Operating Activities



Operating Activities

Basic Operating Activities

The first item on the Income Statement is net sales revenue. Companies with large amounts of service revenues report these in addition to (or instead of) sales revenue. Net revenues result from subtracting discounts and returns and allowances from gross revenues. Cost of goods sold is subtracted from net sales revenue to compute gross profit. The expenses for marketing and distributing a company’s products and managing its operations are subtracted from gross profit to calculate operating income. Non-operating expenses or losses, such as interest expense, are subtracted and non-operating income or gains are added to compute income before taxes. Income tax expense is subtracted from income before taxes to calculate net income. Finally, earnings per share is reported on a corporate Income Statement.

Most companies recognize operating revenues at the time they transfer ownership of goods and services to customers. Ownership of most goods passes to the buyer at the time that the goods are delivered or shipped to the buyer.

Manufacturing and merchandising companies may ship goods to customers. Ownership of these goods is transferred to the buyer at the location named in the sales terms. When goods are shipped FOB (free on board) destination, ownership of goods is transferred to the customer when the goods are delivered. When goods are shipped FOB shipping point, ownership passes to the customer at the shipping point. As a general rule, revenue should be recognized when four criteria have been met:

1. The selling company has completed most of the activities necessary to produce and sell the goods or services.

2. The selling company has incurred the costs associated with producing and selling the goods or services or can reasonably measure those costs.

3. The selling company can measure objectively the amount of revenue it has earned.

4. The selling company is reasonably sure that it is going to collect cash from the purchaser.

For most companies, these criteria have been met when goods are transferred or when services are provided to customers who pay for them or who are obligated to pay for them.

Special measurement and recognition issues arise when revenues are earned over an extended period, as from a long-term contract; when some customers can be expected to return a portion of goods purchased; when some customers are likely not to pay for their purchases, and when the seller provides a warranty for the goods or services sold.

Sales Discounts and Returns

Revenues are reported on the Income Statement net of discounts and expected returns. A discount is a reduction in the normal selling price. Discounts reduce revenues, and companies should record as revenues only the amount it actually expects to receive from a sale.

Like sales discounts, sales returns are subtracted from sales revenues in reporting net operating revenues on the Income Statement.

Future returns are estimated so that revenues for the fiscal period in which the sales were made can be measured more accurately. A major principle of accounting is the matching principle; an effort is made to match revenues and expenses in the period in which they occur so that revenues, expenses, and net income are fairly stated. Sales returns should be matched with the sales that result in the returns. The matching principle often requires that future events be estimated, such as the amount of future returns. These estimates are not completely accurate, but reported revenues and expenses usually are more correct when adjusted using these estimated amounts than when no adjustment is made. The amount of operating revenue a company reports on its Income Statement is the net amount of revenue earned after discounts and returns have been subtracted.

When actual goods are returned to a company, the amount of the return is written off against the allowance for returns account. Accounts receivable is reduced by the amount of the return if the customer purchased on credit. Otherwise, a cash refund may be paid. In addition, cost of goods sold and Merchandise Inventory are adjusted assuming that the goods are put back into inventory to be resold.

Companies that sell goods and services on credit are likely to incur some bad debts. Some customers will be unable to pay for the goods and services they receive. Companies estimate the amount of receivables that are likely to be uncollectible and report this amount as a contra-asset, Allowance for Doubtful Accounts. This allowance is deducted from Accounts Receivable and the net amount of Accounts Receivable is reported on the Balance Sheet. The amount of the allowance is estimated at the end of fiscal periods, at least once a year. When we adjust the balance in the allowance account, we also recognize the bad debt expense which appears on the Income Statement.

Companies base their estimates of the amount of doubtful accounts they expect on experience and on analysis of customer accounts. When a company identifies a receivable as being uncollectible, the receivable is written off and the Allowance for Doubtful Accounts is adjusted. The balance of the Allowance account is reduced by the amount written off, as is Accounts Receivable.

Warranty Costs

Companies often offer warranties on goods they produce. A defective product can be returned to the seller for replacement or can be returned to the manufacturer for repair or replacement. The manufacturer incurs costs when goods are replaced or repaired and these costs should be matched with the revenues resulting from the sale of the defective products. Therefore, companies estimate expected warranty costs each fiscal period and record these as expenses as well as liabilities of the period in which the goods were sold. When actual warranty claims are received, costs of these claims are recorded as a reduction of the liability. No new expense is recorded.

Revenues and expenses associated with selling goods and services should be recognized in the fiscal period in which the revenues are earned. Because the outcomes of some of the events associated with these revenues and expenses are not known until a later fiscal period, it is often necessary to estimate these effects. The estimates are recorded in the fiscal period in which the revenues are earned, and these amounts are adjusted in later periods when actual amounts are known. Doubtful accounts expense, sales returns, and warranty expense are all examples of these required estimates.

Inventories and Cost of Goods Sold

In order to earn revenues, merchandising and manufacturing companies have to acquire or produce goods for sale. These activities increase Inventories on the Balance Sheet and reduce Cash and/or increase Accounts Payable. Once goods are sold Inventories are reduced and Cost of Goods Sold is recognized. The amount reported for Inventories on the Balance Sheet is related to the amount reported for Cost of Goods Sold on the Income Statement and to net operating cash flow on the Cash Flow Statement.

Reporting Inventories and Cost of Goods Sold

Merchandising Companies

When a perpetual inventory system is used and a merchandising company buys inventory, the company will increase the Inventory account (and decrease Cash and/or increase Accounts Payable), and when it sells Inventory, it will decrease the Inventory account and increase Cost of Goods Sold. (These entries are independent of the entry to recognize revenue for the sale of Inventory.)

Manufacturing Companies

Accounting for the inventory transactions of a manufacturing company is more complex than that for a merchandising company because a manufacturing company produces inventory rather than purchasing it from a supplier. Most manufacturing companies separate their inventories into three categories.

Raw Materials Inventory includes the costs of component parts or ingredients that become part of the product being manufactured. Raw materials are reported on the Balance Sheet as the cost of the components or ingredients a company has purchased that have not yet been placed into production.

Work-in-Process Inventory includes the costs of materials, labor, and overhead that have been applied to products that are in the process of being manufactured. Material costs are determined from the amounts paid for Raw Materials. As Raw Materials are used in the production process, the costs of these materials are transferred from Raw Materials Inventory to Work-in-Process Inventory. Direct labor costs are added to Work-in-Process Inventory based on the amount earned by factory workers. Overhead costs include the costs of supplies, utilities, depreciation, and maintenance that are necessary for the manufacturing process.

Finished Goods Inventory includes the costs of products that have been completed in the manufacturing process and are available for sale to customers. These costs include the costs of the materials, labor, and overhead necessary to produce completed products. Manufacturing companies do not recognize expenses for the materials, labor, and overhead used in the production process until goods are sold. These items remain part of the company’s inventories until finished goods are sold. At that time, production costs are transferred to expense as Cost of Goods Sold. The accrual accounting procedure matches expenses with revenues in the period in which the revenues are recognized. The cost of goods that have not been sold by the end of the fiscal period are reported on the Balance Sheet as part of a company’s inventories. Each inventory category (Raw Materials, Work-in-Process, and Finished Goods) may be reported on the Balance Sheet. Sometimes, manufacturing companies report the amount of total inventories on the Balance Sheet and report the amounts of Raw Materials, Work-in-Process, and Finished Goods in a footnote.

Measuring Inventory

Most companies that sell products for which one unit of inventory is like other units of inventory estimate their cost of goods sold using a cost flow assumption rather than trying to keep track of the cost of each individual unit. Exceptions to this practice are made when the cost of individual inventory items is large and one item is easily distinguishable from another. For companies that estimate inventory costs, common methods are first-in, first-out (FIFO), last-in-first-out (LIFO) , and weighted average. The FIFO method assumes that the units of inventory acquired first are sold first. The LIFO method assumes that the last units of inventory acquired are sold first. The weighted average method uses the average cost of units of inventory available during a period as the cost of units sold.

Inventory estimation methods often are used even when a company knows which items of inventory are being sold. Most companies sell their oldest goods first, to avoid spoilage and obsolescence. They may use LIFO to account for those goods anyway. LIFO is often used by businesses because of its beneficial income tax effects.

Inventory Estimation and Income Taxes

The primary reason for the use of LIFO is the tax advantage LIFO provides to many companies. LIFO results in the most recent inventory costs being subtracted when computing net income. FIFO results in the oldest inventory costs being subtracted. In periods of rising prices, LIFO usually produces a higher cost of goods sold and a lower pretax income than does FIFO. Therefore, income taxes are also lower.

Income tax regulations require that, in most cases, a company that uses LIFO to calculate the cost of goods sold in computing its income taxes also must use LIFO to estimate costs of goods sold on its Income Statement. This rule, called a tax conformity rule, is unusual. Tax regulations normally permit companies to use different accounting measurement rules for estimating revenues and expenses for tax and financial reporting purposes. For example, a company can use accelerated depreciation for computing income taxes and straight-line depreciation for computing net income. Because of this tax rule, a company often has to choose between reporting higher net income by using FIFO and paying lower taxes by using LIFO. Once a company chooses an inventory method, GAAP requires that the method be used consistently from year to year.

A change from one method to another (from LIFO to FIFO, for example) is permitted only when management can justify the change because of important changes in the company’s business.

Companies that use FIFO normally do so for sound economic reasons. If the cost of inventory decreases over time because of improvements in technology or increased competition, FIFO produces a tax advantage over LIFO. The oldest items in inventory cost more than the newest items. Including the cost of the oldest items in cost of goods sold reduces taxable income and income taxes.

Lower or Cost or Market Inventory Valuation

GAAP require companies to compare the costs determined through inventory estimation methods with the current market cost of the inventories on hand at the end of a fiscal year. If current market costs are below the costs resulting from the use of an estimation method, such as FIFO, LIFO, or weighted average, the inventories must be written down to current market costs. This requirement is known as the lower of cost of market (LCM) rule. Such writedowns are more common when FIFO is used because FIFO normally results in a higher estimated inventory value at year-end. Therefore, FIFO inventory costs are more likely than LIFO costs to be higher than market. A writedown results in a loss that is recognized in the period in which the inventory decreased in value.

GAAP require companies to disclose the methods they use to measure inventories and cost of goods sold. GAAP also require companies that use LIFO to disclose the effect of the method on the reported value of inventory.

The FIFO, LIFO, and weighted average methods are used by both merchandising and manufacturing companies. Recently, many manufacturing companies have tried to reduce their inventories. Those companies buy materials as they are needed, “just in time” to be used in the manufacturing process. Materials are acquired at a rate sufficient to meet orders without accumulating large amounts of inventories. Companies that use just-in-time manufacturing procedures report relatively small amounts of inventory, and they expense almost all of their manufacturing costs each period as part of the Cost of Goods Sold.

Other Operating Activities and Income Statement Items

Operating Expenses

Most operating expenses other than Cost of Goods Sold are period costs. Period costs are expenses in the period in which they occur. These costs usually reduce cash or other assets or increase liabilities on the Balance Sheet. The use of cash is a cash outflow on the Statement of Cash Flows.

Other Revenues and Expenses

Other revenues include interest and other investment income such as dividends or gains from the sale of stocks and bonds. Other expenses include interest on short-term and long-term debt.

Income Taxes

The Income Statement reports the amount of income taxes that a company would incur if its pretax income were all taxable in the current fiscal year.

Non-recurring Gains and Losses

Certain gains and losses are reported separately on a company’s Income Statement after the calculation of income associated with normal business activities. These items are reported separately because they are not expected to recur. The three types of non-recurring items reported separately are discontinued operations and extraordinary items.

Discontinued operations are product lines or major parts of a company from which the company will no longer derive income because it has sold or closed the facilities that produced the product line or that included that part of the company. Two types of gains or losses associated with discontinued operations are reported. One is the gain or loss associated with operations that are being discontinued. The other is the gain or loss associated with the sale of the discontinued facilities. Non-recurring items are reported net of the tax effect associated with that item because if the non-recurring item had not occurred, the associated tax effect would not have occurred either.

Extraordinary items are gains or losses that are both unusual and infrequent for a particular company. Losses associated with natural disasters are often reported as extraordinary items. The key to identifying those that are extraordinary is whether or not the event rarely occurs. Extraordinary items are reported net of applicable income taxes.

When a company reports non-recurring items on its Income Statement, it also reports earnings per share separately for those items.

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