CH 3 Classpack With Solutions

Chapter 03 - Operating Decisions and the Accounting System
CHAPTER 3
OPERATING DECISIONS AND THE ACCOUNTING SYSTEM
CHAPTER TAKE-AWAYS
3-1 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.
3-2 Explain how business activities affect the elements of the income statement.
 Elements on the income statement:
a. Revenues—increases in assets or settlements of liabilities from major or central ongoing
operations.
b. Expenses—decreases in assets or increases in liabilities from major or central ongoing
operations.
c. Gains—increases in assets or settlements of liabilities from peripheral activities.
d. Losses—decreases in assets or increases in liabilities from peripheral activities.
3-3 Explain the accrual basis of accounting and apply the revenue and expense recognition
principles to measure income.
In accrual basis accounting, revenues are recognized when earned and expenses are recognized when
incurred.
 Revenue recognition principle—recognize revenues (1) when the company transfers promised
goods or services to customers (2) in the amount it expects to receive.
 Expense recognition principle (matching)—recognize expenses when they are incurred in
generating revenue (a matching of costs with benefits).
3-1
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3-4 Apply transaction analysis to examine and record the effects of operating activities on the
financial statements.
The expanded transaction analysis model includes revenues and expenses:
LIABILITIES STOCKHOLDERS’ EQUITY
ASSETS
= (many accounts) +
(many accounts)
+ – – + Contributed Earned Capital
Capital
debit credit debit credit (2 accounts) (1 account)
– + – +
debit credit debit credit
Investments Dividends Net income
by owners declared
EXPENSES
REVENUES
– (many accounts)
(many accounts)
+ +
credit debit
3-5 Prepare a classified income statement.

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:
 Classified income statement––net income is needed to determine ending Retained Earnings;
classifications include Operating Revenues, Operating Expenses (to determine Operating
Income), Other Items (to determine Pretax Income) Income Tax Expense, Net Income (or Net
Loss), and Earnings per Share.
3-6 Compute and interpret the net profit margin ratio.
The net profit margin ratio (Net Income [or Net Loss] ÷ Net Sales [or Operating Revenues])
measures the profit generated per dollar of sales (operating revenues). The higher the ratio, the more
effective the company is at generating revenues and/or controlling costs.
3-2
3-3
Key Ratio
Net profit margin ratio measures the profit generated per dollar of sales (operating revenues). A high
ratio suggests that a company is generating revenues and/or controlling expenses effectively. The ratio is
computed as follows:
Net Profit Margin Ratio = Net Income [or Net Loss]  Net Sales [or Operating Revenues]
Finding Financial Information
BALANCE SHEET INCOME STATEMENT

Current Assets Current Liabilities Revenues (operating)
Cash Accounts payable Sales (from various operating

activities)
Short-term Short-term notes
investments payable Expenses (operating)
Accounts and notes Accrued expenses Cost of goods sold (used inventory)
receivable payable (e.g., wages,
taxes) Rent, wages, depreciation,
Inventory (goods to insurance, etc.
be sold) Unearned revenue
Losses (gains) on disposal of assets
Supplies Noncurrent
Liabilities Operating Income
Prepaid expenses
Long-term notes Other Items
Noncurrent Assets payable Interest expense
Long-term Long-term debt
investments Interest Revenue
Stockholders’ Equity
Land Losses (gains) on sale of investments
Common stock
Buildings Pretax Income
Equipment Additional paid-in Income tax expense
capital
Accumulated Net Income
depreciation Retained earnings
Earnings per Share
Intangible assets
STATEMENT OF CASH FLOWS NOTES

Under operating activities Under Summary of Significant
Accounting Policies
+ Cash from customers
Description of the company’s revenue
3-4
+ Cash from interest and dividends recognition policy.
 Cash to suppliers
 Cash to employees
 Interest paid
 Income taxes paid
3-5
HANDOUT 3 – 1
TRANSACTION ANALYSIS
Tabor Hill Designers entered into the following transactions during February of the current year. Analyze
each of the following transactions and prepare the journal entry required to record the related transaction.
(a) Provide website design services for $40,000.
Debit and credit the accounts affected
Ensure the equation still balances and debits = credits
Assets = Liabilities + Stockholders’ Equity
(b) Provide website design services to Acme Company, for $20,000 on account. We expect Acme to pay
in the future.
3-6
(c) Collect $18,000 from Acme Company on account.
3-7
HANDOUT 3 – 1, continued
(d) Sell a $1,000 gift certificate.
(e) Paid $900 principal and $100 interest on the short-term note payable.
(f) Paid $16,000 wages to employees.
3-8
3-9
(g) Paid $3,000 insurance for next year in advance.
(h) Paid $9,000 rent for next six months in advance.
(i) Received $250 telephone bill for previous month, to be paid next month.
3-10
3-11
(j) Paid $500 utility bill for this month.
3-12
HANDOUT 3 – 1 SOLUTION
TRANSACTION ANALYSIS
Tabor Hill Designers entered into the following transactions during February of the current year. Analyze
each of the following transactions and prepare the journal entry required to record the related transaction.
(a) Provide website design services for $40,000.
Cash (+A) 40,000
Design Revenue (+R, +SE) 40,000
Cash +40,000 Design +40,000

Revenue
(b) Provide website design services to Acme Company, for $20,000 on account. We expect Acme to pay
in the future.
Accounts Receivable (+A) 20,000
Design Revenue (+R, +SE) 20,000
Accounts +20,000 Design +20,000

Receivable Revenue
3-13
(c) Collect $18,000 from Acme Company on account.
Cash (+A) 18,000
Accounts Receivable (–A) 18,000
Cash +18,000
Accounts –18,000
Receivable
3-14
HANDOUT 3 – 1 SOLUTION, continued
(d) Sell a $1,000 gift certificate.
Cash (+A) 1,000
Unearned Revenue (+L) 1,000
Cash +1,000 Unearned +1,000
Revenue
(e) Paid $900 principal and $100 interest on the short-term note payable.
Short-Term Note Payable (-L) 900
Interest Expense (+E, -SE) 100
Cash (-A) 1,000
Cash -1,000 Short-Term -900 Interest -100

Note Payable Expense
(f) Paid $16,000 wages to employees.
3-15
Wage Expense (+E, –SE) 16,000
Cash (–A) 16,000
Cash –16,000 Wage –16,000

Expense
3-16
HANDOUT 3 – 1 SOLUTION, continued
(g) Paid $3,000 insurance for next year in advance.
Prepaid Expenses (+A) 3,000
Cash (–A) 3,000
Prepaid +3,000
Expenses
Cash –3,000
(h) Paid $9,000 rent for next six months in advance.
Prepaid Expenses (+A) 9,000
Cash (–A) 9,000
Prepaid +9,000
Expenses
Cash –9,000
(i) Received $250 telephone bill for previous month, to be paid next month.
3-17
Telephone Expense (+E, –SE) 250
Accounts Payable (+L) 250
Accounts +250 Telephone –250

Payable Expense
(j) Paid $500 utility bill for this month.
Utilities Expense (+E, –SE) 500
Cash (–A) 500
Cash –500 Utilities –500

Expense
3-18
HANDOUT 3 – 2
POSTING TO T-ACCOUNTS
The following T-accounts set forth the ending balances of the accounts of Tabor Hill Designers as of
January 31 of the current year. Refer to Handout 3-1. Post each of the February journal entries to the T-
accounts.
Assets Liabilities Stockholders’ Equity
+ Cash – – Accounts Payable + – Common Stock +
BegBal 4,100 0 BegBal 10,000 BegBal
– Unearned Revenue + – Retained Earnings +
0 BegBal 1,000 BegBa

l
+ Accounts Receivable – – Short-Term Notes Payable +

– Design Revenue +
BegBal 0 15,000 BegBal
0 BegBa
l
+ Supplies –
BegBal 900
+ Wage Expense –
3-19
BegBa 0
l
+ Prepaid Expenses –
BegBa 0
l
+ Utilities Expense –
BegBa 0
l
+ Property, Plant & Equipment –
BegBa 21,000
l + Telephone Expense –
BegBa 0
l
+ Interest Expense –
BegBa 0
l
3-20
POSTING TO T-ACCOUNTS
The following T-accounts set forth the ending balances of the accounts of Tabor Hill Designers as of
January 31of the current year. Refer to Handout 3-1. Post each of the February journal entries to the T-
accounts.
Assets Liabilities Stockholders’ Equity
+ Cash – – Accounts Payable + – Common Stock +
BegBal 4,100 0 BegBal 10,000 BegBal
(a) 40,000 1,000 (e) 250 (i)
(c) 18,000 16,000 (f) 250 EndBal 10,000 EndBal
(d) 1,000 3,000 (g)
9,000 (h) – Unearned Revenue + – Retained Earnings +

500 (j) 0 BegBal 1,000 BegBal
EndBal 33,600 1,000 (d) 1,000 EndBal
1,000 EndBal
+ Accounts Receivable – – Design Revenue +
BegBal 0 – Short-Term Notes Payable + 0 BegBal
(b) 20,000 18,000 (c) 15,000 BegBal 40,000 (a)
EndBal 2,000 (e) 900 20,000 (b)
14,100 EndBal 60,000 EndBal

+ Supplies –
BegBal 900 + Wage Expense –

EndBal 900 BegBal 0
(f) 16,000
+ Prepaid Expenses – EndBal 16,000
3-21
BegBal 0
(g) 3,000 + Utilities Expense –
(h) 9,000 BegBal 0

EndBal 12,000 (j) 500
EndBal 500
+ Property, Plant & Equipment –
BegBal 21,000 + Telephone Expense –
EndBal 21,000 BegBal 0
(i) 250
EndBal 250
+ Interest Expense –
BegBal 0
(e) 100
EndBal 100
3-22
HANDOUT 3 – 3
PREPARING A TRIAL BALANCE

Use the ending balances from the T-accounts on Handout 3-2 to prepare a trial balance for
World Wide Webster as of February 28 of the current year.
World Wide Webster
Trial Balance
At February 28, Current Year
Debit Credit
3-23
3-24
HANDOUT 3 – 3
PREPARING A TRIAL BALANCE

Use the ending balances from the T-accounts on Handout 2-5 to prepare a trial balance for
World Wide Webster as of February 28 of the current year.
World Wide Webster
Trial Balance
At February 28, Current Year
Debit Credit
Cash 33,600
Accounts receivable 2,000
Supplies 900
Prepaid expenses 12,000
Property, plant, and equipment 21,000
Accounts Payable 250
Unearned Revenue 1,000
Short-Term Notes Payable 14,100
Common Stock 10,000
Retained Earnings 1,000
Design revenue 60,000
Wage expense 16,000
Utilities expense 500
Telephone expense 250
Interest expense 100
Totals 86,350 86,350
3-25
HANDOUT 3 – 4
PREPARING A CLASSIFIED INCOME STATEMENT

Use the ending balances from the T-accounts on Handout 3-2 to prepare a classified income
statement for Tabor Hill as of and for the month ended February 28 of the current year. (Ignore
income tax expense.)
Tabor Hill Designers
Income Statement
For the Month ended February 28, Current Year
3-26
PREPARING A CLASSIFIED INCOME STATEMENT

Use the ending balances from the T-accounts on Handout 3-2 to prepare a classified income
statement for Tabor Hill as of and for the month ended February 28 of the current year. (Ignore
income tax expense.)
Tabor Hill Designers
Income Statement
For the Month Ended February 28, Current Year
Design revenue $60,000
Operating expenses:
Wage expense 16,000
Utilities expense 500
Telephone expense 250
Total operating expenses 16,750
Income from operations 43,250
Other items:
Interest expense (100)
Income before income taxes 43,150
Income tax expense 0
Net income $43,150
3-27
HANDOUT 3 – 5
NET PROFIT MARGIN RATIO
Refer to the financial statements from Handout 3-3 and calculate the net profit margin ratio of Tabor Hill
Designers for the month ending February 28 of the current year. Then, indicate what this ratio measures
and how you would interpret the results.
Calculation:
What it measures and how to interpret:
3-28
NET PROFIT MARGIN RATIO
Refer to the financial statements from Handout 3-3 and calculate the net profit margin ratio of Tabor Hill
Designers for the month ending February 28 of the current year. Then, indicate what this ratio measures
and how you would interpret the results.
Calculation:
Net Profit Margin = Net Income ÷ Net Sales (or Operating Revenues)
Net Profit Margin = $43,150 ÷ $60,000 = 0.719 or 71.9%
What it measures and how to interpret:

The net profit margin ratio measures the profit generated per dollar of sales (operating revenues).
Tabor Hill is generating just under $0.72 of net income per dollar of operating revenues.
The net profit margin ratio would be interpreted by comparison to that of prior periods and to that of
the company’s competitors.
The higher the ratio, the more effective the company is at generating revenues and/or controlling costs.
3-29

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Chapter 03 - Operating Decisions and the Accounting System

3-5 Prepare a classified income statement.

Finding Financial Information

BALANCE SHEET INCOME STATEMENT

Cash Accounts payable Sales (from various operating

STATEMENT OF CASH FLOWS NOTES

+ Cash from interest and dividends recognition policy.

 Income taxes paid

(a) Provide website design services for $40,000.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

(c) Collect $18,000 from Acme Company on account.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

(d) Sell a $1,000 gift certificate.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

(f) Paid $16,000 wages to employees.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

(g) Paid $3,000 insurance for next year in advance.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

(h) Paid $9,000 rent for next six months in advance.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

(j) Paid $500 utility bill for this month.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

(a) Provide website design services for $40,000.

Debit and credit the accounts affected

Cash (+A) 40,000

Design Revenue (+R, +SE) 40,000

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

Cash +40,000 Design +40,000

Debit and credit the accounts affected

Accounts Receivable (+A) 20,000

Design Revenue (+R, +SE) 20,000

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

Accounts +20,000 Design +20,000