Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Operating Decisions and the Income Statement Chapter 3

3-2 Business Background How do business activities affect the income statement? How do business activities affect the income statement? How are these activities recognized and measured? recognized and measured? How are these activities recognized and measured? recognized and measured? How are these activities reported on the income statement? How are these activities reported on the income statement?

3-3 Learning Objectives Describe a typical business operating cycle and explain the necessity for the time period assumption.

3-4 The Operating Cycle Purchase or manufacture products or supplies on credit. Deliver product or provide service to customers on credit. Paysuppliers.Paysuppliers. Receive payment from customers. Begin

3-5 The Operating Cycle Time Period: The long life of a company can be reported over a series of shorter time periods. Recognition Issues : When should the effects of operating activities be recognized (recorded)? Measurement Issues: What amounts should be recognized?

3-6 The Time Period Assumption relatively short time periods To meet the needs of decision makers, we report financial information for relatively short time periods (monthly, quarterly, annually) Life of the Business Annual Accounting Periods

3-7 Learning Objectives Explain how business activities affect the elements of the income statement.

3-8 Elements on the Income Statement Losses Decreases in assets or increases in liabilities from peripheral transactions. Losses Revenues Increases in assets or settlement of liabilities from ongoing operations. Revenues Expenses Decreases in assets or increases in liabilities from ongoing operations. Expenses Gains Increases in assets or settlement of liabilities from peripheral transactions. Gains

3-9 Papa John’s Primary Operating Activity is selling pizza and selling franchises. Operating Activities Peripheral Activities

3-10 Papa John’s Primary Operating Expenses Cost of sales (used inventory) Salaries and benefits to employees Other costs (like advertising, insurance, and depreciation)

3-11 Earnings Per Share Net Income Weighted Average Number of Common Shares Outstanding

3-12 Corporations are taxable entities. Income tax expense is Income Before Income Taxes × Tax Rate (Federal, State, Local and Foreign).

3-13 Learning Objectives Explain the accrual basis of accounting and apply the revenue and matching principles to measure income.

3-14 Cash Basis Accounting Revenue is recorded when cash is received. Revenue is recorded when cash is received. Expenses are recorded when cash is paid. Expenses are recorded when cash is paid.

3-15 Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received. Required by - G enerally A cceptable A ccounting P rinciples Accrual Accounting

3-16 Revenue Principle Recognize revenues when... Delivery has occurred or services have been rendered. Delivery has occurred or services have been rendered. There is persuasive evidence of an arrangement for customer payment. There is persuasive evidence of an arrangement for customer payment. The price is fixed or determinable. The price is fixed or determinable. Collection is reasonably assured. Collection is reasonably assured. Recognize revenues when... Delivery has occurred or services have been rendered. Delivery has occurred or services have been rendered. There is persuasive evidence of an arrangement for customer payment. There is persuasive evidence of an arrangement for customer payment. The price is fixed or determinable. The price is fixed or determinable. Collection is reasonably assured. Collection is reasonably assured.

3-17 Revenue Principle If cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE is recorded. Cash received before revenue is earned - Cash Received Cash (+A) xxx Unearned revenue (+L) xxx

3-18 Revenue Principle When the company delivers the goods or services UNEARNED REVENUE is reduced and REVENUE is recorded. Cash received before revenue is earned - Cash Received Company Delivers Cash (+A) xxx Unearned revenue (+L) xxx Revenue will be recorded when earned.

3-19 Revenue Principle Typical liabilities that become revenue when earned include...

3-20 Revenue Principle When cash is received on the date the revenue is earned, the following entry is made: Cash Received Company Delivers Cash (+A) xxx Revenue (+R) xxx AND

3-21 Revenue Principle If cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded. Cash received after revenue is earned - Accounts receivable (+A) xxx Revenue (+R) xxx Company Delivers

3-22 Revenue Principle Cash Received Accounts receivable (+A) xxx Revenue (+R) xxx Cash received after revenue is earned - Company Delivers When the cash is received the ACCOUNTS RECEIVABLE is reduced. Cash will be collected.

3-23 The Revenue Principle Assets reflecting revenues earned but not yet received in cash include...

3-24 The Matching Principle Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid.

3-25 The Matching Principle If cash is paid before the company receives goods or services, an asset account, PREPAID EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Prepaid expense (+A) xxx Cash (-A) xxx

3-26 The Matching Principle Expense Incurred When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Prepaid expense (+A) xxx Cash (-A) xxx Expense will be recorded when incurred.

3-27 The Matching Principle When cash is paid on the date the expense is incurred, the following entry is made: Cash Paid Expense Incurred Expense (+E) xxx Cash (-A) xxx AND

3-28 The Matching Principle If cash is paid after the company receives goods or services, a liability PAYABLE is recorded. Cash paid after expense is incurred - Expense (+E) xxx Payable (+L) xxx Expense Incurred

3-29 The Matching Principle Cash Paid When cash is paid the PAYABLE is reduced. Cash paid after expense is incurred - Expense Incurred Expense (+E) xxx Payable (+L) xxx Cash will be paid.

3-30 The Matching Principle Typical assets and their related expense accounts include...

3-31 Learning Objectives Apply transaction analysis to examine and record the effects of operating activities on the financial statements.

3-32 Expanded Transaction Analysis Model Let’s look at an expanded transaction analysis model that includes the recording of revenues and expenses.

3-33 A = L + SE ASSETS Debit for Increase Credit for Decrease LIABILITIES Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase CONTRIBUTED CAPITAL Debit for Decrease Credit for Increase Next, let’s see how Revenues and Expenses affect Retained Earnings.

3-34EXPENSES Debit for Increase Credit for Decrease REVENUES Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase Expanded Transaction Analysis Model Dividends decrease Retained Earnings. Net Income increases Retained Earnings.

3-35 Analyzing Papa John’s Transactions Let’s apply the complete transaction analysis model to some of Papa John’s transactions. All amounts are in thousands of dollars.

3-36 Identify & Classify the Accounts 1. Cash (asset) 2. Franchise fee revenue (revenue) 3. Unearned franchise fees (liability) Determine the Direction of the Effect 1. Cash increases. 2. Franchise fee revenue increases. 3. Unearned franchise fees increases. Papa John’s sold franchises for $400 cash. The company earned $100 immediately. The rest will be earned over several months. Identify & Classify the Accounts 1. Cash (asset). 2. Franchise fee revenue (revenue). 3. Unearned franchise fees (liability). Determine the Direction of the Effect 1. Cash increases. 2. Franchise fee revenue increases. 3. Unearned franchise fees increases.

3-37 Papa John’s sold franchises for $400 cash. The company earned $100 immediately. The rest will be earned over several months.

3-38 Identify & Classify the Accounts 1. Cash (asset) 2. Restaurant sales revenue (revenue) 3. Cost of sales- restaurant (expense) 4. Inventories (asset) Determine the Direction of the Effect 1. Cash increases. 2. Restaurant sales revenue increases. 3. Cost of sales- restaurant increases. 4. Inventories decrease. The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients for those sales were $9,600. Identify & Classify the Accounts 1. Cash (asset). 2. Restaurant sales revenue (revenue). 3. Cost of sales- restaurant (expense). 4. Inventories (asset). Determine the Direction of the Effect 1. Cash increases. 2. Restaurant sales revenue increases. 3. Cost of sales- restaurant increases. 4. Inventories decrease.

3-39 The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients for those sales were $9,600.

3-40 Learning Objectives Prepare financial statements.

3-41 How are Financial Statements Prepared? Income Statement Revenues – Expenses = Net Income Statement of Retained Earnings Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Balance Sheet Assets = Liabilities + Stockholders’ Equity Contributed Capital Retained Earnings Statement of Cash Flows Change in Cash = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities

3-42  Income Statement

3-43  Statement of Retained Earnings The net income comes from the Income Statement just prepared.

3-44  Balance Sheet The ending balance from the Statement of Retained Earnings flows into the equity section of the Balance Sheet.

3-45 Focus on Cash Flows Cash Inflows Cash Outflows

3-46 The ending cash balance agrees with the amount on the Balance Sheet.  Statement of Cash Flows

3-47 Learning Objectives Compute and interpret the total asset turnover ratio.

3-48 Key Ratio Analysis Measures the sales generated per dollar of assets. Creditors and analysts use this ratio to assess a company’s effectiveness at controlling current and noncurrent assets. Asset Turnover Ratio Sales (or Operating) Revenues Average Total Assets =

3-49 End of Chapter 3