Chapter 3 Operating a Business and the Income Statement © 2009 The McGraw-Hill Companies, Inc.

Slide 2 Revenues are earned when there is an exchange of a business’s products or services for cash or a promise to pay cash. Net income is the excess of revenues over expenses. Income Statement Accounts Expenses are costs incurred to generate revenues.

Slide 3 Income Statement Accounts Cash Expenditures Debt Payments Expenses Asset Purchases

Slide 4 Income Statement Accounts

Slide 5 Operating Cycle Typical Operating Cycle Purchase good and services Pay cash to suppliers Sell goods and services to customers Receive cash from customers

Slide 6 Cash basis accounting records revenues when cash is received and expenses when cash is paid. Cash-Based Measurements

Slide 7 GAAP Revenues are recognized when they are earned and expenses are recognized when they are incurred, regardless of the timing of cash receipts or payments. Accrual Basis Accounting

Slide 8 Business delivers goods or services. here (2) here (3) here (1) Cash can be received... (1)Cash is received in the same period as the goods or services are delivered. Revenue is recorded here. Time Recording Revenues versus Cash Receipts (2) Cash is received before the goods or services are delivered. (3) Cash is received after the goods or services are delivered.

Slide 9 Business delivers goods or services. here (2) here (1) here (3) Cash can be received... Revenue is recorded here. Time Recording Revenues versus Cash Receipts (1)Cash is received in the same period as the goods or services are delivered. (2) Cash is received before the goods or services are delivered. (3) Cash is received after the goods or services are delivered.

Slide 10 Business delivers goods or services. here (2) here (1) here (3) Cash can be received... (1)Cash is received in the same period as the promised acts are performed. (2)Cash is received in a period before the promised acts are performed. (3)Cash is received in a period after the promised acts are performed. Revenue is recorded here. Time When cash is received before goods or services are delivered, the company receiving the cash will report an increase in cash and an increase in a liability, called unearned revenue, which represents the obligation to perform the acts in the future. Recording Revenues versus Cash Receipts

Slide 11 Business delivers goods or services. here (2) here (1) here (3) Cash can be received... (1)Cash is received in the same period as the promised acts are performed. (2)Cash is received in a period before the promised acts are performed. (3)Cash is received in a period after the promised acts are performed. Revenue is recorded here. Time When cash is received after goods or services are delivered, the company performing the services will report an increase in revenue and an increase in accounts receivable. Later, when the cash is received, the accounts receivable is reduced. Recording Revenues versus Cash Receipts

Slide 12 Business incurs costs to generate revenues. here (2) here (1) here (3) Cash can be paid... (1)Cash is paid at the same time as the expense is incurred to generate revenue. Expense is recognized here. Time Recording Expenses versus Cash Payments (2)Cash is paid before the expense is incurred to generate revenue. (3)Cash is paid after the expense is incurred to generate revenue.

Slide 13 Business incurs costs to generate revenues. here (2) here (1) here (3) Cash can be paid... Expense is recognized here. Time Recording Expenses versus Cash Payments (1)Cash is paid at the same time as the expense is incurred to generate revenue. (2)Cash is paid before the expense is incurred to generate revenue. (3)Cash is paid after the expense is incurred to generate revenue.

Slide 14 Business incurs costs to generate revenues. here (2) here (1) here (3) Cash can be paid... (1)Cash is paid at the same time as the cost is incurred to generate revenue. (2)Cash is paid before the the cost is incurred to generate revenue. (3)Cash is paid after the the cost is incurred to generate revenue. Expense is recognized here. Time Recording Expenses versus Cash Payments Given the matching principle, the expense should be reported when the cost is incurred to earn revenue and not in the period when the cash is paid.

Slide 15 Business incurs costs to generate revenues. here (2) here (1) here (3) Cash can be paid... (1)Cash is paid at the same time as the cost is incurred to generate revenue. (2)Cash is paid before the the cost is incurred to generate revenue. (3)Cash is paid after the the cost is incurred to generate revenue. Expense is recognized here. Time Recording Expenses versus Cash Payments Given the matching principle, the expense should be reported when the cost is incurred to earn revenue and not in the period when the cash is paid.

Slide 16 The Expanded Transaction Analysis Model DebitCreditDebitCreditDebitCredit Debit = LeftCredit = Right increase debit decrease credit Asset accounts increase on the left or debit side and decrease on the right or credit side. increase creditdecrease debit Liability accounts increase on the right or credit side and decrease on the left or debit side. increase credit decrease debit Owner’s equity accounts increase on the right or credit side and decrease on the left or debit side. Let’s take a closer look at the accounts that affect Owner’s Equity.

Slide 17 The Expanded Transaction Analysis Model DebitCredit DebitCredit DebitCreditDebitCredit

Slide 18 Analysis of Pizza Aroma’s Transactions (h) During May, Pizza Aroma sells pizza to restaurant customers for $12,000.

Slide 19 Analysis of Pizza Aroma’s Transactions (i) Pizza Aroma delivers $2,000 in pizza on account to various college departments.

Slide 20 Analysis of Pizza Aroma’s Transactions (j) Fraternities place large orders for end-of-May graduation events and for mid-June reunion weekend, giving Pizza Aroma $600 cash on deposit in mid-May.

Slide 21 Analysis of Pizza Aroma’s Transactions (k) Pizza Aroma purchases $3,000 of additional supplies, paying $2,200 in cash and owing the rest on account.

Slide 22 Analysis of Pizza Aroma’s Transactions (l) Pizza Aroma pays $800 cash for newspaper advertising during May.

Slide 23 Analysis of Pizza Aroma’s Transactions (m) Pizza Aroma pays $1,000 cash to employees for work during May.

Slide 24 Analysis of Pizza Aroma’s Transactions (n) College departments pay Pizza Aroma $1,300 cash owed on their accounts (see event i above.)

Slide 25 Analysis of Pizza Aroma’s Transactions (o) Pizza Aroma receives and pays a $600 bill for telephone service in May.

Slide 26 Analysis of Pizza Aroma’s Transactions (p) At the end of May, Pizza Aroma purchases insurance for its restaurant equipment, paying $2,400 cash to cover the months of June, July, and August.

Slide 27 Analysis of Pizza Aroma’s Transactions (q) Owner Mauricio Rosa withdraws $3,000 in cash at the end of May.

Slide 28 Here are the asset account balances. (Transactions (a) to (g) came from Chapter 2.)

Slide 29 Here are the liability account balances. (Transactions (a) to (g) came from Chapter 2.)

Slide 30 Here are the owner’s equity account balances. (Transactions (a) to (g) came from Chapter 2.)

Slide 31 Unadjusted Trial Balance Amounts come from ledger balances Not a financial statement Debits = Credits Listed in financial statement order

Slide 32 Classified Income Statement Operating revenues result from the sale of goods and services. Operating expenses are the costs that are directly related to the generation of operating revenues. Other items include peripheral transactions such as interest and dividends.

Slide 33 McGraw-Hill/Irwin Slide 33 NI  Cash NI   Value NI  Counting Limitations of the Income Statement

Slide 34 End of Chapter 3