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10e

Financial Accounting

Libby • Libby •

chapter 3

Operating Decisions and the Accounting System

Financial Accounting

Libby • Libby • Hodge

chapter

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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.

3-7 Identify operating transactions and demonstrate how they affect

cash flows.

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Learning Objective 3-1

3-1 Describe a typical business operating cycle and explain the necessity for the time period assumption.

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Understanding the Business

How do business activities

affect the income statement?

How are these activities

recognized and measured?

How are these activities reported on the

income statement?

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In this chapter, we will discuss how business activities affect the income statement of a company. We will also look at how these activities are recognized, recorded, and measured. Finally, we will look at the preparation of an income statement.

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The Operating Cycle (1 of 2)

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The operating cycle begins with the purchase or manufacture of a product for sale. When products are purchased from suppliers, those suppliers must be paid. After a sale has been made, the company must deliver the product or service to the customer. Many business sales are made on credit. If credit is extended, payment must be received from customers. Once the cash has been collected from customers, the business cycle begins all over again.

We never want to confuse the business operating cycle with the accounting cycle.

Companies (1) acquire inventory and the services of employees and (2) sell inventory or services to customers. The operating (or cash-to-cash) cycle begins when a company receives goods to sell (or, in the case of a service company, has employees work to provide services to customers) and ends when customers pay cash to the company. The length of time for completion of the operating cycle depends on the nature of the business.

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The Operating Cycle (2 of 2)

Time period assumption: The long life of a company can be reported in shorter time periods, such as months, quarters, and years.

Two issues arise when reporting periodic income:

Recognition issues: When should the effects of operating activities be recognized (recorded)?

2) Measurement issues: What amounts should be recognized?

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We know that most successful companies operate for a very long period of time, and managers and investors need financial information on a timely basis. For accountants to provide this information, we have to divide the life of the business into relatively short, arbitrary time periods. We usually divide the life of a business into months, quarters, and annual time periods. When we establish these relatively short time periods, we create many measurement issues—for example, problems of revenue and expense recognition.

Two issues arise when reporting periodic income:

1) Recognition issues: When should the effects of operating activities be recognized?

2) Measurement issues: What amounts should be recognized?"

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Learning Objective 3-2

3-2 Explain how business activities affect the elements of the income statement.

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Elements of the Income Statement

Losses

Decreases in assets or increases in liabilities from peripheral transactions.

Revenues

Increases in assets or settlements of liabilities from the major or central ongoing operations.

Expenses

Decreases in assets or increases in liabilities from ongoing operations incurred to generate revenues.

Gains

Increases in assets or settlements of liabilities from peripheral transactions.

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The income statement contains revenues, expenses, gains, and losses.

Operating revenues result from the sale of goods or services. When Chipotle sells food to consumers, it earns revenue. When revenue is earned, assets, usually Cash or Accounts Receivables, often increase. Sometimes if a customer pays for goods or services in advance, a liability account, usually Unearned (or Deferred) Revenue, is created.

Expenses are decreases in assets or increases in liabilities from ongoing operations incurred to generate revenues during the period. Chipotle pays employees to make and serve food, uses electricity to operate equipment and light its facilities, advertises its products, and uses food and paper supplies. Without incurring these expenses, Chipotle could not generate revenues.

Gains (with an account called Gain on Sale of Assets) result in an increase in assets or decrease in liabilities from a peripheral transaction. Losses are decreases in assets or increases in liabilities from peripheral transactions.

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Exhibit 3.1

Chipotle Mexican Grill’s Income Statement

CHIPOTLE MEXICAN GRILL, INC.

Consolidated Statement of Income*

For the Year ended December 31, 2017

(in millions of dollars, except per share data)

Restaurant sales revenue $4,477

Restaurant operating expenses:

Supplies expense 1,536

Wages expense 1,206

Rent expense 327

Insurance expense 143

Utilities expense 85

Repairs expense 51

Other operating expenses 373

General and administrative expenses:

Training expense 263

Advertising expense 46

Depreciation expense 163

Loss on disposal of assets 13

Total operating expenses 4,206

Income from operations 271

Other items:

Interest revenue 6

Interest expense (1)

Income before income taxes 276

Income tax expense 100

Net income $ 176

Earnings per share $6.19

Peripheral activities

(not central focus of business)

Operating activities (central focus of business)

= $176 million Net Income ÷ about 28.4 million

weighted average number of common stock

shares outstanding (per 2017 annual report)

*The information has been adapted from actual statements and simplified for this chapter.

Includes salaries expense

Includes pre-opening costs

Also called Provision for Income Taxes

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Here is an income statement for Chipotle for the year ended December 31, 2017. This format is known as multiple step and is very common. You can tell if a company uses the multiple-step format if you see the Operating Income subtotal (also called Income from Operations).

Notice that the company separates its operating activities—that is, its normal revenues and expenses from selling food and beverages—from the peripheral activities that include investment income and interest expense. Income taxes are shown on a separate line. Most financial analysts concentrate on operating income because it represents the income earned from normal operations before taxes.

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Operating Revenues

Operations of the business: the sale of goods or rendering of services as the central focus of the business

e.g., When Chipotle sells burritos, it has earned revenue.

Revenues

Any increases in assets or settlements of liabilities from the major or central ongoing operations of the business

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Revenues are defined as increases in assets or settlements of liabilities from the major or central ongoing operations of the business. For example, when Chipotle sells burritos, it has earned revenue, and assets, usually Cash or Accounts Receivables, often increase.

Sometimes, a customer can pay for goods or services in advance. This results in a cash transaction but no services being rendered or goods being sold. We would define this transaction as unearned revenue, which is a liability account, because the cash was received, but we have not earned the revenue yet by performing the service or selling the goods.

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Operating Expenses

Operating expenses are outflows or the using up of assets or increases in liabilities from ongoing operations incurred to generate revenues during the period.

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

payments

Asset purchases

Expenses

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An expenditure is any outflow of cash for any purpose, whether to buy equipment, pay off a bank loan, or pay employees their wages. Expenses are outflows, or the using up of assets, or increases in liabilities from ongoing operations incurred to generate revenues during the period. Therefore, not all cash expenditures are expenses, but expenses are necessary to generate revenues.

Examples of expenses incurred by a restaurant include:

Food, Beverage, and Packaging Expense

Salaries and Wages Expense

Occupancy Expense

Other Operating Expenses

General and Administrative Expenses

Depreciation Expense

Income Tax Expense

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Examples of Chipotle’s Operating Expenses

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Restaurant Operating Expenses:

• Supplies Expense. In Chipotle’s restaurant operations, any food ingredients or beverage and packaging supplies that are used to produce and sell meals are expensed as they are used. For Chipotle, this is its largest expense at $1,536 million in 2017. In companies with a manufacturing or merchandising focus, the most significant expense is usually Cost of Goods Sold (or Cost of Sales), representing the cost of inventory used in generating sales.

• Wages Expense. When salaried and hourly employees work and generate sales for Chipotle, the company incurs an expense, although wages and salaries will be paid later. Wages Expense of $1,206 million is Chipotle’s second largest expense. In purely service-oriented companies in which no products are produced or sold, the cost of having employees generate revenues is usually the largest expense. For example, Federal Express reported over $21,542 million in salaries expense for the year ended May 31, 2017.

• Rent Expense, Insurance Expense, Utilities Expense, and Repairs Expense. Renting facilities, insuring property and equipment at the stores, using utilities, and repairing and maintaining facilities and equipment are typical expenses related to operating stores. Usually, rent and insurance are paid before occupying the facilities, but utilities and repairs are paid after occupying the facilities.

• Other Operating Expenses. These expenses include a wide variety of accounts with smaller dollar balances.

General and Administrative Expenses: General and Administrative Expenses include costs of training employees and managers, advertising, and other expenses not directly related to operating stores. These often include expenses such as renting headquarters facilities and paying executive salaries.

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 called Depreciation Expense. Chapter 8 discusses methods for estimating the amount of depreciation expense.

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Depreciation expense

Supplies expense

Wages expense

Rent expense

Insurance expense

Utilities expense

Repairs expense

Other Income Statement Items

Interest or Dividend Revenue

Interest Expense

Gains (or Losses) on Sale of Investments

Income Tax Expense

Corporations are required to disclose earnings per share (EPS) on the income statement or in the notes to the financial statements.

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Not all activities affecting an income statement are central to ongoing operations. Any revenues, expenses, gains, and losses that result from other activities are categorized as Other Items. These other items are not included in operating income. Examples include interest or dividend revenue, interest expense, Gains (or losses) on sale of investment, and income tax expenses.

Corporations are required to disclose earnings per share (EPS). This is typically presented at the bottom of the income statement.

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DATA ANALYTICS

Using Big Data in the Restaurant Industry to Increase Revenues and Decrease Costs

Thanks to significant improvements in computing power, storage space, access to the cloud, and new software, businesses can collect and analyze incredible amounts and types of data to enhance revenues and reduce costs.

Data sources include point-of-sale terminals and information systems related to accounting, inventory, scheduling, marketing, and more.

McDonald’s uses data to predict customer demand in drive-thru sales.

Wendy’s analyzes big data to identify the most profitable new restaurant locations.

Pizza Hut uses software to track customer eye movements on digital, interactive menus in some of its restaurants to discover what customers subconsciously want.

SOURCE: https://www.hotschedules.com/blog/biggest-restaurant-brands-use-big-data-stay-competitive/

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Data sources include point-of-sale terminals and information systems related to accounting, inventory, scheduling, marketing, and more.

McDonald’s uses data to predict customer demand in drive-thru sales.

Wendy’s analyzes big data to identify the most profitable new restaurant locations.

Pizza Hut uses software to track customer eye movements on digital, interactive menus in some of its restaurants to discover what customers subconsciously want.

SOURCE: https://www.hotschedules.com/blog/biggest-restaurant-brands-use-big-data-stay-competitive/.

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How Are Operating Activities Recognized and Measured? (1 of 2)

Revenue = cash received

Less: Expenses = cash payments

Net Income (cash basis)

Cash Basis Accounting: Record revenues when cash is received and expenses when cash is paid.

Cash basis accounting may lead to an incorrect interpretation of future company performance. GAAP does not allow the cash basis of accounting.

The cash basis may be adequate for organizations that do not need to report to external users, such as small businesses.

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Companies that use cash basis accounting recognize revenue at the time cash is received and recognize expenses at the time cash is paid. Financial performance is measured as the difference between the cash balance at the beginning of the period and the cash balance at the end of the period (that is, whether you end up with more or less cash). Many local retailers, medical offices, and other small businesses use cash basis accounting. A cash basis is not considered acceptable under generally accepted accounting principles because it may lead to an incorrect interpretation of future company performance.

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Cash Basis Accounting

Cash Basis Income Statements Year 1 Year 2 Year 3 Total

Sales on credit

Cash receipts from customers

Cash disbursements for:

Salaries to employees

Insurance for 3 years

Supplies

Net operating cash flows

$60,000

$20,000

(30,000)

(12,000)

(3,000)

$(25,000)

$60,000

$70,000

(30,000)

(0)

(7,000)

$33,000

$60,000

$90,000

(30,000)

(0)

(5,000)

$55,000

$180,000

(90,000)

(12,000)

(15,000)

$63,000

Using cash basis accounting may lead to an incorrect interpretation of future company performance.

Simply looking at the first year, investors and creditors might interpret the negative cash flows as a problem with the company’s ability to generate cash flows in the future.

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Companies that use cash basis accounting recognize revenue at the time cash is received and recognize expenses at the time cash is paid.

Cade Company earned $60,000 from sales each year. However, because the sales were on account, customers spread out their payments over three years. Salaries to employees were paid in full each year. Insurance was prepaid at the beginning of Year 1 for equal coverage over the three years. Supplies were purchased on credit and used evenly over the three years. However, the company paid part of the first-year purchases in the second year.

Using cash basis accounting may lead to an incorrect interpretation of future company performance. Simply looking at the first year, investors and creditors might interpret the negative cash flows as a problem with the company’s ability to generate cash flows in the future. However, the other two years show positive cash flows. Likewise, performance over time appears uneven when actually it is not. Sales were earned evenly each year, although collections from customers were not. The years in which insurance and supplies were paid for are not the same as the years in which these resources were used.

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Learning Objective 3-3

3-3 Explain the accrual basis of accounting and apply the revenue and expense recognition principles to measure income.

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How Are Operating Activities Recognized and Measured? (2 of 2)

Accrual Basis Accounting

Revenues and expenses are recognized when the transaction that causes them occurs, not necessarily when cash is paid or received.

Accrual Basis Accounting is required by:

Generally Acceptable Accounting Principles (GAAP)

Revenues are recognized when they are earned and expenses when they are incurred to generate revenues.

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In accrual basis accounting, revenues and expenses are recognized when the transaction that causes them occurs, not necessarily when cash is received or paid. That is, revenues are recognized when they are earned and expenses when they are incurred to generate revenues.

The two basic accounting principles that determine when revenues and expenses are recorded under accrual basis accounting are the revenue recognition principle and the expense recognition principle (also called the matching principle).

Accrual Basis Accounting is required by Generally Acceptable Accounting Principles (GAAP).

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Revenue Recognition Principle

A company must recognize revenue:

When the company transfers promised goods or services to customers.

In the amount it expects to be entitled to receive.

Exhibit 3.2

before food delivery

when food is delivered

after food delivery

Cash may be received . . .

TIME

DELIVERY

Record REVENUE here

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The core 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 the company transfers promised goods or services to customers.

In the amount it expects to be entitled to receive.

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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

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Because Chipotle has delivered no food when the cash is received, there is no revenue earned. Instead, it creates a liability account called Unearned Revenue, which represents the amount of food service owed to the customer.

Later, when customers redeem their gift card and Chipotle delivers the food, it earns and records the revenue while reducing the liability account because it has satisfied its promise to deliver.

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(2) When cash is received in the same period as the goods or services are delivered.

Revenue Recognition Principle (2 of 3)

On delivery of ordered food for $12 cash:	Debit	Credit
Cash (+A)	12
Restaurant Sales Revenue (+R, +SE)		12

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This is a typical timing of cash receipts and revenue recognition in the industry. Chipotle earns the revenue when it delivers food to the customer.

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(3) If cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded.

Revenue Recognition Principle (3 of 3)

On delivery of ordered food for $50 on account:	Debit	Credit
Accounts Receivable (+A)	50
Restaurant Sales Revenue (+R, +SE)		50

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

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When a company sells goods or services on account, the revenue is earned when it is delivered, not when the cash is received.

When delivered, Chipotle records both Restaurant Sales Revenue and the asset Accounts Receivable, representing the customer's promise to pay in the future for past food deliveries. When the customer pays its monthly bill, Chipotle will increase its Cash account and decrease the asset Accounts Receivable.

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FINANCIAL ANALYSIS

$$$

Revenue Recognition for More Complex Customer Contracts

The standard specifies five steps to recognizing revenue:

Identify the contract between the company and the customer.

Identify the performance obligations (promised goods and services).

Determine the transaction price.

Allocate the transaction price to the performance obligations.

Recognize revenue when each performance obligation is satisfied (or over time if a service is provided over time).

The FASB and IASB issued a joint revenue recognition accounting standard effective for 2018 financial statements.

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The FASB and IASB issued a new revenue recognition accounting standard that is starting in 2018. The standard lists five steps to recognizing revenue, which are shown on the slide.

Accounting for more complex revenue transactions is covered in intermediate accounting courses.

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to purchase supplies before being used

for repairs the same day (services used)

to employees for work in the prior period

Cash may be paid . . .

TIME

USED

(INCURRED to generate revenue)

Record EXPENSE here

Expense Recognition Principle (also called matching principle)

Exhibit 3.3

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The expense matching principle requires that costs incurred to generate revenues be recognized in the same period—a matching of costs with benefits. For example, when Chipotle’s restaurants provide food service to customers, revenue is earned. The costs of generating the revenue are recognized as expenses in the same period.

Expenses are recognized as incurred, regardless of when cash is paid. Cash may be paid (1) before. (2) during, or (3) after an expense is incurred.

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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

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Companies purchase many assets that are used to generate revenues in future periods. As an example, Chipotle buys paper supplies in one month but uses them the following month.

When acquired, supplies are recorded as an asset called Supplies because they will benefit a future period. When they are used the following month, Supplies Expense is recorded for the month, and the asset Supplies is reduced to the balance yet to be used.

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

Expense Recognition Principle (2 of 3)

On payment of $275 cash for using repair service:	Debit	Credit
Repairs Expense (+E, -SE)	275
Cash (-A)		275

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When cash is paid in the same period as expense is incurred, the cash reduction is recorded with a credit and the related expense (i.e., Repairs Expense) is recorded with a debit.

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

Expense Recognition Principle (3 of 3)

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

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When cash is paid after the expense is incurred, we record the expense when it is incurred and then credit a liability (i.e., Wages Payable). Then, when the cash is paid at a later date, we record the cash paid with a credit and then debit the accompanied liability to remove it from the balance sheet.

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A Question of Ethics

A QUESTION

OF ETHICS

Management’s Incentives to Violate Accounting Rules

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Consider the unethical and illegal activities entered into by leaders at companies with little or no internal or external oversight.

Greed may lead some managers to make unethical accounting and reporting decisions, often involving falsifying revenues and expenses. While this sometimes fools people for a short time, it rarely works in the long run and often leads to very bad consequences.

Fraud is a criminal offense for which managers may be sentenced to jail. Samples of fraud cases, a few involving faulty revenue and expense accounting, are shown here. Just imagine what it must have been like to be 65-year-old Bernie Ebbers or 21-year-old Barry Minkow, both sentenced to 25 years in prison for accounting fraud.

Many others are affected by accounting fraud. Shareholders lose stock value, employees may lose their jobs (and pension funds, as in the case of Enron), and customers and suppliers may become wary of dealing with a company operating under the cloud of fraud. As a manager, you may face an ethical dilemma in the workplace. The ethical decision is the one you will be proud of 20 years later.

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Learning Objective 3-4

3-4 Apply transaction analysis to examine and record the effects of operating activities on the financial statements.

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Exhibit 3.4

Expanded Transaction Analysis Model

STOCKHOLDERS’ EQUITY

Credit

Issuance of Stock

Contributed Capital

(2 accounts)

Common Stock and

Additional Paid-in

Capital

–

Debit

Credit

Net

income

Earned Capital

(1 account)

Retained

Earnings

–

Debit

Dividends declared

ASSETS

(many

accounts)

Debit

−

Credit

–

Debit

Credit

LIABILITIES

(many

accounts)

REVENUES

(many

accounts)

Debit

Credit

EXPENSES

(many

accounts)

–

Note: As expenses increase (are debited), net income, retained earnings, and stockholders’ equity decrease.

Note: Instead of reducing Retained Earnings directly when dividends are declared, companies may use the account Dividends Declared, which has a debit balance.

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Here is the expanded transaction analysis model. We know that stockholders’ equity consists of contributed capital and retained earnings. Let’s see how revenues and expenses impact retained earnings.

From our Statement of Retained Earnings, we know that net income increases retained earnings. Revenues increase net income, and expenses decrease net income. Revenues show increases and decreases on the same sides of the T-account as retained earnings. A credit to the revenue account increases revenue, a debit to the revenue account decreases revenue. Because expenses reduce revenues in the calculation of net income, increases and decreases in expense accounts are shown on the opposite sides when compared to revenue accounts. A debit to an expense account represents an increase in expenses, while a credit to an expense account represents a decrease in expenses.

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In summary:

Understand how revenues and expenses impact the balance sheet and income statement:

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Revenues increase net income, and expenses decrease net income.

A credit to the revenue account increases revenue, a debit to the revenue account decreases revenue.

A debit to the expense account increases expense; a credit to the expense account decreases expense.

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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?

Identify the accounts affected by title (e.g., Cash and Notes Payable). Remember: Make sure that at least two accounts change.

Classify them by type of account: asset (A), liability (L), stockholders’ equity (SE), revenue/gain (R), or 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)

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These steps were shown in Chapter 2, but they have been modified here to determine the effects of earning revenues and incurring expenses.

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Exhibit 3.6

Chipotle Mexican Grill’s Trial Balance

CHIPOTLE MEXICAN GRILL

Trial Balance

(based on investing and financing transactions during the first quarter ended March 31, 2018)

(in millions) Debit Credit

Cash 389

Short-term investments 333

Accounts receivable 49

Supplies 20

Prepaid expenses 51

Land 21

Buildings 1,711

Equipment 637

Accumulated depreciation 979

Long-term investments 35

Intangible assets 81

Accounts payable 82

Unearned revenue 64

Dividends payable 2

Income taxes payable 18

Wages payable 83

Utilities payable 77

Notes payable (current) 0

Notes payable (noncurrent) 80

Other liabilities 279

Common stock 2

Additional paid-in capital 1,604

Treasury stock 2,334

Retained earnings 2,391

Total 5,661 5,661

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Here is the trial balance sheet for Chipotle, which includes only the investing and financing transactions occurring during the first quarter of 2018. Using the transaction analysis steps in Exhibit 3.5, we now analyze, record, and post to the T-accounts the effects of the operating activities that also occurred during the first quarter.

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(1) Chipotle purchased food, beverage, and packaging supplies costing $370, paying $290 in cash and owing the rest on account.

Assets = Liabilities + Stockholders’ Equity

Supplies +370 Accounts payable +80

Cash −290

+ Cash (A) − + Supplies (A) − − Accounts Payable (L) +

Bal. 389 Bal. 20 82 Bal.

290 (1) (1) 370 80 (1)

Analyzing Chipotle’s Transactions (1 of 11)

	Debit	Credit
(1) Supplies (+A)	370
Cash (-A)		290
Accounts payable (+L)		80

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Chipotle purchased food, beverage, and packaging supplies costing $370, paying $290 in cash and owing the rest on account. Supplies increases by $370. Cash decreases by $290, and Accounts Payable increases by $80.

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(2) At the beginning of January, Chipotle paid $80 cash for rent, insurance, and advertising to be used in the future (all prepaid expenses).

Assets = Liabilities + Stockholders’ Equity

Prepaid expenses +80

Cash −80

+ Cash (A) − + Prepaid Expenses (A) +

290 (1) (2) 80

80 (2)

Analyzing Chipotle’s Transactions (2 of 11)

	Debit	Credit
(2) Prepaid expenses (+A)	80
Cash (-A)		80

Bal. 389 Bal. 51

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At the beginning of January, Chipotle paid $80 cash in advance for rent, insurance, and advertising to be used in the future. They are all prepaid expenses.

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(3) During the first quarter, Chipotle sold food and beverages to customers for $1,228; $44 was sold to universities on account (to be paid by the universities next quarter) and the rest was received in cash in the stores. NOTE: To measure revenues and expenses in a period, these accounts begin with a $0 balance; notice they are not listed on the trial balance in Exhibit 3.6 because they have no balances yet.

Analyzing Chipotle’s Transactions (3 of 11)

	Debit	Credit
(3) Cash (+A)	1,184
Accounts receivable (+A)	44
Restaurant sales revenue (+R, +SE))		1,228

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During the first quarter, Chipotle sold food and beverages to customers for $1,228; $44 was sold to universities on account, and the rest was received in cash in the stores.

You should notice that each journal entry in which a revenue is recorded, we insert ( +R, +SE) to emphasize the effect of the transaction on the accounting equation and to help you see that the equation remains in balance.

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(4) Chipotle paid $41 for management training expenses.

Analyzing Chipotle’s Transactions (4 of 11)

	Debit	Credit
(4) Training Expense (+E, -SE)	41
Cash (-A)		41

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Chipotle paid $41 for management training expenses.

You should notice that each journal entry in which an expense is recorded, we insert ( +E, -SE) to emphasize the effect of the transaction on the accounting equation and to help you see that the equation remains in balance.

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(5) Chipotle paid employees $177 for work this quarter and $83 for work last quarter (recorded last quarter as Wages Expense and Wages Payable).

Analyzing Chipotle’s Transactions (5 of 11)

	Debit	Credit
(5) Wages Expense (+E, -SE)	177
Wages Payable (-L)	83
Cash (-A)		260

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Chipotle paid employees $177 for work this quarter and $83 for work last quarter. In this case, the Wages Expense account increases by $177, Wages Payable decreases by $83, and Cash decreases by $260.

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(6) Chipotle sold equipment costing $9 for $5 cash, resulting in a loss of $4 (ignore any accumulated depreciation on the equipment, which will be explained in more depth in Chapter 8).

Analyzing Chipotle’s Transactions (6 of 11)

	Debit	Credit
(6) Cash (+A)	5
Loss on disposal of assets (+E, -SE)	4
Equipment (-A)		9

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Chipotle sold equipment costing $9 for $5 cash, resulting a loss of $4.

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(7) Chipotle received $39 cash from customers paying on their accounts.

Analyzing Chipotle’s Transactions (7 of 11)

	Debit	Credit
(7) Cash (+A)	39
Accounts receivable (-A)		39

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Chipotle received $39 cash from customers paying on their accounts. Cash increases by $39, and Accounts Receivable decreases by $39.

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(8) During the quarter, Chipotle paid suppliers $74 on accounts payable, paid $72 on utilities payable from last year, and paid $18 in income taxes payable from last year.

Analyzing Chipotle’s Transactions (8 of 11)

	Debit	Credit
(8) Accounts payable (-L)	74
Utilities payable (-L)	72
Income taxes payable (-L)	18
Cash		164

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During the quarter, Chipotle paid suppliers $74 on accounts payable. It also paid $72 on utilities payable and $18 in income taxes payable from last year.

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(9) Chipotle paid $75 for utilities used during the quarter and paid $19 for repairs of its buildings and equipment during the quarter.

Analyzing Chipotle’s Transactions (9 of 11)

	Debit	Credit
(9) Utilities expense (+E, -SE)	75
Repairs Expense (+E, -SE)	19
Cash		94

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Chipotle paid $75 for utilities used during the quarter and paid $19 for repairs of its buildings and equipment during the quarter.

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(10) Chipotle received $1 cash as interest revenue earned during the quarter.

Analyzing Chipotle’s Transactions (10 of 11)

	Debit	Credit
(10) Cash (+A)	1
Interest revenue (+R, +SE)		1

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Chipotle received $1 cash as interest revenue earned during the quarter.

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(11) During the quarter, Chipotle sold gift cards to customers for $42 in cash (expected to be redeemed for food next quarter).

Analyzing Chipotle’s Transactions (11 of 11)

	Debit	Credit
(11) Cash (+A)	42
Unearned revenue		42

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During the quarter, Chipotle sold gift cards to customers for $42 in cash

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Chipotle’s Balance Sheet Accounts

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Here are the new balances in the Balance Sheet accounts due to the operating activities this quarter.

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Chipotle’s Income Statement Accounts

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Here are the new balances in the Income Statement accounts due to the operating activities this quarter.

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Learning Objective 3-5

3-5 Prepare a classified income statement.

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How Is the Income Statement Prepared and Analyzed? (1 of 2)

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Before creating any statements for Chipotle, we must first determine that the debits equal credits, after recording all of the transactions illustrated above, by generating a trial balance for the Chipotle accounts. Accounts are listed in financial statement order: assets, liabilities, stockholders' equity, revenues/gains, and expenses/losses.

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Classified Income Statement

How Is the Income Statement Prepared and Analyzed? (2 of 2)

Note: Because this statement is based on unadjusted balances, it would not be presented to external users.

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This classified income statement is organized into operating activities and peripheral activities. However, note that the numbers are unadjusted and would not be presented to external users.

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Learning Objective 3-6

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

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KEY RATIO ANALYSIS

$$$

How effective is management in generating

profit on every dollar of sales?

Net Profit = Net Income

Margin Net Sales (or Operating Revenues)

Net Profit Margin Ratio

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.

A rising net profit margin signals more efficient management of sales and expenses.

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Net profit margin measures how much every sales dollar generated during the period affects profit. A rising net profit margin signals more efficient management of sales and expenses.

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Learning Objective 3-7

3-7 Identify operating transactions and demonstrate how they affect

cash flows.

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Only transactions affecting cash are reported on the Statement of Cash Flows. Cash flows from operating activities are primarily cash received from customers and cash paid to suppliers and other involved in operations.

Effect of Operating Activities on Cash Flows

$$$

Let’s analyze the Cash T-account for Chipotle’s transactions in this chapter:

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Recall from Chapter 1 that companies report cash inflows and outflows over a period of time in their statement of cash flows. This statement categorizes all transactions that affect cash into three categories: operating, investing, and financing activities.

Operating activities include those primarily with customers and suppliers, as well as interest payments and earnings on investments.

Investing activities include buying and selling noncurrent assets and investments.

Financing activities include borrowing and repaying debt, including short-term bank loans, issuing and repurchasing stock, and paying dividends."

When Cash is involved in a transaction, it will be reported on the statement of cash flows.

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