BUAD 203 Chapter 3 Notes
BUAD 203 Chapter 3 Notes BUAD 203
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This 7 page Class Notes was uploaded by Danielle Palmucci on Tuesday February 16, 2016. The Class Notes belongs to BUAD 203 at College of William and Mary taught by Michael Stump in Spring 2016. Since its upload, it has received 24 views. For similar materials see Principles of Accounting in Accounting at College of William and Mary.
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Date Created: 02/16/16
Chapter #3- Operating Decisions and the Accounting System The Operating Cycle Begins with the purchase or manufacture of a product for sale. When products are purchased from suppliers, those suppliers must be paid. After a sale has been made, the company must deliver the product or service to the customer. Many business sales are made on credit. If credit is extended, payment must be received from customers. Once the cash has been collected from customers, the business cycle begins all over again. Companies (1) acquire inventory and the services of employees and (2) sell inventory or services to customers. The 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, then ends when customers pay cash to the company. The length of time for completion of the operating cycle depends on the nature of the business. Time Period: The long life of a company can be reported over a series of shorter time periods. Recognition Issues: When should the effects of operating activities be recognized (recorded)? Measurement Issues: What amounts should be recognized? The income statement contains revenues, expenses, gains and losses. Revenues result from the sale of goods or services. When Chipotle sells food to consumers it has earned revenue. When revenue is earned, assets, usually Cash or Accounts Receivables, often increase. Sometimes if a customer pays for goods or services in advance, a liability account, usually Unearned (or Deferred) Revenue, is created. Expenses are decreases in assets or increases in liabilities from ongoing operations incurred to generate revenues during the period. Gains (with an account called Gain on Sale of Assets) result in an increase in assets or decrease in liabilities from a peripheral transaction. Losses are decreases in assets or increases in liabilities from peripheral transactions. Operating Expenses Expenditure- any outflow of cash for any purpose, whether to buy equipment, pay off a bank loan, or pay employees their wages. Expenses are outflows or the using up of assets or increases in liabilities from ongoing operations incurred to generate revenues during the period. Therefore, not all cash expenditures are expenses, but expenses are necessary to generate revenues. Ex. Restaurant operating expenses include among other items: 1. Food, Beverage, and Packaging Expense. 2. Salaries and Wages Expense. 3. Occupancy Expense. 4. Other Operating Expenses. 5. General and Administrative Expenses. 6. Depreciation Expense. 7. Income Tax Expense. International Perspective Similar expenses are required to be reported but may be grouped in different ways. GAAP generally requires that expenses by classified by business function like production, marketing, etc. The IFRS permits companies to categorize expenses by either function or nature. Companies that use the cash accounting basis recognize revenue at the time cash is received, and recognize expenses at the time cash is paid. Your financial performance is measured as the difference between your cash balance at the beginning of the period and the cash balance at the end of the period (that is, whether you end up with more or less cash). Many local retailers, medical offices, and other small businesses use cash basis accounting. A cash basis is not considered acceptable under generally accepted accounting principles. Revenue is recorded when cash is received Expenses are recorded when cash is paid Ex. Cade Company earns $60,000 from sales each year. Because the sales are on account, cash collections are spread over the period. Salaries are paid in full each year. Insurance was prepaid at the beginning of Year 1. Supplies were purchased on credit and used evenly during the three-year period. Performance over time appears uneven, when actually it is not. Accrual Accounting Generally accepted accounting principles require that assets, liabilities, revenues, and expenses be recognized when the transaction that causes them occurs. Generally accepted accounting principles require the use of the accrual method. In accrual basis accounting, revenues and expenses are recognized when the transaction that causes them occurs, not necessarily when cash is received or paid. o Revenues are recognized when they are earned and expenses when they are incurred. o The two basic accounting principles that determine when revenues and expenses are recorded under accrual basis accounting are the revenue principle and the matching principle. Revenue realization principle: four criteria or conditions must normally be met for revenue to be recognized. If any of the following criteria are not met, revenue normally is not recognized and cannot be recorded. 1. Delivery has occurred or services have been rendered. 2. There is persuasive evidence of an arrangement for customer payment. 3. The price is fixed or determinable. There are no uncertainties as to the amount to be collected. 4. Collection is reasonably assured. Revenue principle: four criteria or conditions must normally be met for revenue to be recognized. If any of the following criteria is not met, revenue normally is not recognized and cannot be recorded. 1. Delivery has occurred or services have been rendered. The company has performed or substantially performed the acts promised to the customer by providing goods or services. 2. There is persuasive evidence of an arrangement for customer payment. In exchange for the company’s performance, the customer has provided cash or a promise to pay cash (a receivable). 3. The price is fixed or determinable. There are no uncertainties as to the amount to be collected. 4. Collection is reasonably assured. For cash sales, collection is not an issue since it is received on the date of the exchange. For sales on credit, the company reviews the customer’s ability to pay. If the customer is considered creditworthy, collecting cash from the customer is reasonably likely. These conditions normally occur when the title, risks, and rewards of ownership have transferred to the customers. For most businesses, these conditions are met at the point of delivery of goods or services, regardless of when cash is received. In our case, cash was received before the goods or services were rendered to the customer, so no revenue is to be recognized. Rather we establish and Unearned Revenue account that is classified as a liability. If cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE is recorded when the company delivers the goods or services, UNEARNED REVENUE is reduced and REVENUE is recorded cash can be received on the date the product is delivered or the services provided. The journal entry is to debit cash and credit revenue if cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded when the cash is received the ACCOUNTS RECEIVABLE is reduced. The expense matching principle Requires that costs incurred to generate revenues be recognized in the same period—a matching of costs with benefits. For example, when Chipotle’s restaurants provide food service to customers, revenue is earned. The costs of generating the revenue include expenses that are recognized in the same period. If cash is paid before the company receives goods or services, an asset account, PREPAID EXPENSE is recorded When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded the expense can be incurred on the same day cash is paid. In this case, the journal entry is to debit the Expense and credit Cash If cash is paid after the company receives goods or services, a liability PAYABLE is recorded When cash is paid the PAYABLE is reduced. Expanded transaction analysis model From our Statement of Retained Earnings we know that net income increases Retained Earnings. Revenues increase net income and Expenses decrease net income. Revenues show increases and decreases on the same sides of the T- account as retained earnings. A credit to the Revenue account increases revenue, a debit to the Revenue account decreases revenue. Because expenses reduce revenues in the calculation of net income, increases and decreases in Expense accounts are shown on the opposite sides when compared to revenue accounts. A debit to an Expense account represents an increase in expenses, a credit to an Expense account represents a decrease in expenses. How are Financial Statements Prepared and Analyzed? The first statement we prepare is the income statement. The income statement shows revenues minus expenses. The second financial statement we prepare is the statement of retained earnings. In preparing the statement of retained earnings, we start with beginning retained earnings, we add net income and subtract dividends declared to arrive at ending retained earnings. The third financial statement we prepare is the balance sheet. The balance sheet shows assets, liabilities and stockholders’ equity. Stockholders’ equity is comprised of contributed capital and retained earnings. The final statement we prepare is the statement of cash flows. The statement of cash flows determines the change in our cash balance during the period. The statement is divided into three major sections, cash from operating activities, cash from investing activities, and cash from financing activities. We must prepare the Income Statement first because net income is needed before we can prepare the Statement of Retained earnings. Next, we prepare the Statement of Retained Earnings because we need the ending balance in Retained Earning to show the proper balance in the stockholders’ equity section of the Balance Sheet. Recall that stockholders’ equity is composed of the sum of Contributed Capital and Retained Earnings. Next, we prepare the Balance Sheet. We need the beginning and ending cash balance to prepare the fourth, and final statement, the Statement of Cash Flows. So the order of preparation of financial statements at the end of the accounting period is: 1. Income Statement 2. Statement of Retained Earnings 3. Balance Sheet 4. Statement of Cash Flows Net Profit Margin Measures how much of every sales dollar generated during the period is profit. A rising net profit margin signals more efficient management of sales and expenses. Differences among industries results from the nature of the products or services provided and the intensity of competition. 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. Financial analysts expect well-run businesses to maintain or improve their net profit margin over time. 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.
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