CH2109: Decision Tools for

Engineering Business

Dr. Kelvin Yong

Lecturer
N1.2 B2-26B
School of Chemical and Biomedical Engineering
kmyong@ntu.edu.sg

CH2109 Decision Tools for Engineering

Business
Lecture 3: Operating Decisions and the
Income Statement
•  Operation Flow and Income Statement Elements
•  How are operating activities recorded and
measured?
•  Revenue and Matching Principles
•  Impact of revenues and expenses on income
statement and hence on balance sheet
•  Total asset turnover ratio, Profit Margin
Percentage and Percentage Return on Assets
•  Summary
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 Income Statement/Activities in Business
•  Some common questions such as:-
–  How income statement can affect decisions?
–  How income statement items are computed?
–  How business activities affect income statement?
–  How these activities recognized and measured?
–  How these activities are presented in income statement?

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 Operation Flow
•  Long time period to be divided into shorter time
periods for assessment
–  Managers/Investors need financial information in a
timely fashion
–  To do this, the long operating period must be divided
into shorter periods
•  When and what problems in the operating
activities should be recognized(recorded)
–  For example, revenue and expense problems recognition.

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 Operation Flow
Purchase or Manufacture
Products or Supplies on credit.
(Beginning)
After grace
period due.
(X days)
Pay Suppliers.
Products delivery
or service due.
(Y days)
Deliver product or
Customers pay up provide service to
after grace period customers on credit.
or the period listed
in contract is up.
(Z days) Receive Payment
from Customers.

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 Operation Flow
•  Between purchasing of products and payment to
suppliers, many scenarios:-
–  Some suppliers allow 30 days payment (on credit)
–  Some suppliers do not allow, and request immediate
payment
–  Some suppliers allow partial payment first and pay the
balance within 30 days

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 Operation Flow
•  Between delivery of products or service to
customers payment, many scenarios:-
–  Customers allowed 30 days to pay
–  Customers must make payment straight away
–  Customers are allowed partial payment first and pay the
balance within 30 days

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 Operation Flow

Beginning of time frame Pay Suppliers Delivery Received Payments

(X days) (Y days) (Z days)

[X < Y < Z ], [X > Y, X < Z] Need sufficient cash capital to pay for supplies or
manufacturing before receiving payment.
[X > Y > Z] Cash received (full or partial) from customers can be used to pay for
supplies or manufacturing.

•  Cash inflow and outflow events are important and need to be

monitored within the operation activates to ensure there are
sufficient cash capital to pay for supplies or products
manufacturing, even in the event when there is a time lapse after
delivery for payments to be made by customers.
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 Income Statement Elements
•  Revenues
–  Increase in assets or settlement of liabilities from
ongoing operation
–  Eg. Payment from customers for service or products,
delivering service or products to customers paid earlier
•  Expenses
–  Decreases in assets or increase in liabilities from
ongoing operation
–  Eg. Wage expense, tax expense, operating expense

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 Income Statement Elements
•  Gains
–  Increase in assets or settlement of liabilities from
peripheral operation
–  Eg. Winning lawsuit settlements, sale of land with
increased in prices

•  Losses
–  Decreases in assets or increase in liabilities from
peripheral operation
–  Eg. Losing lawsuit settlements, sale of land with
depreciation in prices
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 XYZ Pte Ltd
Consolidated Income Statement (Page 1 of 2)
For the year ended 31 Dec 2013 (dollars in thousands)
Operating Revenues
Sales Revenue $4100
Services Revenue $5900
Total Revenues $10000
Operating Expenses
Operating Wages Expense $2300
Activities Depreciation Expense $700
(Core business) Rent Expense $1200
Maintenance Expense $800
Marketing and Advertising Expense $1000
Cost of Goods Sold (COGS) $2000
Total Expenses $8000
Operating Income $2000

Peripheral Other Items

Activities Investment income $2500
(Non-Core Interest expense ($1500)
business) Revenue from Royalties $5400

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 XYZ Pte Ltd
Consolidated Income Statement (Page 2 of 2)
For the year ended 31 Dec 2013 (dollars in thousands)
Income before Income Taxes $8400
Income tax expense $1000

Net Income $7400

Earnings per Share (Total of 10 millions outstanding $0.00074
shares)

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 How are Operating Activities Recognized
(Recorded) and Measured?
•  Cash Basis
–  Revenue is recognized when cash is received.
–  Expense is recognized when cash is paid.
–  Not considered part of generally accepted accounting
principles (GAAP).
•  Accrual Accounting
–  Assets, liabilities, revenues, expenses should be
recorded when transaction which causes them occurs,
not necessary when cash is paid or received.
–  Required by GAAP.
–  Recording guided by revenue and matching principles
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 Revenue Principle
•  Recognize revenues when the following
conditions are met:-
–  Delivery has occurred or services have been rendered.
–  There is evidence of an arrangement for customer
payment.
–  The price is fixed or determinable.
–  There must not be substantial doubt that the payment
cannot be received. Thus, default payments, we usually
do not group them as unearned revenue in the liability
account, but as expenses.

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 Revenue Principle
•  Unearned Revenue in liability account
–  Cash received before services rendered or products
delivered.
–  Scenario #1: Buyer paid first before any services
rendered or products sent to him.
–  Scenario #2: Buyer paid on the promise that the
company will deliver services or products in future
although some services are delivered.
–  Cash (+A) Debit in journal entry
–  Unearned Revenue (+L) Credit in journal entry

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 Revenue Principle
•  When company delivered services or products
–  Unearned revenue in liability account will be reduced
–  Unearned revenue liability (-L) debit in journal entry
–  Revenue will increase
–  Revenue (+R) credit in journal entry
•  Examples:-
–  Rent collected in advance becomes rent revenue
overtime.
–  Unearned maintenance revenue becomes maintenance
revenue overtime.

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 Revenue Principle
•  When cash is received at the same time revenue is
earned:-
–  Cash will be increase (+A) and is a debit in journal
entry.
–  Revenue will be increase (+R) and is a credit in journal
entry.
•  When invoices are sent after services are
rendered:-
–  accounts receivable in asset account will be recorded as
debit. i.e. Account receivable (+A).
–  Revenue will be recorded as credit (+R).
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 Revenue Principle
•  When company received cash payment:-
–  accounts receivable will be reduced (-A) and is a credit
in journal entry.
–  Cash will be increased (+A) and is a debit in journal
entry.
•  Examples:-
–  Rent, interest and royalties receivables become earned
as rent, interest and royalties revenue.

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 Matching Principle
•  Resources consumed to earn revenues to an
accounting period should be recorded in that
period, regardless of when cash is paid.
•  A matching of costs with benefits.
•  Example:-
–  All operating expenses should be recorded in same
period as those revenues earned from it.
–  Examples of operating expenses are wage expenses,
rent expenses and utilities expenses.

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 Matching Principle
•  When cash is paid before company receives any
services or products:-
–  Prepaid Expense (+A) will be recorded as Debit in
journal entry.
–  Cash (-A) will be recorded as Credit in journal entry.
•  When expense is incurred from prepaid expense:-
–  Expense (+E) will be recorded as Debit in journal entry.
–  Prepaid Expense (-A) will be reduced and recorded as
Credit in journal entry.

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 Matching Principle
•  When cash is paid at the same time expense is
incurred:-
–  Expense (+E) will be recorded as Debit in journal entry.
–  Cash (-A) will be recorded as Credit in journal entry.
•  When cash is paid after services rendered or
products delivered:-
–  Accounts payable (+L) will be recorded as Credit in
journal entry.
–  Expense (+E) will be recorded as Debit in journal entry.

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 Matching Principle
•  When cash is paid for the accounts payable:-
–  Accounts payable (-L) will be reduced and recorded as
Debit in journal entry.
–  Cash (-A) will be recorded as Credit in journal entry.
•  Examples:-
–  Cash paid for supplies inventory becomes supplies
expense overtime when payments are made.
–  Prepaid insurance becomes prepaid expense overtime
when payments are made.
–  Buildings and equipment become depreciation expense
overtime.
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 Transaction Analysis Model
•  How will revenues and expenses affect retained
earnings?
Assets = Liabilities + Stockholders’ Equity

Debit (+) Credit(-) Debit(-) Credit(+) Debit(-) Credit(+)

Stockholders’ Equity
Contributed Capital Retained Earnings

Debit(-) Credit(+) Debit(-) Credit(+)

Investments Dividends Net income
by owners declared of business

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 Expanded Transaction Analysis Model

Retained Earnings
Dividends Net Income
Debit(-) Credit(+)
decrease retained increases retained
For decrease For increase
earnings earnings

Revenues Expenses

Debit(-) Credit(+) Debit(+) Credit(-)

For decrease For increase For increase For decrease

•  Increase in revenues leads to increase in net income and retained

earnings, hence credit for increase and debit for decrease in revenues.
•  Increase in expenses leads to decrease in net income and hence
decrease in retained earnings. Thus debit for increase in expenses, and
credit for decrease in expenses.
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 Examples of Transactions
Example 1: XYZ Pte Ltd received $90000 cash for selling products to
customers, and also sold $20000 of consultancy services to another customer,
receiving $10000 cash and the rest will be paid in 30 days.

Reference
Account’s title Debit Credit
General Number
Journal Q12345 Cash (+A) 100000
Accounts Receivable (+A) 10000
Sales Revenue(+R,+SE) 110000

Assets = Liabilities + Stockholders’ Equity

Cash +100000 Sales Revenue +110000
Equation is
balance! Accounts +10000
Receivable
Total: $110000 Total: $110000

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 Examples of Transactions
Example 2: The cost of purchasing parts and supplies for the products sold in
example 1 is $40000.

Reference
Account’s title Debit Credit
General Number
Journal Q12346 Parts/Supplies (-A) 40000
Cost of Sales (+E,-SE) 40000

Equation is Assets = Liabilities + Stockholders’ Equity

balance! Parts/Supplies -40000 Cost of Sales (+E, -SE) -40000

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 Examples of Transactions
Example 3: XYZ Pte Ltd received $5000 cash payment of maintenance services
from a client, earning $1000 immediately by performing initial maintenance; the
rest will be earned over next 12 months.

Reference
Account’s title Debit Credit
General Number
Journal Q12345 Cash (+A) 5000
Maintenance Fee Revenue (+R,+SE) 1000
Unearned Maintenance Fee (+L) 4000

Assets = Liabilities + Stockholders’ Equity

Maintenance Fee +1000
Equation is Cash +5000
Revenue (+R,+SE)
balance!
Unearned +4000
Maintenance
Fee (+L)
Total:
© Dr Kelvin Yong +5000 CH2109 Decision Tools forTotal:
Engineering $+5000
26
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 Examples of Transactions
Example 4: XYZ Pte Ltd paid $9000 cash for rent, repairs, and transportation for
delivery which is all grouped under general expenses.

Reference
Account’s title Debit Credit
General Number
Journal Q12347 Cash (-A) 9000
General Expenses (+E,-SE) 9000

Assets = Liabilities + Stockholders’ Equity

Equation is Cash -9000 General Expenses (+E,-SE) -9000
balance! Total: -9000 Total: $-9000

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Balance Sheet Accounts

+ Cash (A) - + Accounts Receivable (A) -

Bal. 10000 Bal. 8000
A1 23000 A2 1000 A1 12000 A2 5000
A4 3000 A3 300 A4 5000 A3 2300
A5 4000 A6 700 A5 5000 A6 2700
Bal. 38000 Bal. 20000

+ Equipment (A) - - Accounts Payable (A) +

Bal. 5000 Bal. 15000
A1 25000 A1 3000
A2 2000
Bal. 30000
A3 4000
Bal. 16000

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Income Statement Accounts

- Sales Revenue (R) + + Cost of Sales (E) -

Bal. 0 Bal. 0
A1 73000 A1 25000

Bal. 73000 Bal. 25000

- Investment Revenues (R) + + Wages Expense (E) -

Bal. 0 Bal. 0
A9 15000 A10 23000
Bal. 15000 Bal. 23000

- Gain on sales of land (R) + + Loss from lawsuit(E) -

Bal. 0 Bal. 0
A8 45000 A1 10000
Bal. 45000 Bal. 10000

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 Financial Statements
Preparation and Analysis

Income Statement Revenues – Expenses = Net Income

Statement of Beginning Retained Earnings

Stockholders’ + Net Income
Equity - Dividends Declared
= Ending Retained Earnings

Assets = Liabilities + Stockholders’ Equity

Balance Sheet [Contributed Capital]
[Retained Earnings]

Change in Cash =
Statement of Cash Cash from operating activities
Flows
+Cash from investing activities
+Cash from financing activities

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 XYZ Pte Ltd
Consolidated Statement of Stockholders’ Equity
For the month ended 31 Jan 2014 (dollars in thousands)
Total
Contributed Retained
Stockholders’
Capital Earnings
Equity
Beginning balance, Dec 31, 2013 $5000 $5000 $10000
Net income (before adjustment) $3000 $3000
Dividends declared ($1000) ($1000)
Additional stock issuances $3000 $3000
Ending balance, Jan 31, 2014 $8000 $7000 $15000

Import from Export to Balance

Income Statement sheet

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 Total Asset Turnover Ratio
•  Measured by taking the ratio of sales or operating
revenues over average total assets.
•  Average total assets is the sum of beginning and
end total assets divided by 2.
Sales or Operating Revenues
TATR =
Average Total Assets
where
1 !Beginning Total Assets +$
Average Total Assets = # &
2 "Ending Total Assets %

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 Total Asset Turnover Ratio
•  It reflects the efficiency of company in using
assets to generate revenues
•  High asset turnover means good sales are
generated from its assets
•  Total assets include cash, warehouses etc
•  An example of how to have maximum efficiency
is using warehouses to store the products and able
to sell at a cheaper prices thus generating more
sales

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 Profit Margin Percentage
•  Profit margin percentage (PM) is net income
divided by sales revenue
•  Measures the profit generated from its sales
•  Low prices usually resulted in low profit margin to
attract more customers
•  High asset turnover usually occurs for companies
with low profit margin
–  Because when companies are able to use assets to
generate sales efficiently, they are able to push the price
low to attract more customers without sacrificing
profitability
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 Profit Margin Percentage
–  Companies selling commodities usually have lowest
profit margins as customers will look to low pricing as
the main decision to purchase the product
•  Low asset turnover usually occurs for companies
with high profit margin
–  Because the companies are not able to use assets to
generate sales efficiently, these companies usually have
to push higher price or not able to drive down price in
their products to maintain the level of profitability
–  Companies selling specialize products usually have
highest profit margins as customers look to features/
applications of products over pricing when purchasing
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 Percentage Return on Assets
•  Percentage Return on Assets (ROA) defined as:-

ROA = PM × TATR

•  Measures how much company can earn in profit

from its asset
•  To achieve good ROA, the company has to be
efficient to have high TATR because low PM
usually leads to low ROA
•  Challenge is to have a high TATR and a low PM
company in order to achieve a good ROA
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 Percentage Return on Assets
•  ROA statistics can be compared over a certain
period for a company or compared against other
companies in the same industry to indicate its
improving or deteriorating conditions
•  Companies with high ROA might look to acquire
those with low ROA if they believe they can
extract more values out of these companies

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 Summary (Lecture 1,2,3)
•  Introduction to financial accounting statements.
•  Relationship between the statements.
•  Financing and investing decisions and activities,
and their impact from balance sheets.
•  Operating decisions and activities and their impact
from income statement
•  TATR, PM and ROA

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•  Credit some of the contents to the following
sources:-
–  The McGraw-Hill Companies, Inc.
–  Susan Coomer Galbreath, Ph.D., CPA
–  Charles W. Caldwell, D.B.A, CMA
–  Jon A. Booker, Ph.D., CPA, CIA
–  Cynthia J. Rooney, Ph.D., CPA
–  http://smallbusiness.chron.com/
–  Investopedia

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 End of Lecture 3
THANK YOU

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