Ch3 ACCT1101 PPT

3
Dr. Olivia Leung

ACCT1101
HKU Business School
chapter Operating Decisions and
the Accounting System
Financial Accounting
9e
11e
Libby • Libby • Hodge
3-1
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Learning Objectives
After studying this chapter, you should be able to:
3-1 Describe a typical business operating cycle and explain the
necessity for the time period assumption.
3-2 Explain how business activities affect the elements of the

income statement.
3-3 Explain the accrual basis of accounting and apply the revenue
and expense recognition principles to measure income.
3-4 Apply transaction analysis to examine and record the effects of

operating activities on the financial statements.
3-5 Prepare a classified income statement.
3-6 Compute and interpret the net profit margin ratio.
Lecture Exercises: E3-12 & COMP3-1
3-2
3-3
3-4
The Accounting Cycle
(From Ch 2)
Steps:
(1) Journalize daily business transactions in
general journal using journal entries.
(2) Post journal entries to Ledger (or T-
Accounts).
(3) Prepare Trial Balance based on T-Account
balances (or Ledger balances).
(4) To be continued in Chapter 3…
3-5
Steps:
(in summary)
(1) Journalize daily business transactions in general journal.
(2) Post journal entries to ledger (or T-Accounts).
(3) Prepare Unadjusted Trial Balance.
(4) Journalize & Post adjusting entries at period end.
(5) Prepare Adjusted Trial Balance.
(6) Prepare Financial Statements.
(7) Journalize & Post closing entries.
(8) Prepare Post-Closing Trial Balance.
Your accounting system is then ready for next year !
Steps (1-3) are in Ch 2 & 3.
Steps (4-8) are in Ch 4.
3-6
Learning Objective 3-1
3-1 Describe a typical business operating cycle and explain the
necessity for the time period assumption.
3-7
The Operating Cycle (1 of 2)
3-8
The Operating Cycle (2 of 2)
Accountants follow the time period assumption, which assumes that the
long life of a company can be reported in shorter time period such as:
• months
• quarters
• years
Two issues arise when reporting periodic income:

1) Recognition issues: When should the effects of operating activities
be recognized (recorded)?
2) Measurement issues: What amounts should be recognized?
3-9
3-2 Explain how business activities affect the elements of the
income statement.
3-10
Elements of the Income Statement
Revenues Expenses
Increases in assets or Decreases in assets or
settlements of liabilities increases in liabilities from
from the major or central ongoing operations incurred
ongoing operations. to generate revenues.
main biz
not main biz
Gains Losses
Increases in assets or Decreases in assets
settlements of or increases in
liabilities from liabilities from
peripheral peripheral
transactions. transactions.
accural basis: depends on service received

cash basis: depends on payment type
3-11
Exhibit 3.1 Chipotle Mexican Grill’s Income Statement
*The information
has been adapted
from actual
statements and
simplified for this
chapter.
3-12
Operating Revenues
• The amounts earned and recorded from a company’s day-

to-day business activities.
• Amount earned when a company sells products or
provides services to customers or clients.
• Earnings from the central focus of the business. e.g., when
Chipotle sells burritos, it has earned revenue.
3-13
Operating Expenses
• Operating expenses are the costs of operating the business that are
incurred to generate revenues during the period.
• Incurred = the resources or services of others that are used
• Many expenses are incurred in making a sale or providing a service.
• Expenses may be incurred before, after, or at the same time as they are
paid in cash.
• Don’t confuse expenditures and expenses! An expenditure is an
outflow of cash for any purpose, whether to buy equipment, pay
off a bank loan, or pay employees their wages.
• Therefore, not all cash expenditures are expenses!
Cash
expenditures
Debt Asset
payments purchases
Expenses
3-14
Examples of Chipotle’s Operating Expenses
Depreciation
Repairs expense Supplies
expense expense
Utilities
Wages
expense
expense
Insurance
Rent expense
expense
Losses (gains) General &

on disposal of administrative
assets expense
3-15
Other Income Statement Items
Not all activities affecting the income statement are “central to
ongoing operations”.
Revenues, expenses, gains, or losses that result from other

activities that are NOT central to ongoing operations are
categorized as Other Items.
These items are not included in the subtotal “Income from

Operations”.
Other items typically include:

v Interest Revenue (also Investment Revenue, Investment Income,
or Dividend Revenue)
v Interest Expense
v Losses (Gains) on Sale of Investments
3-16
Typical Income Statement Format
Operating Revenues
Less Operating Expenses
Income from Operations
Add/Less: Other Items
Income before Income Taxes (or Pretax Income)
Income Tax Expense
Net Income
Corporations are required to disclose earnings per share (EPS) on the
income statement or in the notes to the financial statements.
3-17
How Are Operating Activities Recognized and Measured?
(1 of 2)
Cash Basis Accounting
§ Cash basis accounting is used by many sole proprietors
and small partnerships to determine performance.
§ It is simple and permitted for tax purposes.
§ Cash basis accounting records each cash payment as a
cash outflow and each cash receipt as a cash inflow.
§ This produces net cash flow information that is often
quite adequate for organizations that do not need to
report to external users.
CAUTION: Cash basis accounting

may lead to an incorrect Revenue = cash received
interpretation of future company Less: Expenses = cash payments
performance. GAAP does not allow Net Income (cash basis)
the cash basis of accounting.
3-18
3-3 Explain the accrual basis of accounting and apply the revenue
and expense recognition principles to measure income.
3-19
How Are Operating Activities Recognized and Measured?
(2 of 2)
Accrual Basis Accounting
§ Accrual basis accounting is required by GAAP and used to report to
external decision makers.
§ The accounting principles that determine when revenues and
expenses are recorded are the revenue recognition principle and
the expense recognition principle (also called the matching
principle).
§ Revenues are recognized when goods and services are
provided to customers (they are earned)
§ Expenses are recognized in the same period as the revenues
to which they relate (resources are used or debts are incurred
to generate revenues), regardless of when cash is received or
paid.
3-20
Revenue Recognition Principle
The revenue recognition principle specifies the timing and amount of
revenue to be recognized during an accounting period.
Revenue is recognized (1) when the company transfers promised goods or
services to customers (2) in the amount it expects to be entitled to receive.
The five steps to follow for recognizing revenue for complex contracts
are:
1. Identify the contract between the company and the customer.
2. Identify the seller’s performance obligations (promised goods
and services).
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when each performance obligation is satisfied
(or over time if a service is provided over time).
The critical point for revenue recognition under the five-step model is when
goods or services are delivered, not when cash is received from customers.
3-21
Exhibit 3.2 Revenue Revenues versus Cash Receipts
Cash may be received at any of these times:

1. Before the goods or services are delivered.
2. In the same period as the goods or services are delivered.
3. After the goods or services are delivered.
Revenue is always recorded when the goods or services are delivered, not
when the cash is received from customers.
3-22
Revenue Recognition Principle (1 of 3)
(1) If cash is received before the company delivers goods or

services, the liability account UNEARNED REVENUE is recorded.
On receipt of a $100 cash deposit: Debit Credit

Cash (+A) 100
Unearned Revenue (+L) 100
On delivery of ordered food: Debit Credit

Unearned Revenue (-L) 100
Restaurant Sales Revenue (+R, +SE) 100
3-23
(2) When cash is received in the same period as the goods or

services are delivered.
On delivery of ordered food for $12 cash: Debit Credit

Cash (+A) 12
3-24
(3) If cash is received after the company delivers goods or services, an

asset ACCOUNTS RECEIVABLE is recorded.
On delivery of ordered food for $50 on account: Debit Credit

Accounts Receivable (+A) 50
On receipt of cash after delivery: Debit Credit

Cash (+A) 50
Accounts Receivable (-A) 50
3-25
Expense Recognition Principle
The expense recognition principle (also called the matching
principle) requires that costs incurred to generate revenues be
recognized in the same period—a matching of costs with benefits.
The costs of generating revenue include expenses incurred such as:

• Salaries and wages to employees who worked during the period.
• Utilities for the electricity used during the period.
• Supplies used during the period.
• Facilities rented during the period.
• Equipment used during the period.
Expenses are recorded as incurred, regardless of when cash is paid.
3-26
Exhibit 3.3 Recording Expenses versus Cash Payments
Cash may be paid at any of these times:

1. Before the expense is incurred to generate revenue.
2. In the same period as the expense is incurred to generate revenue.
3. After the cost is incurred to generate revenue.
Expense is always recorded when the cost is incurred, not when the cash is
paid.
3-27
Expense Recognition Principle (1 of 3)
(1) Cash is paid before the expense is incurred to generate revenue.
On payment of $200 cash for supplies: Debit Credit

Supplies (+A) 200
Cash (-A) 200
On subsequent use of half of the supplies: Debit Credit

Supplies Expense (+E, -SE) 100
Supplies (-A) 100
3-28
(2) Cash is paid in the same period as the expense is incurred to

generate revenue.
On payment of $275 cash for using repair service: Debit Credit

Repairs Expense (+E, -SE) 275
Cash (-A) 275
3-29
(3) Cash is paid after the expense is incurred to generate revenue.
On the use of $400 in employees’ services Debit Credit

during the period:
Wages Expense (+E, -SE) 400
Wages Payable (+L) 400
On payment of cash after using employees: Debit Credit

Wages Payable (-L) 400
Cash (-A) 400
3-30
3-4 Apply transaction analysis to examine and record the effects of
operating activities on the financial statements.
3-31
Exhibit 3.4 Expanded Transaction Analysis Model
Note: As expenses
increase (are debited),
net income, retained
earnings, and
stockholders’ equity
ASSETS
(many
= LIABILITIES
(many
+ STOCKHOLDERS’ EQUITY
decrease.
accounts) accounts) Contributed Capital Earned Capital
(2 accounts) (1 account)
+ − – + Common Stock and Retained
Debit Credit Debit Credit Additional Paid-in Earnings
Capital
– + – +
Debit Credit Debit Credit
Issuance of Dividends Net = REVENUES
(many
EXPENSES
(many
–
Stock declared income accounts)
accounts)
+ +
Credit Debit
Note: Instead of reducing Retained Earnings directly when dividends are declared, companies
may use the account Dividends Declared, which has a debit balance.
3-32
In summary:
Understand how revenues and expenses impact the balance sheet and
income statement:
3-33
Exhibit 3.5
Transaction Analysis Steps
Step 1: Ask → Was a revenue earned by delivering goods or services?
If so, credit the revenue account and debit the appropriate accounts for
what was received.
or Ask → Was an expense incurred to generate a revenue in the current period?
If so, debit the expense account and credit the appropriate accounts for
what was given.
or Ask → If no revenue was earned or expense incurred, what was received
and given?
Debit the account for what was received
Credit the account for what was given
• Identify the accounts affected by title (e.g., Cash and Notes Payable).
Remember: Make sure that at least two accounts change.
• Determine the direction of the effect. Did the account increase (+) or
decrease (−)?
• Classify them by type of account: asset (A), liability (L), stockholders’ equity
(SE), revenue/gain (R), or expense/loss (E).
Step 2: Verify → Is the accounting equation in balance? (A = L + SE)

3-34
Analyzing Chipotle’s Transactions (1 of 12)
We will now analyze, record, and post to the T-accounts the
effects of the first quarter’s operating activities for Chipotle.
• The T-accounts begin with the trial balance amounts in Exhibit

2.8.
• All amounts are in millions of dollars, except per share
information.
For each journal entry:

• When a revenue or expense is recorded, we insert (+R, +SE)
for revenues and (+E, −SE) for expenses to emphasize the
effect of the transaction on the accounting equation and to
see that the equation remains in balance.
• Debits equal credits!
3-35
Exhibit 2.8 T-Accounts
After analyzing the transactions from (a)–(h), the T-accounts balances are:
3-36
(1) Chipotle sold food and beverages to customers for $1,359; $44
was sold to universities on account (to be paid by the universities
next quarter) and the rest was received in cash from customers.
3-37
(2) Assume Chipotle purchased packaging supplies costing $459

during the quarter, paying $379 in cash, and owing the rest on
account to the suppliers.
3-38
(3) At the beginning of January, Chipotle paid $207 cash for rent,
insurance, and advertising to be used in the future (all included in
the account Prepaid Expenses until used).
3-39
(4) Chipotle paid $65 as training expense for management during the
quarter.
3-40
(5) Chipotle paid employees $342 for work this quarter and $47 for
work last quarter (recorded last quarter as Wages Expense and Wages
Payable for the amount owed to employees who worked then).
3-41
(6) Chipotle sold land costing $21 for $12 cash, resulting in a loss of $9
on the disposal of the asset.
3-42
(7) Chipotle received $61 cash from customers paying on their

accounts.
3-43
(8) During the quarter, assume Chipotle paid $66 on accounts payable
to suppliers and paid $25 on utilities payable (recorded last quarter
as Utilities Expense and Utilities Payable for the amount owed for
utility service used last year).
3-44
(9) Chipotle paid $117 for utilities used during the quarter and paid
$35 for repairs of its buildings and equipment during the quarter.
3-45
(10) During the quarter, Chipotle sold gift cards to customers for $35
in cash (expected to be redeemed for food next quarter).
3-46
(11) Assume Chipotle received $3 cash as interest revenue earned

during the quarter.
3-47
Exhibit 3.6 T-Accounts Summary Balance Sheet Accounts
3-48
Exhibit 3.6 T-Accounts Summary Income Statement Accounts
3-49
Lecture Exercise
E3-12
3-50
E3-12
Additional Accounts the company has:

Consulting fees revenue,
Interest Revenue
Salaries Expense,
Utilities Expense
3-51
Required:
(1) Journalize the transactions
3-52
3-53
3-54
(2) Post the transactions to T-Accounts
3-55
3-56
(3) Prepare (Unadjusted) Classified Income Statement
For the year ended Dec 31 (Ignore income taxes).
3-57
3-5 Prepare a classified income statement.
3-58
How Is the Income Statement Prepared and Analyzed?
3-59
Exhibit 3.7 Unadjusted Income Statement
Classified
seperated diff types of income
Income revenue
based on whether they’re
Statement earned in
operating VS non operating
Note: Because this statement is

based on unadjusted balances, it
would not be presented to external
users.
3-60
3-6 Compute and interpret the net profit margin ratio.
3-61
Net Profit Margin Ratio
How effective is management in generating profit on every dollar of sales?
Net Profit = Net Income

Margin Net Sales (or Operating Revenues)
A rising net profit margin signals more efficient management of sales

and expenses.
Note: Net sales is sales revenue less any returns from customers and other reductions. For companies
in the service industry, total operating revenues is equivalent to net sales.
3-62
Steps:
(in summary)
(1) Journalize daily business transactions in general journal.
(2) Post journal entries to ledger (or T-Accounts).
(3) Prepare Unadjusted Trial Balance.
(4) Journalize & Post adjusting entries at period end.
(5) Prepare Adjusted Trial Balance.
(6) Prepare Financial Statements.
(7) Journalize & Post closing entries.
(8) Prepare Post-Closing Trial Balance.
Your accounting system is then ready for next year !
Steps (1-3) are in Ch 2 & 3.
Steps (4-8) are in Ch 4.
3-63
Ch 3 Assignment
current month: Ad expense

next month: pre-paid
previous month: Ad expense payable
3-64
3-65
3-66
no cash no delivery!!
3-67
3-68
MORE EXERCISE: COMP3-1
(Ch 1 to Ch3)
3-69
3-70
3-71
3-72
3-73

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3

Dr. Olivia Leung

3-2 Explain how business activities affect the elements of the

3-4 Apply transaction analysis to examine and record the effects of

3-5 Prepare a classified income statement.

3-6 Compute and interpret the net profit margin ratio.

Lecture Exercises: E3-12 & COMP3-1

Two issues arise when reporting periodic income:

accural basis: depends on service received

• The amounts earned and recorded from a company’s day-

Losses (gains) General &

Revenues, expenses, gains, or losses that result from other

These items are not included in the subtotal “Income from

Other items typically include:

CAUTION: Cash basis accounting

Cash may be received at any of these times:

(1) If cash is received before the company delivers goods or

On receipt of a $100 cash deposit: Debit Credit

On delivery of ordered food: Debit Credit

(2) When cash is received in the same period as the goods or

On delivery of ordered food for $12 cash: Debit Credit

(3) If cash is received after the company delivers goods or services, an

On delivery of ordered food for $50 on account: Debit Credit

On receipt of cash after delivery: Debit Credit

The costs of generating revenue include expenses incurred such as:

Expenses are recorded as incurred, regardless of when cash is paid.

Cash may be paid at any of these times:

(1) Cash is paid before the expense is incurred to generate revenue.

On payment of $200 cash for supplies: Debit Credit

On subsequent use of half of the supplies: Debit Credit

(2) Cash is paid in the same period as the expense is incurred to

On payment of $275 cash for using repair service: Debit Credit

(3) Cash is paid after the expense is incurred to generate revenue.

On the use of $400 in employees’ services Debit Credit

On payment of cash after using employees: Debit Credit

Step 2: Verify → Is the accounting equation in balance? (A = L + SE)

• The T-accounts begin with the trial balance amounts in Exhibit

For each journal entry:

(2) Assume Chipotle purchased packaging supplies costing $459

(7) Chipotle received $61 cash from customers paying on their

(11) Assume Chipotle received $3 cash as interest revenue earned

Additional Accounts the company has:

Note: Because this statement is

Net Profit = Net Income

A rising net profit margin signals more efficient management of sales

current month: Ad expense

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