account. We expect Acme to pay
in the future.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets
=
Liabilities
+
Stockholders’ Equity
(c) Collect $18,000 from Acme Company on account.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets
=
Liabilities
+
Stockholders’ Equity
Chapter 03 – Operating Decisions and the Accounting System
3-14
HANDOUT 3 – 1, continued
(d) Sell a $1,000 gift certificate.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets
=
Liabilities
+
Stockholders’ Equity
(e) Customer redeems $1,000 gift certificate for website design services.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets
=
Liabilities
+
Stockholders’ Equity
(f) Paid employees $16,000 earned.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets
=
Liabilities
+
Stockholders’ Equity