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Chapter 3

Chapter 3 BU227.docx

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Wilfrid Laurier University
Carolyn Mac Tavish

BU227 Chapter 3 – Operating Decisions and the Income Statement Week 3 How do Business Activities Affect the Income Statement? The Operating Cycle -The long-term objective for business is to turn cash into more cash -This excess cash must be generated into operations -The length of time between the payment of cash to suppliers of inventory and to employees and the collection of cash from customers depends on the nature of the business -In some companies, inventory is paid for well before it is sold -Ex. Toys R Us, builds it inventory for months prior to the year-end holiday season. It borrows funds from banks to pay for the inventory and repays the loans with interest when cash is received from customers -In other companies, cash is received from customers well after a sale takes place -Companies attempt to shorten the operating cycle by creating incentives to encourage customers to buy sooner or pay faster in order to improve company’s cash flows -Shortening the operating cycle means higher profits and faster grown -To measure income for a specific period of time accountants follow the periodicity assumption, which assumes that the long life of a company can be reported in shorter time periods, such as months, quarters, and years: there’s the recognition issue and the measurement issue Elements of the Income Statement -Sometimes, income statements have multiple subtotals -The income statement 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 -The results of continuing operations Operating Revenues -Increases in assets or settlement of liabilities from ongoing operations of the business are defined as revenues -Result from the sale of goods or services -When revenues are earned, assets, usually cash or trades receivables, often increase -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 Operating Expenses -An expenditure is any outflow of cash for any purpose, whether to buy equipment, pay off a bank loan, or pay employees their wages -An expense is used to generate revenue during a period, or when an amount is incurred to generate revenues during a period -Not all expenditures are expenses and expenses are necessary to generate revenues -Expenses are decreases in assets or increases in liability from ongoing operations and are incurred to generate revenue during the period -When an expense occurs, assets such as supplies inventory decrease or liabilities such as salaries BU227 Chapter 3 – Operating Decisions and the Income Statement Week 3 payable or utilities payable increase -Primary operating expenses: 1. Cost of goods sold – the cost of products sold to customers 2. Operating expenses – the usual expenses, other than cost of goods sold, that are incurred in operating a business during a specific accounting period -Most companies classify their expenses by function. Ex. Distribution expenses, marketing and admin expenses, research and development expenses, etc. -Gross profit – net sales les cost of goods sold -Operating profit – equals net sales less cost of goods sold and other operating expenses Non-operating Items -Not all activities affecting an income statement are central to continuing operations – any revenues, expenses, gains or losses that result from these other activities are not included as part of operating profit, but are instead categorized as other income or expenses -Any interest or dividends earned on investments is called investment income -Borrowing money is called interest expense -The non-operating items that are not subject to income taxes are added or subtracted from operating profit to obtain profit before income taxes, also called pre-tax profit Income Tax Expense -Income tax expense is calculated as a percentage of profit before income taxes, reflecting the difference between income, which includes revenues and gains, and expenses and losses 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 disclosed separately on the income statement as discontinued operations Non-controlling Interests -Purchase of all or a majority of other companies’ shares allows Nestle to control their operating, investing and financing decisions -When you own a majority of the shares of another company it becomes a controlling shareholder and all other shareholders are non-controlling shareholders
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