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Unformatted text preview: Chapter 03 - Operating Decisions and the Income Statement Chapter 03 Operating Decisions and the Income Statement ANSWERS TO QUESTIONS 1. A typical business operating cycle for a manufacturer would be as follows: inventory is purchased, cash is paid to suppliers, the product is manufactured and sold on credit, and the cash is collected from the customer. 2. The time period assumption means that the financial condition and performance of a business can be reported periodically, usually every month, quarter, or year, even though the life of the business is much longer. 3. Net Income = Revenues + Gains - Expenses - Losses. Each element is defined as follows: Revenues -- increases in assets or settlements of liabilities from ongoing operations. Gains -- increases in assets or settlements of liabilities from peripheral transactions. Expenses -- decreases in assets or increases in liabilities from ongoing operations. Losses -- decreases in assets or increases in liabilities from peripheral transactions. 4. Both revenues and gains are inflows of net assets. However, revenues occur in the normal course of operations, whereas gains occur from transactions peripheral to the central activities of the company. An example is selling land at a price above cost (at a gain) for companies not in the business of selling land. Both expenses and losses are outflows of net assets. However, expenses occur in the normal course of operations, whereas losses occur from transactions peripheral to the central activities of the company. An example is a loss suffered from fire damage. 5. Accrual accounting requires recording revenues when earned and recording expenses when incurred, regardless of the timing of cash receipts or payments. Cash basis accounting is recording revenues when cash is received and expenses when cash is paid. 3-1 Chapter 03 - Operating Decisions and the Income Statement 6. The four criteria that must be met for revenue to be recognized under the accrual basis of accounting are (1) delivery has occurred or services have been rendered, (2) there is persuasive evidence of an arrangement for customer payment, (3) the price is fixed or determinable, and (4) collection is reasonably assured. 7. The matching principle requires that expenses be recorded when incurred in earning revenue. For example, the cost of inventory sold during a period is recorded in the same period as the sale, not when the goods are produced and held for sale. 8. Net income equals revenues minus expenses. Thus revenues increase net income and expenses decrease net income. Because net income increases stockholders’ equity, revenues increase stockholders’ equity and expenses decrease it. 9. Revenues increase stockholders’ equity and expenses decrease stockholders’ equity. To increase stockholders’ equity, an account must be credited; to decrease stockholders’ equity, an account must be debited. Thus revenues are recorded as credits and expenses as debits....
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