Copyright © 2014 McGraw-Hill Ryerson Limited 3-1 PowerPoint Author: Robert G. Ducharme, MAcc, CPA, CA University of Waterloo, School of Accounting and Finance FINANCIAL ACCOUNTING Fifth Canadian Edition LIBBY, LIBBY, SHORT, KANAAN, GOWING Operating Decisions and the Statement of Earnings Chapter 3

3-2 Copyright © 2014 McGraw-Hill Ryerson Limited GoalsPlans Strategies Measurable indicators Businesses develop... The goals include elements of income. Business Background LO1

3-3 Copyright © 2014 McGraw-Hill Ryerson Limited Understanding the Business How do business activities affect the statement of earnings? How do business activities affect the statement of earnings? How are these activities recognized and measured? recognized and measured? How are these activities recognized and measured? recognized and measured? How are these activities reported on the statement of earnings? How are these activities reported on the statement of earnings? LO1

3-4 Copyright © 2014 McGraw-Hill Ryerson Limited The Operating Cycle (cash-to-cash cycle) Begin Purchase or manufacture products or supplies on credit. Deliver product or provide service to customers on credit. Paysuppliers.Paysuppliers. Receive payment from customers. The operating (or cash-to-cash) cycle The operating (or cash-to-cash) cycle is the time it takes for a company to pay cash to suppliers, sell those goods and services to customers, and collect cash from customers. LO1

3-5 Copyright © 2014 McGraw-Hill Ryerson Limited relatively short time periods To meet the needs of decision makers, we report financial information for relatively short time periods (monthly, quarterly, annually) Life of the Business Annual Accounting Periods The Periodicity Assumption LO1

3-6 Copyright © 2014 McGraw-Hill Ryerson Limited The Operating Cycle – Underlying Accounting Assumptions 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? LO1

3-7 Copyright © 2014 McGraw-Hill Ryerson Limited Earnings per share Results of continuing operations Results of discontinued operations Elements on the Classified Statement of Earnings The statement of earnings includes up to three major sections: = net earnings LO2

3-8 Copyright © 2014 McGraw-Hill Ryerson Limited Results of continuing operations Results of continuing operations can be presented in one of the two formats Single step format list all revenues followed by all expense items and then shows the difference between revenue and expenses Multiple step format cost of goods sold are deducted from sales to present gross margin (or gross profit) as a subtotal. Other operating expenses are then deducted to show operating earnings (income) as a second subtotal Elements on the Classified Statement of Earnings LO2

3-9 Copyright © 2014 McGraw-Hill Ryerson Limited Elements on the Statement of Earnings Losses Decreases in assets or increases in liabilities from peripheral transactions. Losses Decreases in assets or increases in liabilities from peripheral transactions. Revenues Increases in assets or settlement of liabilities from ongoing operations. Revenues Increases in assets or settlement of liabilities from ongoing operations. Expenses Decreases in assets or increases in liabilities from ongoing operations. Expenses Decreases in assets or increases in liabilities from ongoing operations. Gains Increases in assets or settlement of liabilities from peripheral transactions. Gains Increases in assets or settlement of liabilities from peripheral transactions. LO2

3-10 Copyright © 2014 McGraw-Hill Ryerson Limited Discontinued Operations Result from the disposal of a major segment of the business and are reported net of the related income tax effect. Elements on the Statement of Earnings Discontinued operations are presented separately because of their non-recurring nature and thus are not useful in predicting the future earnings of the company. LO2

3-11 Copyright © 2014 McGraw-Hill Ryerson Limited LO2 Elements on the Statement of Earnings

3-12 Copyright © 2014 McGraw-Hill Ryerson Limited How Are Operating Activities Recognized and Measured? Revenue is recorded when cash is received. Revenue is recorded when cash is received. Expenses are recorded when cash is paid. Expenses are recorded when cash is paid. Cash Basis LO3

3-13 Copyright © 2014 McGraw-Hill Ryerson Limited Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received. Required by - I nternational F inancial R eporting S tandards How Are Operating Activities Recognized and Measured? Accrual Accounting Required by - G enerally A cceptable A ccounting P rinciples LO3

3-14 Copyright © 2014 McGraw-Hill Ryerson Limited Revenue Principle Recognize revenues when... The entity has transferred to the buyer the significant risks and rewards of ownership. The entity has transferred to the buyer the significant risks and rewards of ownership. The entity retains neither continuing managerial involvement nor effective control over the goods sold. The entity retains neither continuing managerial involvement nor effective control over the goods sold. The amount of revenue can be reliably measured. The amount of revenue can be reliably measured. Collection is reasonably assured. Collection is reasonably assured. The costs in respect of the transaction can be measured reliably. The costs in respect of the transaction can be measured reliably. Recognize revenues when... The entity has transferred to the buyer the significant risks and rewards of ownership. The entity has transferred to the buyer the significant risks and rewards of ownership. The entity retains neither continuing managerial involvement nor effective control over the goods sold. The entity retains neither continuing managerial involvement nor effective control over the goods sold. The amount of revenue can be reliably measured. The amount of revenue can be reliably measured. Collection is reasonably assured. Collection is reasonably assured. The costs in respect of the transaction can be measured reliably. The costs in respect of the transaction can be measured reliably. LO3

3-15 Copyright © 2014 McGraw-Hill Ryerson Limited Revenue Principle situation #1 – cash is received BEFORE revenue is earned If cash is received before the company delivers goods or services, the liability account DEFERRED REVENUE is recorded. Cash is received before revenue is earned - Cash Received Cash (+A) xxx Deferred revenue (+L) xxx LO3

3-16 Copyright © 2014 McGraw-Hill Ryerson Limited Revenue Principle situation #1 – cash is received BEFORE revenue is earned When the company delivers the goods or services DEFERRED REVENUE is reduced and REVENUE is recorded. Cash is received before revenue is earned - Cash Received Company Delivers Cash (+A) xxx Deferred revenue (+L) xxx Revenue will be recorded when earned. Deferred revenue (-L) xxx Service revenue (+R) xxx LO3

3-17 Copyright © 2014 McGraw-Hill Ryerson Limited Revenue Principle situation #1 – cash is received BEFORE revenue is earned Typical liabilities that become revenue when earned include... LO3

3-18 Copyright © 2014 McGraw-Hill Ryerson Limited Revenue Principle situation #2 – cash is received ON the date revenue is earned When cash is received on the date the revenue is earned, the following entry is made: Cash Received Company Delivers Cash (+A) xxx Revenue (+R) xxx AND LO3

3-19 Copyright © 2014 McGraw-Hill Ryerson Limited Revenue Principle situation #3 – cash is received AFTER revenue is earned If cash is received after the company delivers goods or services, an asset TRADE RECEIVABLES is recorded. Cash is received after revenue is earned - Trade receivables (+A) xxx Revenue (+R) xxx Company Delivers LO3

3-20 Copyright © 2014 McGraw-Hill Ryerson Limited Revenue Principle situation #3 – cash is received AFTER revenue is earned Cash Received Trade receivables (+A) xxx Revenue (+R) xxx Cash is received after revenue is earned - Company Delivers When the cash is received the TRADE RECEIVABLES is reduced. Cash will be collected. Cash (+A) xxx Trade receivables (-A) xxx LO3

3-21 Copyright © 2014 McGraw-Hill Ryerson Limited Revenue Principle situation #3 – cash is received AFTER revenue is earned Assets reflecting revenues earned but not yet received in cash include... LO3

3-22 Copyright © 2014 McGraw-Hill Ryerson Limited The Matching Process Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid. LO3

3-23 Copyright © 2014 McGraw-Hill Ryerson Limited The Matching Process situation #1 – cash is paid BEFORE expense is incurred If cash is paid before the company receives goods or services, an asset account, PREPAID EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Prepaid expense (+A) xxx Cash (-A) xxx LO3

3-24 Copyright © 2014 McGraw-Hill Ryerson Limited The Matching Process situation #1 – cash is paid BEFORE expense is incurred Expense Incurred When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Prepaid expense (+A) xxx Cash (-A) xxx Expense will be recorded when incurred. Expense (+E) xxx Prepaid expense (-A) xxx LO3

3-25 Copyright © 2014 McGraw-Hill Ryerson Limited The Matching Process situation #1 – cash is paid BEFORE expense is incurred Typical assets and their related expense accounts include... LO3

3-26 Copyright © 2014 McGraw-Hill Ryerson Limited The Matching Process situation #2 – cash is paid ON the date expense is incurred When cash is paid on the date the expense is incurred, the following entry is made: Cash Paid Expense Incurred Expense (+E) xxx Cash (-A) xxx AND LO3

3-27 Copyright © 2014 McGraw-Hill Ryerson Limited The Matching Process situation #3 – cash is paid AFTER expense is incurred Cash Paid When cash is paid the PAYABLE is reduced. Cash is paid after expense is incurred - Expense Incurred Expense (+E) xxx Payable (+L) xxx Cash will be paid. Payable (-L) xxx Cash (-A) xxx LO3

3-28 Copyright © 2014 McGraw-Hill Ryerson Limited The Matching Process situation #3 – cash is paid AFTER expense is incurred If cash is paid after the company receives goods or services, a liability PAYABLE is recorded. Cash is paid after expense is incurred - Expense (+E) xxx Payable (+L) xxx Expense Incurred LO3

3-29 Copyright © 2014 McGraw-Hill Ryerson Limited A Question of Ethics LO3

3-30 Copyright © 2014 McGraw-Hill Ryerson Limited A = L + SE ASSETS Debit for Increase Credit for Decrease LIABILITIES Debit for Decrease Credit for Increase Next, let’s see how Revenues and Expenses affect Retained Earnings. LO4 RETAINED EARNINGS Debit for Decrease Credit for Increase CONTIBUTED CAPITAL Debit for Decrease Credit for Increase OTHER COMPONENTS Debit for Decrease Credit for Increase

3-31 Copyright © 2014 McGraw-Hill Ryerson Limited EXPENSES and LOSSES Debit for Increase Credit for Decrease REVENUES and GAINS Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase The Expanded Transaction Analysis Model Net losses and dividends decrease Retained Earnings. Net earnings increase Retained Earnings. LO4

3-32 Copyright © 2014 McGraw-Hill Ryerson Limited (a) Sun-Rype sold fruit-based beverages and snacks to customers for $3,520 in cash. The cost of these sales was $1,960. Analyzing Some of Sun-Rype’s Transactions Equality checks: 1.Debits $5,480 equal Credits $5,480, 2.The accounting equation is in balance. LO4

3-33 Copyright © 2014 McGraw-Hill Ryerson Limited (b) Sun-Rype sold food and beverage products to retail outlets for $3,020; $2,020 was received in cash and the rest was due from the outlets. The cost of products sold was $1,400. Analyzing Some of Sun-Rype’s Transactions Equality checks: 1.Debits $4,420 equal Credits $4,420, 2.The accounting equation is in balance. LO4

3-34 Copyright © 2014 McGraw-Hill Ryerson Limited (c) Sun-Rype received $345 from customers, including $75 for sales made in December and the rest from January sales. Analyzing Some of Sun-Rype’s Transactions Equality checks: 1.Debits $345 equal Credits $345, 2.The accounting equation is in balance. LO4

3-35 Copyright © 2014 McGraw-Hill Ryerson Limited (d) Sun-Rype signed contracts with new clients and received $50 cash. The company earned $40 immediately by performing services for these clients; the rest will be earned over the next several months. Analyzing Some of Sun-Rype’s Transactions Equality checks: 1.Debits $50 equal Credits $50, 2.The accounting equation is in balance. LO4

3-36 Copyright © 2014 McGraw-Hill Ryerson Limited (e) Sun-Rype paid $740 in advance for the following: $160 for insurance covering the next four months beginning January 1, $450 for rent of warehousing facilities for the next three months beginning January 1, and $130 for advertising to be run in February. Analyzing Some of Sun-Rype’s Transactions Equality checks: 1.Debits $740 equal Credits $740, 2.The accounting equation is in balance. LO4

3-37 Copyright © 2014 McGraw-Hill Ryerson Limited (f) Sun-Rype paid $731 for utilities, repairs, and fuel for delivery vehicles, all considered distribution expenses. Analyzing Some of Sun-Rype’s Transactions Equality checks: 1.Debits $731 equal Credits $731, 2.The accounting equation is in balance. LO4

3-38 Copyright © 2014 McGraw-Hill Ryerson Limited LO4 The balances in the statement of financial position accounts and statement of earnings accounts after posting the transactions to the T-accounts (all revenue and expense accounts begin with a zero balance).

3-39 Copyright © 2014 McGraw-Hill Ryerson Limited How are Financial Statements Prepared and Analyzed? Statement of Earnings Revenues – Expenses = Net Earnings Statement of Changes in Shareholders’ Equity Beginning Equity + Net Earnings - Dividends Declared +/- Other Components Changes, net Ending Equity Statement of FinancialPosition Assets = Liabilities + Shareholders’ Equity Contributed Capital Retained Earnings Other Components Statement of Cash Flows Change in Cash = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities LO5

3-40 Copyright © 2014 McGraw-Hill Ryerson Limited How are Financial Statements Prepared and Analyzed? Statement of Earnings Revenues – Expenses = Net earnings Statement of Changes in Shareholders’ Equity Beginning Equity + Net Earnings - Dividends Declared +/- Other Components Changes, net Ending Equity Statement of FinancialPosition Assets = Liabilities + Shareholders’ Equity Contributed Capital Retained Earnings Other Components Statement of Cash Flows Change in Cash = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities Cash LO5

3-41 Copyright © 2014 McGraw-Hill Ryerson Limited Sun-Rype's Statement of Earnings LO5

3-42 Copyright © 2014 McGraw-Hill Ryerson Limited Focus on Cash Flows Direct approach to preparing operating cash flows. LO6

3-43 Copyright © 2014 McGraw-Hill Ryerson Limited Total Asset Turnover Ratio Sales (or Operating) Revenues Average Total Assets = (Beginning total assets + ending total assets) ÷ 2 Sun-Rype's Total Asset Turnover Ratio for 2012 (dollars in millions): $152,795 ($96,139 + $91,473) ÷ 2 = 1.63 This ratio measures the sales generated per dollar of assets. Creditors and analysts use this ratio to assess a company’s effectiveness at controlling current and noncurrent assets. LO6

3-44 Copyright © 2014 McGraw-Hill Ryerson Limited Return on Assets (ROA) Ratio ROA measures how much the firm earned for each dollar of investment. * In complex calculations, interest expense (net of tax) and minority interest are added back to net earnings. Return on Assets (ROA) Ratio Net Earnings* + Interest Expense (net of tax) Average Total Assets = (Beginning total assets + ending total assets) ÷ 2 This ratio answers the question “How well has management use the total invested capital provided by debtholders and shareholders during the period?” LO6

3-45 Copyright © 2014 McGraw-Hill Ryerson Limited End of Chapter 3