Operating Decisions

and the Accounting System

Chapter 3
Learning Objectives
 LO3-1 Describe a typical business operating cycle and
explain the necessity for the periodicity assumption.
 LO3-2 Explain how transactions arising from operating
activities affect the elements of the statement of
earnings.
 LO3-3 Explain the accrual basis of accounting and apply
the revenue recognition principle and the matching
process to measure net earnings.
 LO3-4 Apply transaction analysis to recognize, classify,
and record the effects of transactions arising from
operating activities on the financial statements.
Learning Objectives Continued
 LO3-5 Prepare a classified statement of earnings and
explain the difference between net earnings and cash
flow from operations.
 LO3-6 Compute and interpret the total asset turnover
ratio and the return on assets.

SUPPLEMENTARY MATERIAL
 LO3-S1 Explain earnings measurement and
comprehensive income.
The Operating Cycle (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.
The Periodicity Assumption
 To meet the needs of decision makers, we report financial
information for relatively short time periods (monthly,
quarterly, annually).
 Two types of issues arise in reporting periodic net
earnings to users:
 Recognition issues. When should the transactions and
their effects of operating activities be recognized,
classified, and recorded?
 Measurement issues. What amounts should be
recognized and recorded for the transactions?
Classified Statement of Earnings
 The statement of earnings includes a number of sections
and subtotals to aid the user in identifying the company’s
earnings from operations for the year, and to highlight
the effect of other items on net earnings.

 Most manufacturing and merchandising companies use

the following basic structure as shown on the next slide.
Classified Statement of Earnings basic structure:
    Net sales
    − Cost of sales
    = Gross profit
    − Operating expenses
    = Earnings from operations
+/−  Non-operating revenues/expenses and gains/losses
    = Earnings before income taxes
    − Income tax expense
    = Earnings from continuing operations
+/−  Earnings/loss from discontinued operations
    = Net earnings
Classified Statement of Earnings
 The statement of earnings includes three major sections: 
1. Results of continuing operations
2. Results of discontinued operations
3. Earnings per share

 All companies report information for sections 1 and 3,

while some companies report information in section 2,
depending upon their particular circumstances.

 The bottom line, net earnings, is the sum of sections 1

and 2.
Continuing Operations
 This section of the statement of earnings presents the
results of normal or continuing operations. 

 Revenues are defined as increases in assets or

settlements of liabilities from ongoing operations of the
business. Operating revenues result from the sale of
goods or services. 

 Expenses are decreases in assets or increases in liabilities

from ongoing operations, and are incurred to generate
revenues during the period. 
Primary Operating Expenses
 The following are primary operating expenses for most
merchandising companies: 
 Cost of sales is the cost of products sold to customers. In
companies with a manufacturing or merchandising focus, the
cost of sales (also called cost of goods sold) is usually the most
significant expense. The difference between sales—net of
sales discounts, returns, and allowances—and cost of sales is
known as gross profit (or gross margin).
 Operating expenses are the usual expenses, other than cost of
sales, that are incurred in operating a business during a
specific accounting period. The expenses reported will depend
on the nature of the company’s operations.
 Earnings from operations, also called operating income,
equals net sales less cost of sales and operating expenses.
Primary Operating Expenses Continued
Non-Operating Items
 Not all activities affecting a statement of earnings are
central to continuing operations.
 Any revenues, expenses, gains, or losses that result from
these other activities are not included as part of earnings
from operations but instead categorized as other income
or expenses.
 These typically include:
 Interest income, financing costs, gains or losses on disposal of
assets.
 The non-operating items that are subject to income taxes
are added to or subtracted from earnings from operations
to obtain the earnings before income taxes (or pretax
earnings).
Income Tax Expense
 Income tax expense is the last expense listed on the
statement of earnings.
 All for-profit corporations are required to compute
income taxes owed to federal, provincial, and foreign
governments.
 Income tax expense is calculated as a percentage of
earnings before income taxes, reflecting the difference
between income, which includes revenues and gains, and
expenses and losses.
 It is determined by using applicable tax rates. 
Discontinued Operations
 Companies may dispose of a major line of business or a
geographical area of operations during the accounting
period, or decide to discontinue a specific operation in
the near future.
 The net earnings or loss from that component, as well as
any gain or loss on subsequent disposal, are disclosed
separately on the statement of earnings as discontinued
operations.
 Because of their non-recurring nature, the financial
results of discontinued operations are not useful in
predicting future recurring net earnings.
Earnings per Share
 Corporations are required to disclose earnings per share
on the statement of earnings or in the notes to the
financial statements.
 This ratio is widely used in evaluating the operating
performance and profitability of a company.
 Simple earnings per share can be calculated as net
earnings divided by the average number of shares
outstanding during the period.
 The calculation of the ratio is actually more complex and
beyond the scope of this course.
How Are Transactions from Operating Activities
Recognized and Measured?
 Many local retailers and other small businesses use cash
basis accounting, in which revenues are recorded when
cash is received and expenses are recorded when cash is
paid, regardless of when and revenues are earned or the
expenses are incurred.
 A cash basis is often quite adequate for these small
businesses, which usually do not have to report to
external users. 
Cash Basis Accounting
 Financial statements created under cash basis accounting
normally postpone or accelerate recognition of revenues
and expenses long after or before goods and services are
produced and delivered (when cash is received or paid).
 The cash basis also does not necessarily reflect all assets
and liabilities of a company on a particular date.
 Cash basis financial statements are not very useful to
external decision makers.
 IFRS therefore require accrual basis accounting for
financial reporting purposes.
Accrual Accounting
 In accrual basis accounting, revenues and expenses are
recognized when the transaction that causes them
occurs, not necessarily when cash is received or paid. 
 Revenues are recognized when they are earned and
expenses when they are incurred. 
 The revenue recognition principle and the matching
process determine when revenues and expenses are to
be recorded under accrual basis accounting.
The Revenue Recognition Principle
 The revenue recognition principle specifies both the
timing and amount of revenue to be recognized during an
accounting period. It requires that a company recognize
revenue when goods and services are transferred to
customers in an amount it expects to receive.
 Revenue is earned when the business delivers goods or
services, although cash can be received from customers
(1) in a period before delivery, (2) in the same period as
delivery, or (3) in a period after delivery. 
Recording Revenues versus Cash Receipts
Revenue Recognition – Example 1
 Cash is received before the goods or services are
delivered.

On receipt of a $1,000 cash deposit Debit Credit

Cash (+A) 1,000

Deferred revenue (+L) 1,000

On delivery of ordered goods

Deferred revenue (−L) 1,000

Sales revenue (+R, +SE) 1,000
Revenue Recognition – Example 2
 Cash is received in the same period as the goods or
services are delivered.

On delivery of purchased goods for $300

Debit Credit
cash
Cash (+A) 300
Sales revenue (+R, +SE) 300
Revenue Recognition – Example 3
 Cash is received after the goods or services are delivered.

On delivery of purchased goods for $500 on account Debit Credit

Accounts receivable (+A) 500

Sales revenue (+R, +SE) 500

On receipt of cash after delivery

Cash (+A) 500

Accounts receivable (−A) 500
The Matching Process

 The matching process requires that expenses be

recorded when incurred in earning revenue; all of the
resources consumed in earning revenues during a specific
period must be recognized in that same period.

 A matching of costs with benefits.

The Matching Process Continued
 The costs of generating revenue include expenses
incurred, such as:
 Salaries to employees who worked during the period (wages
expense)
 Utilities for the electricity used during the period (utilities
expense)
 Inventory items (e.g., T-shirts, legwear, pants and shorts) that
are sold during the period (cost of sales)
 Facilities rented during the period (rent expense)
 Use of buildings and equipment for production
purposes during the period (depreciation expense)
Recording Expenses versus Cash Payments
 As with revenues and cash receipts, expenses are
recorded as incurred, regardless of when cash is paid. 
 Cash may be paid before, during, or after an expense is
incurred.
 An entry is made on the date the expense is incurred and
another one on the date of the cash payment, if at
different times.
The Matching Process – Example 1
 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 the
assets used—costs are matched with the benefits. 
The Matching Process – Example 1 Continued
 Cash is paid before the expense is incurred to generate
revenue. 

On payment of $2,000 cash for office supplies Debit Credit

Office supplies (+A) 2,000
Cash (−A) 2,000

On subsequent use of half of the supplies

 Supplies expense (+E, −SE) 1,000

Office supplies (−A) 1,000

The Matching Process – Example 2
 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 sewing machines the day of the service. 

On payment of $500 cash for using a repair service

Repairs expense (+E, −SE)  500

Cash (−A)  500
The Matching Process – Example 3
 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 and used.
 Examples include using electric and gas utilities in the
current period that are not paid for 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.
The Matching Process – Example 3 Continued
 Cash is paid after the cost is incurred to generate
revenue. 

On the use of $4,000 employees’ services during the period Debit Credit
Salaries expense (+E, −SE) 4,000
Salaries payable (+L) 4,000

On payment of cash after using employees’ services

 Salaries payable (−L) 4,000

Cash (−A) 4,000

Transaction Analysis Rules
The Expanded Transaction Analysis Model Part 1
 All accounts can increase or decrease, although revenues
and expenses tend to increase throughout a period as
transactions occur.

 For accounts on the left side of the accounting equation,

the increase symbol, +, is written on the left side of the T-
account.

 For accounts on the right side of the accounting equation,

the increase symbol, +, is written on the right side of the
T-account, except for expenses, which increase on the left
side of the T-account.
The Expanded Transaction Analysis Model Part 2
 Debits (dr) are written on the left side of each T-account
and credits (cr) are written on the right.

 Total debits equal total credits when changes arising from

each transaction are recognized, classified, and recorded
in the proper accounts.

 Every transaction affects at least two accounts.

The Expanded Transaction Analysis Model Part 3
 When a revenue or expense is recorded, either an asset
or a liability will be affected as well:

 Revenues increase net earnings, retained earnings, and

shareholders’ equity.
 Revenues have credit balances; that is, to increase a
revenue account, you credit it, which increases net
earnings and retained earnings.
 Recording revenue results in either increasing an asset
(such as cash or accounts receivable) or decreasing a
liability (such as deferred subscriptions revenue).
The Expanded Transaction Analysis Model Part 4
 Expenses decrease net earnings, thus decreasing retained
earnings and shareholders’ equity.
 Expenses have debit balances (opposite of the balance in
retained earnings); that is, to increase an expense, you
debit it, which decreases net earnings 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).
Summary

REVENUES   EXPENSES

•Increase net earnings and •Decrease net earnings and

shareholders’ equity shareholders’ equity

•↑ with credits •↑ with debits

•Accounts have credit balances •Accounts have debit balances

Transaction Analysis Steps:
Step 1: Ask → Was a revenue earned by delivering goods or services?
• If so, credit the revenue account and debit the account for what was
received to recognize the sales transaction.
• or Ask → Was an expense incurred to generate a revenue in the current
period?
• If so, recognize the transaction, debit the expense account, and credit
the appropriate accounts for what was given.
• or Ask → If the transaction resulted in no revenue earned or expense
incurred, what was received and given?
• Identify the accounts affected by title (e.g., cash, deferred revenue). Make
sure that at least two accounts change.
• Classify the accounts by type. Was each account an asset (A), a liability (L),
shareholders’ equity (SE), a revenue/gain (R), or an expense/loss (E)?
• Determine the direction of the effect. Did the account increase [+] or
decrease [−]? 
Step 2: Verify → Is the accounting equation in balance? (A = L + SE) 
How is the Statement of Earnings Prepared and
Analyzed?
 First determine that the debits equal credits after all of
the transactions from the period by generating a trial
balance.
 Accounts are listed in a specific order: assets, liabilities,
and shareholders’ equity accounts are reported on the
statement of financial position, followed by
revenues/gains, and expenses/losses that are reported on
the statement of earnings. 
 The ending account balances that did not change as a
result of the transactions are taken from the beginning
trial balance from the period.
How is the Statement of Earnings Prepared and
Analyzed Continued?
 The accounts that did change due to transactions, their
ending balances are taken from the T-accounts.
 There may also be new accounts that are added from the
previous list of accounts.
 End-of-period adjustments have to be made to reflect all
revenues earned and expenses incurred during the
period.
 Chapter 4 will describe the adjustment process to update
the accounting records.
 After the adjustments are made, the amount of income
tax expense and net earnings will be determined and
reported in the statement of earnings.
Focus on Cash Flows – Direct Approach to
Preparing Operating Cash Flows
Effect on
Operating activities Cash Flows
Cash received: Customers +
Interest and div idends on investments +
Cash paid: Suppliers -
Employees -
Interest on debt obligations -
Income taxes -
Cash Flows from Operating Activities Total
Investing Activities
Purchase of property, plant or equipment -
Purchase of other long-term assets -
Sale of property, plant or equipment +
Sale of other long-term assets +
Cash Flows from Investing Activities Total
Financing Activities
Issuance of long-term debt +
Issuance of contributed capital +
Dividends paid -
Repurchase of long-term debt -
Repurchase of contributed capital -
Cash Flows from Financing Activities Total
Net increase or (decrease) in cash
Beginning balance in cash account
Ending balance in cash account
Key Ratio Analysis
TOTAL ASSET TURNOVER RATIO
ANALYTICAL QUESTION → How effective is management at
generating sales from assets (resources)?
RATIO AND COMPARISONS → The total asset turnover ratio
is useful in answering this question. It is computed as
follows:
​ ​
Total Asset Sales (or Operating) Revenues
Turnover =
Ratio Average Total Assets*

*Average total assets = (Beginning total assets + Ending

total assets) ÷ 2.
Key Ratio Analysis Interpretation
 TOTAL ASSET TURNOVER RATIO INTERPRETATION
 The total asset turnover ratio measures the sales
generated per dollar of assets.
 A high total asset turnover ratio signifies efficient
management of assets; a low total asset turnover ratio
signifies less-efficient management.
 Stronger operating performance improves the total asset
turnover ratio. 
 Creditors and security analysts use this ratio to assess a
company’s effectiveness at controlling current and non-
current assets.
Key Ratio Analysis Part 2
RETURN ON ASSETS (ROA)
ANALYTICAL QUESTION → How well has management used
the total invested capital provided by debt holders and
shareholders during the period? 
RATIO AND COMPARISONS → Analysts refer to the rate of
return on assets (ROA) as a useful measure in addressing
this issue. It is computed as follows:
Return on Net Earnings* + Interest Expense (net of tax)
Assets (ROA) =
Ratio
Average Total Assets
*
In complex calculations, interest expense (net of tax) and
minority interest are added back to net earnings.
Key Ratio Analysis Interpretation Part 2
 RETURN ON ASSETS INTERPRETATION
 ROA measures how much the firm earned from the use of
its assets.
 It is the broadest measure of profitability and
management effectiveness, independent of financing
strategy.
 ROA allows investors to compare management’s
investment performance against alternative investment
options.
 Firms with higher ROA are doing a better job of selecting
new investments, all other things being equal.
Appendix 3A: Earnings Measurement
 The following table summarizes the valuation bases that
are currently permitted by IFRS for the reporting of asset
and liability values on the statement of financial position:
Asset or Liability Group Valuation Basis
Financial assets (e.g., investment in shares of other
Amortized cost or fair value
corporations, trade receivables, notes receivable)
Inventories Lower of cost and net realizable value
Depreciated cost or recoverable
Property, plant, and equipment
amount
Investment properties (e.g., commercial real estate
Depreciated cost or fair value
properties)
Intangible assets Amortized cost or fair value
Financial liabilities Amortized cost or fair value
The concepts of amortized cost, net realizable value, and recoverable amount are discussed in
later chapters.
Appendix 3A: Statement of Comprehensive
Income
 The statement of earnings includes the results of
operations for a specific accounting period as well as the
effects of discontinued operations.

 Publicly accountable enterprises are now required to

disclose additional information in a statement of
comprehensive income.

 The additional components of income reflect the financial

effect of events that cause changes in shareholders’
equity, other than investments by shareholders or
distributions to shareholders.
Appendix 3A: Statement of Comprehensive
Income Continued
 The additional components of income, or other
comprehensive income, include unrealized gains and
losses on certain financial instruments, as well as other
items discussed in advanced accounting courses.

 The net earnings and other comprehensive income totals

are then combined to create a final total called
comprehensive income (the bottom line for this
statement). 
End of Chapter Summary
 Elements on the classified statement of earnings are as
follows:
a. Revenues are increases in assets or settlements of liabilities
from ongoing operations.
b. Expenses are decreases in assets or increases in liabilities
from ongoing operations.
c. Gains are increases in assets or settlements of liabilities from
peripheral activities.
d. Losses are decreases in assets or increases in liabilities from
peripheral activities.
End of Chapter Summary Continued
 When applying accrual accounting concepts, revenues are
recognized (recorded) when earned and expenses are
recognized when incurred.
 Based on the revenue recognition principle, we recognize
revenues when goods and services are transferred to
customers in an amount they expect to receive.
 Based on the matching process, we recognize expenses
when incurred in generating revenue.