Chapter3: How do Business Activities Affect the Business Cycle?

Question 1

Operating Cycle

Answer 1

The operating cycle refers to the sequence of events or transactions that a company goes through from acquiring inventory or services to ultimately receiving cash from the sale of goods or services.

It represents the core operational activities of a business.

Question 2

Generating Cash

Answer 2

Companies aim to generate cash primarily through their operating activities, which involve selling goods or services.

This is essential for sustaining the business without relying on borrowing money or selling non-current assets.

Question 3

Key Transactions

Answer 3

Key transactions in the operating cycle include:

Acquiring inventory or services

Selling goods or services to customers

Receiving cash from the sale.

These transactions are central to a company’s core operations.

Question 4

Length of Operating Cycle

Answer 4

The length of the operating cycle varies depending on the nature of the business. Some businesses complete the cycle quickly, while others take more time due to factors like inventory build-up or delayed customer payments.

Question 5

Managing the Operating Cycle

Answer 5

Companies can manage their operating cycle by strategies such as encouraging customers to buy sooner or pay faster.

This can help improve the company’s cash flows and overall financial health.

Question 6

Cash Flow Timing

Answer 6

The timing of cash outflows and inflows in a business often results in the need for short-term financing. Businesses typically have to pay suppliers and employees before receiving cash from customers.

Question 7

Short-Term Financing

Answer 7

Short-term financing is sought by businesses to bridge the gap between cash outflows (such as paying suppliers and employees) and cash inflows (receipts from customers).

It helps businesses manage their cash flow effectively.

Question 8

Sources of Financing

Answer 8

Sources of short-term financing include suppliers and financial institutions such as banks and commercial credit companies.

These entities provide the necessary funds to cover short-term cash flow gaps.

Question 9

Growth and Operating Cycle

Answer 9

When a company plans to grow, it may require additional cash to purchase more inventory or assets for expansion.

This can be challenging if sufficient cash hasn’t been collected from previous customers.

Shortening the operating cycle can help in generating more cash for growth opportunities.

Question 10

Benefits of Shortening the Operating Cycle

Answer 10

Shortening the operating cycle can lead to completing transactions more quickly, resulting in the conversion of cash into more cash.

This provides opportunities for higher net earnings, faster growth, and various financial management options, such as debt repayment or distribution of excess cash to owners.

Question 11

Periodicity Assumption

Answer 11

The periodicity assumption is an accounting concept that assumes a company’s long life can be divided into shorter time periods (e.g., months, quarters, and years) for the purpose of reporting financial information.

It enables decision-makers to assess a company’s financial performance and condition over specific intervals.

Question 12

Recognition Issues

Answer 12

Recognition issues in accounting pertain to determining when the effects of operating activities should be officially recognized and recorded in financial statements.

This involves deciding when to record revenues and expenses.

Question 13

Measurement Issues

Answer 13

Measurement issues in accounting involve determining the specific amounts that should be recognized for various financial elements, such as revenue, expenses, assets, and liabilities, in order to accurately report periodic net earnings.

Question 14

Statement of Earnings

Answer 14

The statement of earnings, also known as the income statement, is a financial statement that reports a company’s revenues, expenses, and net earnings over a specific period.

It provides insights into the company’s profitability.

Question 15

Structure of Statement of Earnings

Answer 15

The typical structure of a statement of earnings for manufacturing and merchandising companies includes sections such as

net sales,
cost of sales,
gross profit,
operating expenses,
earnings from operations,
non-operating revenues/expenses and gains/losses,
earnings before income taxes,
income tax expense,
earnings from continuing operations, earnings/loss from discontinued operations, and net earnings.

Question 16

Gross Profit

Answer 16

Gross profit is a key financial indicator calculated by subtracting the cost of sales from net sales. It represents the profit generated from a company’s core operations before deducting operating expenses.

Question 17

Operating Expenses

Answer 17

Operating expenses encompass distribution costs, administrative expenses, and other expenses directly related to a company’s day-to-day operations.

These expenses are subtracted from gross profit to determine earnings from operations.

Question 18

Non-operating Revenues/Expenses and Gains/Losses

Answer 18

Non-operating revenues and expenses, as well as gains and losses, are items that affect a company’s earnings but are not directly related to its core operations. They are reported separately on the statement of earnings.

Question 19

Earnings Before Income Taxes

Answer 19

Earnings before income taxes (EBIT) is a subtotal on the statement of earnings, representing a company’s earnings before accounting for income tax expenses.

Question 20

Comprehensive Income

Answer 20

Comprehensive income is a broader measure of a company’s financial performance that includes not only net earnings but also other comprehensive income items.

It is presented in a statement of comprehensive income, which is discussed later in the chapter.

Question 21

Financial Statement Classification

Answer 21

Classifying the various elements of the statement of earnings aids financial statement users in assessing a company’s operating performance and predicting its future profitability.

This classification enhances the clarity and usefulness of the financial statement.

Question 22

Statement of Earnings Sections

Answer 22

The statement of earnings comprises three major sections:

1) Results of continuing operations,
2) Results of discontinued operations, and 3) Earnings (loss) per share.

Net earnings is the sum of sections 1 and 2.

Question 23

Continuing Operations

Answer 23

The section of the statement of earnings that presents the results of a company’s normal or ongoing operations.

It provides information about the company’s core business activities.

Question 24

Operating Revenues

Answer 24

Operating revenues are defined as increases in assets or settlements of liabilities resulting from the ongoing operations of a business.

These revenues are earned mainly through the sale of goods or provision of services to customers.

Question 25

Recognition of Revenue

Answer 25

Revenue is recognized in the statement of earnings when the significant risks and rewards of ownership have been transferred to the buyer.

This typically occurs upon the delivery of goods or completion of services.

Question 26

Deferred Revenue

Answer 26

Deferred revenue is a liability account created when a company receives cash in exchange for a promise to provide goods or services in the future.

Revenue is recognized and the liability settled when the promised goods or services are delivered.

Question 27

Operating Expenses

Answer 27

Operating expenses are costs incurred in the operation of a business to generate revenues during a specific period.

They include expenses related to daily business activities.

Question 28

Expenses vs. Expenditures

Answer 28

Expenses are costs that result when assets or resources are used to generate revenue during a period, while expenditures encompass any cash outflows for various purposes, including buying equipment, paying off loans, or employee wages.

Not all expenditures are expenses, but expenses are essential for revenue generation.

Question 29

What are the primary operating expenses for most merchandising companies?

Answer 29

The primary operating expenses for most merchandising companies include:

Cost of sales (or cost of goods sold)
Selling and distribution expenses
Administrative expenses
Gains (or losses) on disposal of assets

Question 30

What is the “cost of sales” (or “cost of goods sold”) for a merchandising company, and why is it significant?

Answer 30

The “cost of sales” (or “cost of goods sold”) is the cost of products sold to customers. It includes all costs associated with acquiring or manufacturing the products.

This expense is significant because it represents the cost incurred to produce the goods that are sold and is a crucial factor in determining the company’s profitability.

Question 31

What is “gross profit” (or “gross margin”), and how is it calculated?

Answer 31

Gross profit (or gross margin) is the difference between sales (net of sales discounts, returns, and allowances) and the cost of sales.

It represents the profit a company makes after deducting the direct cost of producing or acquiring the goods it sells.

Question 32

What are “selling and distribution expenses” in a company’s financial statements?

Answer 32

Selling and distribution expenses include the costs associated with supporting the sales effort. This includes salaries of sales personnel, marketing and promotion expenses, distribution costs, warehouse rental, and insurance expenses. These expenses are incurred to market and distribute the company’s products to customers.

Question 33

What do “administrative expenses” encompass in a company’s financial statements?

Answer 33

Administrative expenses encompass a variety of costs related to administrative functions within a company.

These expenses include salaries of administrative personnel, legal fees, accounting expenses, travel costs, telecommunications services, and other administrative overhead costs.

Question 34

What are “gains” and “losses” on disposal of assets in a company’s financial reporting?

Answer 34

Gains on disposal of assets are increases in assets or decreases in liabilities that result when assets (other than investments) are sold for more than their cost.

Losses, on the other hand, are decreases in assets or increases in liabilities resulting from the sale of assets for less than their cost.

These gains and losses are reported on a company’s income statement to reflect the financial impact of disposing of property and equipment.

Question 35

Where are gains or losses from selling short- or long-term investments reported in a company’s financial statements, and why are they reported there?

Answer 35

Gains or losses from selling short- or long-term investments are reported in the Non-operating Items section of the multiple-step statement of earnings.

They are not considered operating activities.

This reporting distinction is made to separate gains and losses related to investments from the core operating activities of the company.

Question 36

What is an impairment loss in accounting, and how was Gildan affected by it in 2020?

Answer 36

An impairment loss in accounting occurs when the value of specific assets, such as accounts receivable, intangible assets, or goodwill, is reduced due to circumstances that affect their recoverable amount.

In 2020, Gildan reported an impairment loss of $109 due to the negative impact of the COVID-19 pandemic, which caused a decline in economic activity, increased expected credit losses on accounts receivable, and affected the value of intangible assets and goodwill.

Question 37

How does Gildan classify its expenses, and what are the two classification methods mentioned?

Answer 37

Gildan classifies its expenses by function or by the nature of the expense. The two classification methods are as follows:

By Function: Expenses are categorized based on the functions they serve within the company, such as marketing and promotion, distribution, and administrative expenses.

By Nature: Expenses are categorized based on the three main costs of production: materials, labor, and the use of property and equipment.

Question 38

What is the significance of “earnings from operations” (or “operating income or loss”) in a company’s financial statement?

Answer 38

“Earnings from operations” (or “operating income or loss”) represents the financial result of a company’s core operating activities. It is calculated as net sales minus cost of sales and operating expenses.

This figure helps assess the company’s profitability from its primary business operations.

Question 39

EARNINGS (LOSS) FROM OPERATIONS

Answer 39

Net sales less cost of sales and operating expenses (also known as operating income or loss).

Question 40

What are non-operating items in a company’s financial statement, and why are they separated from earnings from operations?

Answer 40

Non-operating items in a company’s financial statement are revenues, expenses, gains, or losses that result from activities not central to continuing operations.

They are separated from earnings from operations to provide a clearer picture of the company’s core business performance, as these items can be unrelated to its primary operations.

Question 41

Give an example of a non-operating item related to income.

Answer 41

An example of a non-operating item related to income is “Interest income” (also known as interest revenue, investment income, or dividend income).

This includes any interest or dividends earned on investments made using excess cash.

These earnings are categorized as non-operating income because they result from investing activities, not the central operations of the company.

Question 42

Why are financing costs not considered operating expenses, and what are some examples of financing costs mentioned in the text?

Answer 42

Financing costs are not considered operating expenses because they arise from borrowing money, which is a financing activity, not a core operating activity.

Examples of financing costs mentioned in the text include “interest expense” and other financing costs related to transactions involving different currencies, such as the euro.

Question 43

How are gains and losses on the sale of investments treated in a company’s financial statements, and did Gildan report any such gains or losses in 2020?

Answer 43

Gains and losses on the sale of investments are reported as non-operating items on the statement of earnings. In 2020, Gildan did not report any gains or losses from selling investments.

Question 44

What is the significance of non-operating items in relation to income taxes, and how are they incorporated into a company’s financial statement?

Answer 44

Non-operating items that are subject to income taxes are added to or subtracted from earnings from operations to obtain the earnings before income taxes (or pretax earnings or loss).

This separation helps calculate the income tax liability based on the company’s core operating performance, excluding non-operating items.

Question 45

What is income tax expense in a company’s financial statement, and where is it typically listed?

Answer 45

Income tax expense in a company’s financial statement represents the taxes owed to federal, provincial, and foreign governments. It is the last expense listed on the statement of earnings.

Income tax expense is calculated as a percentage of earnings before income taxes, reflecting the difference between income (including revenues and gains) and expenses and losses. It represents the amount a company owes in taxes based on its taxable income.

Question 46

What is the significance of applicable tax rates when calculating income tax expense?

Answer 46

Applicable tax rates are crucial when calculating income tax expense because they determine the percentage of taxable income that a company must pay in taxes. Different tax rates apply to different levels of income, and knowing the applicable rates is essential for accurate tax calculations.

Question 47

What are discontinued operations in a company’s financial statement, and why are they presented separately from continuing operations?

Answer 47

Discontinued operations in a company’s financial statement refer to a major line of business, geographical area of operations, or a specific operation that the company has decided to dispose of or discontinue.

They are presented separately from continuing operations because they are non-recurring and not useful in predicting future recurring net earnings.

This separation allows for a clear distinction between the financial results of the discontinued component and the ongoing operations of the company, net of income tax effects.

Question 48

What is earnings (loss) per share (EPS) in a company’s financial statement, and why is it important?

Answer 48

Earnings (loss) per share (EPS) is a financial ratio that corporations are required to disclose on the statement of earnings or in the notes to the financial statements.

EPS is widely used to evaluate a company’s operating performance and profitability.

At an introductory level, it can be computed as **net earnings divided by the average number of shares outstanding during the period. **

It’s important because it provides information about how much profit or loss is attributable to each share of common stock.

Question 49

How do stock market analysts and investors typically react to accounting announcements, and why is accounting information important to them?

Answer 49

Stock market analysts and investors use accounting information to make investment decisions.

They often react negatively when a company does not meet previously specified operating results.

Accounting information is crucial to them because it helps assess a company’s financial health, performance, and adherence to its operating plan, influencing their investment choices.