Describe a typical business operating cycle and explain the necessity for the time period assumption.
The operating cycle, or cash-to-cash cycle, is the time needed to purchase goods or services from suppliers, sell the goods or services to customers, and collect cash from customers.
Time period assumption—to measure and report financial information periodically, we assume the long life of a company can be cut into shorter periods.
Explain how business activities affect the elements of the income statement.
Elements on the income statement:
Revenues—increases in assets or settlements of liabilities from ongoing operations.
Expenses—decreases in assets or increases in liabilities from ongoing operations.
Gains—increases in assets or settlements of liabilities from peripheral activities.
Losses—decreases in assets or increases in liabilities from peripheral activities.
Explain the accrual basis of accounting and apply the revenue and matching principles to measure income.
In accrual basis accounting, revenues are recognized when earned and expenses are recognized when incurred.
Revenue principle—recognize revenues when (1) delivery has occurred, (2) there is persuasive evidence of an arrangement for customer payment, (3) the price is fixed or determinable, and (4) collection is reasonably assured.
Matching principle—recognize expenses when they are incurred in generating revenue.
Apply transaction analysis to examine and record the effects of operating activities on the financial statements.
Prepare financial statements.
Until the accounts have been updated to include all revenues earned and expenses incurred in the period (due to a difference in the time when cash is received or paid), the financial statements are unadjusted:
Income statement.
Statement of retained earnings.
Balance sheet.
Statement of cash flows.
Compute and interpret the total asset turnover ratio.
The total asset turnover ratio (Sales _ Average Total Assets) measures the sales generated per dollar of assets. The higher the ratio, the more efficient the company is at managing assets. In this chapter, we discussed the operating cycle and accounting concepts relevant to income determination: the time period assumption, definitions of the income statement elements (revenues, expenses, gains, and losses), the revenue principle, and the matching principle. The accounting principles are defined in accordance with the accrual basis of accounting, which requires revenues to be recorded when earned and expenses to be recorded when incurred in the process of generating revenues. We expanded the transaction analysis model introduced in Chapter 2 by adding revenues and expenses and prepared unadjusted financial statements. In Chapter 4, we discuss the activities that occur at the end of the accounting period: the adjustment process, the preparation of adjusted financial statements, and the closing process.
