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Financial Accounting Chapter 3
Terms in this set (17)
What Activities Affect the Income Statement?
A. The Operating Cycle
B. Elements of the Income Statement
The Operating Cycle
is the "cash-to-cash" cycle (earnings process)
- This cycle represents the time it takes to purchase goods or services, pay the suppliers for these goods or services, make sales to customers, and collect cash from those customers
- 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.
- reducing the operating cycle can lead to greater profits and faster growth.
- the long life of a company needs to be broken down and reported in shorter time periods
i. Annual income statements are for the period of a year.
ii. "Interim" reports are prepared more frequently (monthly or quarterly).
Elements on the Income Statement
reports revenues, expenses, gains, and losses
- Multi-step Income Statement = The income statement format often presents subtotals such as operating income and income before income taxes
- Revenues are inflows of net assets from normal ongoing operations (+A, -L)
- Costs and Expenses are outflows of net assets from normal ongoing operations (necessary to generate revenue) (-A, +L)
costs of supplies used
occupancy expenses depreciation expense amortization expense
income tax expense
general and administrative expenses
are inflows of net assets from normal ongoing operations (+A, -L)
increases in assets or decreases in liabilities from peripheral transaction
outflows of net assets from normal ongoing operations (necessary to generate revenue)
decreases in assets or increases in liabilities from peripheral transactions
Income Tax Expense
This is the last expense listed on the income statement for profit-making corporations. The expense is calculated on pretax income (all revenues and gains minus all costs, expenses, and losses).
Earnings Per Share
This is required disclosure on corporate income statements. It is computed as:
EPS = Net Income / Weighted average # of common shares outstanding
How Are Operating Activities Recognized and Measured?
A. Accrual Accounting vs. Cash Basis Accounting
B. The Revenue Principle
C. The Matching Principle
Cash Basis Accounting
1. Cash basis accounting records revenues when cash is received and records expenses when cash is paid.
- Many small companies not reporting to external users use cash basis accounting.
2. Cash basis accounting is not generally appropriate (is not GAAP) for the preparation of balance sheets and income statements.
3. Cash basis accounting is used (is GAAP) for the preparation of the statement of cash flows.
1. Accrual basis accounting requires the reporting of revenues when earned and expenses when incurred, regardless of the timing of cash receipts and cash payments.
2. Accrual basis accounting is appropriate (is GAAP) for the preparation of the balance sheet, statement of retained earning, statement of stockholders' equity, and the income statement.
3. There are two important accounting principles for the accrual basis of accounting. They are the revenue principle and the matching principle. These are important concepts for recognition and measurement issues.
The Revenue Principle
The revenue principle requires that four conditions be met for revenue recognition.
a. The earnings process is complete or nearly complete (the promised acts have been performed). That is, goods have been delivered or services have been rendered.
b. An exchange transaction takes place (the customer pays or promises to pay for the performed act). That is, an agreement for customer payment is acknowledged.
c. The price is fixed or determinable.
d. Collection is reasonably assured (the customer is expected to pay and it is probable that payment will be received).
- A liability account is used when cash is collected from the customer before goods or services are delivered. The liability results from a revenue DEFERRAL since the earnings will be recognized in the future.
- An asset account is used when cash is NOT collected from the customers by the time goods or services are delivered. The asset results from a revenue ACCRUAL because the earnings are accrued or increased before cash is actually collected in the future.
The Matching Principle
The matching principle requires that
- expenses be recorded when incurred in earning revenues - a matching of costs with benefits
- this recognition is required regardless of when cash is actually paid. Expenses are resources used up to generate revenues.
- An asset account is established when cash is paid for property or services BEFORE they are "used up". The asset results from an expense DEFERRAL since it will be used in the future (deferred).
- A liability account is used when cash is not paid out when services are provided by employees or goods are received from suppliers. The liability results from an expense ACCRUAL because the expense has been accrued or increased before cash is actually spent. The cash payment will occur in the future.
Unadjusted Income Statement
adjusting entries have not been prepared yet; therefore, this is incomplete and it is not in conformity with GAAP based on accrual accounting principles. Accounts need to be updated for revenues earned and expenses incurred
Unadjusted Statement of Retained Earnings
presents the beginning balance of the retained earnings account, the changes in this account (an increase for net income or a decrease for net loss and a decrease for dividends), and its ending balance
- net income or net loss comes from income statement
- ending balance for retained earnings goes to the balance sheet
Unadjusted Balance Sheet
reflects the balances of assets, liabilities, and stockholders' equity accounts before end-of-period adjustments.
This set is often in folders with...
Financial Accounting Chapter 1
Financial Accounting Chapter 2
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