Operating Decisions and

the Income Statement

Chapter 3

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.

The Operating Cycle

Begin
Purchase or
manufacture
products or
supplies on
credit.
Receive payment
from customers.

Pay
suppliers.
Deliver product
or provide service
to customers on
credit.

McGraw-Hill/Irwin

Slide 2

Elements on the Income Statement

Revenues
Revenues
Increases
Increases in
in assets
assets or
or settlement
settlement of
of
liabilities
liabilities from
from ongoing
ongoing operations.
operations.
Expenses
Expenses
Decreases
Decreases in
in assets
assets or
or increases
increases in
in
liabilities
liabilities from
from ongoing
ongoing operations.
operations.
Gains
Gains
Increases
Increases in
in assets
assets or
or settlement
settlement of
of
liabilities
liabilities from
from peripheral
peripheral transactions
transactions..
Losses
Losses
Decreases
Decreases in
in assets
assets or
or increases
increases in
in
liabilities
liabilities from
from peripheral
peripheral transactions.
transactions.
McGraw-Hill/Irwin

Slide 3

Cash Basis Accounting

Revenue is recorded
when cash is received.

McGraw-Hill/Irwin

Expenses are recorded

when cash is paid.

Slide 4

Accrual Accounting
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 Generally
Acceptable
Accounting
Principles
McGraw-Hill/Irwin

Slide 5

Revenue Principle
When the company delivers the goods or
services UNEARNED REVENUE is reduced
and REVENUE is recorded.
Cash received before revenue is earned Cash
Received
Cash (+A)
Unearned revenue (+L)

Company
Delivers
xxx

xxx
Revenue will be recorded when earned.

McGraw-Hill/Irwin

Slide 6

Revenue Principle

Typical liabilities that become

revenue when earned include . . .
CASH COLLECTED
(Goods or services due to
customers)

REVENUE
over time will (Earned when goods
become
or services provided)

Rent collected in advance

Rent revenue

Unearned air traffic revenue

Air traffic revenue

Deferred subscription revenue

Subscription revenue

McGraw-Hill/Irwin

Slide 7

Revenue Principle
When the cash is received the ACCOUNTS
RECEIVABLE is reduced.
Cash received after revenue is earned Cash
Received

Company
Delivers

Accounts receivable (+A)

Revenue (+R)

xxx

xxx
Cash will be collected.

McGraw-Hill/Irwin

Slide 8

Revenue Principle

Assets reflecting revenues earned but

not yet received in cash include . . .
CASH TO BE
COLLECTED
(Owed by
customers)

and already
earned as

REVENUE
(Earned when
goods or services
provided)

Interest receivable

Interest revenue

Rent receivable

Rent revenue

Royalties receivable

Royalty revenue

McGraw-Hill/Irwin

Slide 9

The Matching Principle

Resources
consumed to earn
revenues in an
accounting period
should be recorded
in that period,
regardless of when
cash is paid.

McGraw-Hill/Irwin

Slide 10

The Matching Principle

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)
Cash (-A)

Expense
Incurred
xxx

xxx
Expense will be recorded when
incurred.

McGraw-Hill/Irwin

Slide 11

The Matching Principle

Typical assets and their related

expense accounts include. . .
CASH PAID FOR

as used over
time becomes

EXPENSE

Supplies inventory

Supplies expense

Prepaid insurance

Insurance expense

Buildings and equipment

Depreciation expense

McGraw-Hill/Irwin

Slide 12

A = L + SE
ASSETS

LIABILITIES

Debit
Credit
for
for
Increase Decrease

Debit
Credit
for
for
Decrease Increase

Next, lets see how

Revenues and
Expenses affect
Retained Earnings.

McGraw-Hill/Irwin

CONTRIBUTED
CAPITAL

RETAINED
EARNINGS

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Decrease Increase
Slide 13

How are Financial Statements

Prepared?
Income
Statement

Revenues Expenses = Net Income

Statement of
Retained
Earnings

Beginning Retained Earnings

+ Net Income
- Dividends Declared
Ending Retained Earnings

Balance
Sheet

Statement
of Cash Flows
McGraw-Hill/Irwin

Assets = Liabilities + Stockholders Equity

Contributed Capital
Retained Earnings
Change =
Cash from Operating Activities
in
+ Cash from Investing Activities
Cash
+ Cash from Financing Activities
Slide 14

End of Chapter 3

2009 The McGraw-Hill Companies, Inc.