Lecture Notes: Chapter 3 – Operating Decisions and the Accounting System
Based on Financial Accounting, 11th Edition by Libby, Libby, and Hodge
Introduction
This chapter focuses on how businesses report and analyze operating activities through the
accounting system. The income statement reflects a company’s performance over a period, and
accurate measurement requires understanding of the time period assumption, accrual
accounting, and the recognition principles. We explore how transactions are recorded using
journal entries and transaction analysis, how to prepare a classified income statement, how
to interpret the net profit margin ratio, and how operating activities impact cash flows. Mastery
of these concepts is critical for making informed business and financial decisions.
1. The Business Operating Cycle and the Time Period
Assumption
1.1 The Business Operating Cycle
A typical business operating cycle refers to the time it takes for a company to:
1. Purchase inventory or supplies
2. Sell goods or services
3. Collect cash from customers
This cycle may be days, weeks, or months depending on the industry.
Example:
A retailer purchases inventory in January, sells it in February, and collects payment in March.
This full cycle spans three months.
1.2 The Time Period Assumption
Because companies must report financial results regularly (e.g., quarterly, annually), accountants
adopt the time period assumption:
The life of a business can be divided into artificial time periods for reporting purposes.
This enables stakeholders to assess performance over consistent intervals, even though the
business operates continuously.
, 2. Operating Activities and the Income Statement
2.1 What Are Operating Activities?
Operating activities are the day-to-day transactions related to the company's core operations,
including:
Selling products/services
Paying wages
Buying inventory
Paying for utilities and rent
2.2 The Income Statement
The income statement reports revenues and expenses for a specific period, revealing net income
or loss.
Components:
Revenues: Income from goods/services sold
Expenses: Costs incurred in earning revenues
2.3 How Business Activities Affect the Income Statement
Each operating transaction changes the company’s revenues, expenses, or both.
Example 1 – Revenue Transaction:
A business delivers services and earns $5,000.
→ Increase in revenue, which increases net income and retained earnings.
Example 2 – Expense Transaction:
A business pays $2,000 in employee wages.
→ Increase in expenses, which decreases net income and retained earnings.
Based on Financial Accounting, 11th Edition by Libby, Libby, and Hodge
Introduction
This chapter focuses on how businesses report and analyze operating activities through the
accounting system. The income statement reflects a company’s performance over a period, and
accurate measurement requires understanding of the time period assumption, accrual
accounting, and the recognition principles. We explore how transactions are recorded using
journal entries and transaction analysis, how to prepare a classified income statement, how
to interpret the net profit margin ratio, and how operating activities impact cash flows. Mastery
of these concepts is critical for making informed business and financial decisions.
1. The Business Operating Cycle and the Time Period
Assumption
1.1 The Business Operating Cycle
A typical business operating cycle refers to the time it takes for a company to:
1. Purchase inventory or supplies
2. Sell goods or services
3. Collect cash from customers
This cycle may be days, weeks, or months depending on the industry.
Example:
A retailer purchases inventory in January, sells it in February, and collects payment in March.
This full cycle spans three months.
1.2 The Time Period Assumption
Because companies must report financial results regularly (e.g., quarterly, annually), accountants
adopt the time period assumption:
The life of a business can be divided into artificial time periods for reporting purposes.
This enables stakeholders to assess performance over consistent intervals, even though the
business operates continuously.
, 2. Operating Activities and the Income Statement
2.1 What Are Operating Activities?
Operating activities are the day-to-day transactions related to the company's core operations,
including:
Selling products/services
Paying wages
Buying inventory
Paying for utilities and rent
2.2 The Income Statement
The income statement reports revenues and expenses for a specific period, revealing net income
or loss.
Components:
Revenues: Income from goods/services sold
Expenses: Costs incurred in earning revenues
2.3 How Business Activities Affect the Income Statement
Each operating transaction changes the company’s revenues, expenses, or both.
Example 1 – Revenue Transaction:
A business delivers services and earns $5,000.
→ Increase in revenue, which increases net income and retained earnings.
Example 2 – Expense Transaction:
A business pays $2,000 in employee wages.
→ Increase in expenses, which decreases net income and retained earnings.
