Accounting Ch.3

What are the 2 types of issues that arise when reporting income to users?

1. Recognition issues: When should the effects of operating activities be recognized (recorded) 2. Measurement issues: What amounts should be recognized?

When recording a loss on the sale of fixed assets, the account loss on disposal of assets is increased with

A debit

What is prepaid expense the opposite of?

Accrued expenses

Which circumstance would cash basis accounting always report lower revenue than accrual basis accounting?

Accts Receivable increases and unearned revenue remains unchanged for the period

What would appear only on accrual based and not on cash based financial statements?

Accts receivable on the balance sheet and unearned revenue on the balance sheet.

What would appear only on accrual and not on cash basis of accounting?

Accts receivable on the balance sheet and unearned revenue on the balance sheet. Sales on the income statement would appear on both.

What is pretax income?

Adding and subtracting other items to operating income gives a subtotal of income before income taxes

Why are adjusting entries required before financial statements are prepared?

All expenses and revenue during the period are recorded

What is income tax expense?

Also called Provision for Income Taxes. It's the last expense listed on the income statement before determining net income. All profit making corporations are required to compute income taxes owed to federal, state, and foreign governments. Income tax expense is calculated as a percentage of pretax income determined by applying the tax rates of federal, state, local, and foreign taxing authorities. EX: Chipotle's effective tax rate in 2011=38.5%. This indicates that for every dollar of income before taxes that Chipotle made in 2011, the company paid nearly $.39 to taxing authorities

What is investment income?

Also called investment revenue, interest revenue, or dividend revenue. Using excess cash to purchase stocks or bonds in other companies is an investing activity for Chipotle and not the central operation of making and selling food. Therefore, any interest or dividends earned on investments in other companies are not included in operating revenue.

What happens when cash is paid after the cost is incurred to generate revenue?

Although rent and supplies are typically purchased before they are used, many costs are paid after goods or services have been received or used. Examples include using electric and gas utilities in the current period that are not paid until the following period, using borrowed funds and incurring Interest Expense to be paid in the future, and owing wages to employees who worked in the current period. When Chipotle's restaurants use employees to make and serve food in the current accounting period (and thus assist in generating revenues), the company records Salaries and Wages Expense. Any amount that is owed to employees art the end of the current period is recorded as a liability called Accrued Expenses Payable (also called Salaries Payable or Wages Payable)

What is Salaries and Wage Expense?

Amount employees worked to generate sales during the period

What is accrued expenses payable?

Amounts owed for services received

What is supplies expense?

Amounts used to produce and sell products

What is the unadjusted trial balance?

An internal report used to determine whether total debits equal total credits

What is an expenditure?

Any outflow of cash for any purpose, whether to buy equipment, pay off a bank loan, or pay employees their wages

What is the accounting equation?

Assets=liabilities + stockholders' equity +revenues-expenses

What is the time period assumption?

Because decision makers require info periodically about a company's financial condition and performance, to measure income for a specific period of time, accountants must follow the time period assumption, which assumes that the long life of a company can be reported in shorter time periods such as months, quarters, and years.

When may expenses be incurred?

Before, after, or at the same time as cash is paid

What do T accounts show?

Beginning balances of zero for all income statement accounts, the prior period ending balances as beginning balances for all balance sheet accounts, and the activity for the current period. Not: Beginning balances of zero for all income statement accounts or the prior period ending balances as beginning balances for all income statement accounts

What activities are part of the operating cycle?

Buying goods and services, paying cash to suppliers, and collecting cash from customers

Not all activities affecting an income statement are

Central to ongoing operations. Any revenues, expenses, gains, or losses that result from these other activities are not included as part of operating income but are instead categorized as other items

What is operating?

Collecting cash from customers for services provided

Instead of reducing Retained Earnings directly when dividends are declared,

Companies may use the account Dividends Declared which has a debit balance.

What happens when cash is paid before the expense is incurred to generate revenue?

Companies purchase many assets that are used to generate revenues in future periods. Examples include buying insurance for future coverage, paying rent for future use of space, and acquiring supplies and equipment for future use. When revenues are generated in the future, the company records an expense for the portion of the cost of assets used-costs are matched with benefits EX: Chipotle buys paper supplies (napkins, bags, cups, etc) in one month, but uses them the following month. When acquired, the supplies are recorded as an asset called Supplies b/c they will benefit future periods. When they are used the following month, Supplies Expense is recorded for the month and the asset Supplies is reduced to the amount yet to be used. Similarly, rent, insurance, and advertising that are prepaid are often recorded as an asset called Prepaid expenses and expensed when used.

What is Gain (Loss) on disposal of assets?

Companies sell property, plant, and equipment from time to time to maintain modern facilities. They also sell investments as needed. Selling these assets for more than their purchase price does not result in earning revenue b/c the transaction is not the central operating focus for the business. Gains result in increases in assets or decreases in liabilities from peripheral transactions. Losses are decreases in assets or increases in liabilities from peripheral transactions.

What does shortening the operating cycle do?

Creates incentives that encourage customers to buy sooner and/or pay faster improves a company's cash flows. The operating cycle for Chipotle is relatively short. It spends cash to purchase fresh ingredients, prepares the food, and sells it to customers for cash. In some cases, inventory is paid for well before it is sold. Toys R Us builds its inventory for months preceding the year end holiday season. It borrows funds from banks to pay for the inventory and repays the loans with interest when it receives cash from customers. In other companies, cash is received well after a sale takes place. Furniture retailers often allow customers to make monthly payments over several years.

What are examples of operating activities?

Credit for Payment of supplies, Credit for prepaid assets, Credit to payments to employees, and debit for collections from customers

A company receives $12K from a tenant for 4 months rent in advance. What's the entry?

Credit to unearned rent revenue b/c the rent has not yet been earned and debit to cash

Which accounts are often associated with operating activities?

Current assets and current liabilities

A company paid $55K to employees who worked this month for $30K and last month for $25K (recorded last month as a liability in Accrued Expenses Payable. What's the entry?

Debit to accrued expenses payable of $25K and wages expense for $30k and credit to cash of $55k

What happens when cash is paid in the same period as the expense is incurred to generate revenue?

Expenses are sometimes incurred and paid for in the period in which they arise. An example is paying for repairs on grills the day of the service. If Chipotle spends $275 cash to repair grills so that food can be prepared to sell, an expense is incurred and recorded

What activities provide the money needed to pay for resources?

Financing activities

When does operating revenue result?

From the sale of goods or services. When Chipotle sells tacos to customers, it has earned revenue. When revenue is earned, assets such as cash or accts receivable often increase

How do many companies generate revenues from a variety of sources?

GM reports revenues from its automotive sales as well as providing financing to customers. In the restaurant industry, many companies such as McDonald's have company owned stores but also sell franchise right. The franchisor (seller) reports revenues from both the sales of food in company owned stores and the fees from franchises. Chipotle does not sell franchises. Therefore, the company generates revenues from one source-sales of food orders to customers-that is reported in the Restaurant Sales Revenue account.

What does a common sized income statement do?

Helps to identify changes in expenses relative to net sales and presents each income statement line item as a percentage of net sales

What does net profit margin measure?

How much of every sales dollar generated during the period is profit. Differences among industries result from the nature of the products or services provided and the intensity of competition. Differences among competitors in the same industry reflect how each company responds to changes in competition (and demand for the product or service) and changes in managing sales volume, sales price, and costs

How can you tell if a company uses the multi step format?

If you see the Operating income (income from operations) subtotal

What are General and Administrative expenses?

Include costs of renting headquarters facilities, executive salaries, and training managers. These are typically expenses that are not directly related to operating stores.

What are subtotals found on a multiple step income statement?

Income before taxes and operating income

A company sells a delivery truck for $500 more than book value. What will the sale result in?

Increase in net income on the income statement

What are revenues?

Increases in assets or settlements of liabilities from ongoing operations.

What activities are the acquiring and disposing of assets that an organization uses in its business?

Investing activities

What are examples of Other items on the income statement?

Investment income, interest expense, and gain (loss) on disposal of assets

If Notes Payable is on the balance sheet at the end of the accounting period,

It is most likely that Interest expense will be listed below income from operations and interest expense will be on the income statement

What is the problem with cash basis accounting?

It may lead to an incorrect interpretation of future company performance. Performance over time can appear uneven when it really isn't. Sales can be earned evenly each year although collections from customers were not. The years for which insurance and supplies were paid for may not be the same year they were used. Financial statements created under cash basis accounting normally postpone or accelerate recognition of revenues and expenses long before or after goods and services are produced and delivered (when cash is received or paid). They do not necessarily reflect all assets or liabilities of a company on a particular date.

What is the single step format?

It reorganizes all accounts from the multi step format. All revenues and gains are listed together, and all expenses and losses except taxes are listed together. The expense subtotal is then subtracted from the revenue subtotal to arrive at income before taxes, the same subtotal as on the multiple step statement.

What is accrued expenses classified as?

Liability

If there is a gain on the sale of assets,

Net income will be greater

What is the formula for calculating earnings per share?

Net income/weighted average number of shares outstanding

What does unadjusted trial balance mean?

No end of period adjustments have been made yet to reflect all revenues earned and expenses incurred during the quarter. Therefore, the trial balance is unadjusted until adjustments are made.

What is a key difference between expenditures and expenses?

Not all cash expenditures are expenses, but expenses are necessary to generate revenues.EX: Chipotle's employees make and serve food. The company uses electricity to operate equipment and light its facilities, and it uses food and paper supplies. W/o incurring these expenses, Chipotle could not generate revenues.

What are the primary sources of revenues and expenses involved in running a business?

Operating activities

What is operating income?

Operating revenues less expenses. Also called income from operations. A measure of the profit from central ongoing operations.

What are expenses?

Outflows or the use of assets or increases in liabilities from ongoing operations incurred to generate revenues during the period

What are examples of prepaid expense accounts?

Prepaid insurance, prepaid rent, not: prepaid land or prepaid dividends

What is the difference between rent expense and prepaid rent?

Prepaid rent is an asset on the balance sheet and represents the amount of rent paid in advance. Prepaid rent will be expensed during the period the rent is used. The amount of rent used during the period is reported on the Income statement as rent expense.

What are the steps in a typical operating cycle?

Purchase goods and services on credit, then pay cash to suppliers, then sell goods and services to customers for cash, and then receive cash from customers

In addition to annual reports, what do most businesses prepare?

Quarterly financial statements known as interim reports covering a 3 month time period for external users. The SEC requires public companies to do so.

What is cash basis accounting?

Records revenues when cash is received and expenses when cash is paid. This basis produces net operating cash flow, which is often quite adequate for organizations that do not need to report to external users.

What is accrual basis accounting?

Records revenues when earned and expenses when incurred, regardless of the timing of cash receipts or payments.

What is occupancy expense?

Renting facilities, insuring property and equipment at the stores, and using utilities are typical expense related to occupying facilities. Usually rent and insurance is paid before occupying the facilities, but utilities are paid after occupying the facilities.

What kind of account is fees earned considered?

Revenue

At Chipotle, cash may be received before, when, or after food delivery, but

Revenue is recorded when food is delivered

How do revenues affect the financial statements?

Revenues increase stockholders' equity through the account Retained Earnings and therefore have credit balances. Recording revenues results in either increasing an asset or decreasing a liability.

What would salaries expenses and supplies expense be classified as on a company's income statement?

Salaries expense and supplies expense

What is Net Sales?

Sales revenue less any returns from customers and other reductions. For companies in the service industry, total operating revenues is equivalent to net sales.

What are differences in how GAAP and IFRS report expenses?

Similar expenses are reported, but they may be grouped in different ways. In GAAP, public companies categorize expenses by business function (production, research, marketing, general operations). In IFRS, companies can categorize expenses by either function or nature (salaries, rent, supplies, electricity). Foreign companies often use account titles that differ from those used by US companies

What is interest expense?

Since borrowing money is a financing activity, any cost of using that money is not an operating expense. Except for financial institutions, incurring interest expense and earning investment income are not the central operations of most businesses, including Chipotle. We say these are peripheral (normal but not central) transactions

When does unearned revenue result?

Sometimes, if a customer pays for goods or services in advance, a liability account, usually Unearned (or Deferred) revenue is created. At this point, no revenue has been earned. There is simply a receipt of cash in exchange for a promise to provide a good or service in the future. When the company provides the promised goods or services to the customer, then the revenue is reorganized and the liability eliminated.

What is the income statement called in IFRS?

Statement of operations

What is the revenue realization principle?

States that revenues are recognized when 1. Delivery has occurred or services have been rendered. The company has performed or substantially performed the acts promised to the customer by providing goods or services 2. There is persuasive evidence of an arrangement for customer payment. In exchange for the company's performance, the company has provided cash or a promise to pay cash (a receivable) 3. The price is fixed or determinable. There are no uncertainties as to the amount to be collected 4. Collection is reasonably assured. For cash sales, collection is not an issue since it is received on the date of the exchange. For sales on credit, the company reviews the customer's ability to pay. If the customer is considered creditworthy, collecting cash from the customer is reasonably likely. If any of the 4 criteria are not met, revenue normally is not recognized and can't be recorded. These conditions normally occur when the title, risks, and rewards of ownership have transferred to the customers. For most businesses, these conditions are met at the point of delivery of goods or services regardless of when cash is received.

What does a multiple step income statement display?

Subtotals that indicate multiple steps before reaching net income at the bottom. The subtotals displayed include income from operations and profit before taxes

What is true regarding supplies and the income statement?

Supplies expense is on the income statement and reports the amounts of supplies used during the period

What does the expense matching principle require?

That costs incurred to generate revenue be recognized in the same period -a matching of costs with benefits. Expenses are recorded regardless of when cash is paid. Cash may be paid before, during, or after an expense is incurred and another on the date cash is paid if they occur at different times. EX: When Chipotle provides food service to customers, revenue is earned

Where do companies usually disclose their revenue recognition practices?

The Significant Accounting Policies Notes to the Financial Statements

What does unearned revenue report?

The amount of cash collected from customers in advance on the balance sheet

What are some cautions about the profit margin?

The decisions that management makes to maintain the company's net profit margin in the current period may have negative long run implications. Analysts should perform additional analysis of the ratio to identify trends in each component of revenues and expenses. This involves dividing each line on the income statement by net sales. Statements with these percentages are called common sized income statements. Changes in the percentages of the individual components of net income provide information on shifts in management's strategies.

Until a company ceases its activities,

The operating cycle is repeated continuously

What are the 2 basic principles that determine when revenues and expenses are recorded?

The revenue realization principle and expense matching principle.

What is the operating (cash to cash) cycle?

The time it takes for a company to pay cash to suppliers, sell goods and services to customers, and collect cash from customers. It begins when a company receives goods to sell (or in the case of a service company has employees work), pays for them and sells to customers. It ends when customers pay cash to the company. The length of time for completion depends on the nature of the business.

What do companies usually disclose?

Their revenue recognition practices in the financial statement note titled Significant Accounting Policies

What are other operating expenses?

These include advertising and marketing costs and repair and maintenance of store facilities

What happens to assets when an expense is incurred?

They decrease b/c they are used up or liabilities increase such as wages or utilities payable

How do expenses affect the financial statements?

They decrease net income, thus decreasing Retained Earnings and stockholders' equity. Therefore, they have debit balances (opposite of the balance in Retained Earnings). To increase an expense, you debit it, thereby decreasing net income and Retained Earnings. Recording an expense results in either decreasing an asset (such as supplies when used) or increasing a liability (such as Wages Payable when money is owed to employees)

What is the long term objective for any business?

To turn cash into more cash. If a company is to stay in business, this excess cash must be generated from operations not from borrowing money or selling fixed assets.

Performing services on account will increase

Total assets and stockholders' equity

On the income statement, income from operations differs from income before income taxes in that

Transactions that are non operating or infrequently occurring are subtracted from Income from operations to arrive at income before income taxes.

Whats is a good starting point for determining which accounts require adjustment?

Unadjusted trial balance

What is Depreciation expense?

When a company uses buildings and equipment to generate revenues, a part of the cost of these assets is reported as an expense.

What is multiple step format?

When it has multiple subtotals such as operating income and income before taxes

What is the key determinant of when to report revenue?

Whether the business has done what it promised to do. Revenue is earned when the business delivers goods or services although cash can be received from customers in a period before delivery, in the same period as delivery, or in a period after delivery

What do the totals on a trial balance reveal?

Whether the total debits equal the total credits

What are gains on the sale of assets recorded as?

With a credit. Gains occur when the cash received is greater than the asset's value on the books. Gains increase stockholders' equity and are recorded with a credit.

To see the details of increases and decreases in a company's cash account,

You should look at the company's general ledger