Accounting – Chapter 3: Operating Decisions and the Income Statement
How do Business Activities Affect the Income Statement?
The Operating (CashtoCash) Cycle: is the time it takes for a company to pay cash to
suppliers, sell goods and services to customers and collect cash from customers.
Managers know that reducing the time needed to turn cash into more cash (shortening the
operating cycle) means higher profits and faster growth.
Periodicity assumption: means that the long life of a company can be reported in shorter
periods.
To measure income for a specific period of time, accountants follow the periodicity assumption.
2 types of issues arise in reporting periodic income to users:
• Recognition issues: When should the effects of operating activities be recognized
(recorded)?
• Measurement issues: What amounts should be recognized?
Elements of the Income Statement
The income state includes three major sections:
1. Results of continuing operations
2. Results of discontinued operations
Profit (the sum of 1 and 2)
3. Earnings per share
Continuing operations – this section presents the results of continuing operations.
Operating revenues – Revenues: increases in assets or settlements of liabilities from ongoing
operations. Operating revenues result from the sale of goods or services.
Sometimes, a company receives cash in exchange for a promise to provide goods or services in
the future. At that point, revenue is not earned, but a liability account, deferred revenue, is
created. When the company provides the promised goods or services to the customer, revenue is
recognized and the liability is settled.
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 decreases in assets
or increases in liabilities to generate revenues during the period.
Not all expenditures are expenses and expenses are necessary to generate revenues.
Cost of goods sold (also called cost of sales) is the cost of products sold to customers. The
difference between sales revenues and cost of goods sold is known as gross profit or gross
margin.
Gross profit (or gross margin): net sales less cost of goods sold
Operating expenses are expenses that are incurred in operating a business during a specific
accounting period.
Operating profit (profit from operations): equals net sales less cost of goods sold and other
operating expenses.
Nonoperating items Using excess cash to purchase shares in other companies is an investing activity, not a central
operation. Any interest or dividends earned on the investment is called investment income or
finance income.
Borrowing money is a financing activity, the cost of using that money is called interest expense.
Selling land for more than it was bought results in a gain, not in revenue.
Gains increases in assets or decreases in liabilities from peripheral transactions (normal but not
central transactions).
Losses decreases in assets or increases in liabilities from peripheral transactions.
Income tax expense
It is the last expense listed on the income statement.
Discontinued operations
When the decision is made to discontinue a major component of a business, the profit or loss
from that component, as well as any gain or loss on subsequent disposal, are disclose separately
on the income statement as discontinued operations.
Noncontrolling interests
Earnings per share
To compute earnings per share, profit is divided by the weighted average number of shares
outstanding during the period. The calculation of the denominator is complex and is presented in
advanced accounting courses.
How are Operating Activities Recognized and Measured?
Your financial performance is
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