© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Chapter 3 Operating Decisions and the Income Statement

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background GoalsPlans Strategies Measurable indicators Businesses develop... The goals include elements of income.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background What business activities affect the income statement? How are these activities recognized and measured? How are these activities reported on the income statement?

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Operating Cycle Purchase products or supplies on credit. Deliver product or provide service to customers on credit. Pay suppliers. Receive payment from customers. Begin

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Underlying Accounting Assumptions Periodicity: The long life of a company can be reported over a series of short time periods. Recognition Issues : When should the effects of operating activities be recognized (recorded)? Measurement Issues: What amounts should be recognized?

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Periodicity 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

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Elements on the Income Statement Losses Decreases in assets or increases in liabilities from peripheral transactions. Losses Decreases in assets or increases in liabilities from peripheral transactions. Revenue Increases in assets or settlement of liabilities from ongoing operations. Revenue Increases in assets or settlement of liabilities from ongoing operations. Expense Decreases in assets or increases in liabilities from ongoing operations. Expense Decreases in assets or increases in liabilities from ongoing operations. Gains Increase in assets or settlement of liabilities from peripheral transactions. Gains Increase in assets or settlement of liabilities from peripheral transactions.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Papa John’s Primary Operating Activities Sell pizza Sell franchises Sell supplies and equipment to franchisees

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Cash Basis Accounting Revenue is recorded when cash is received. Expenses are recorded when cash is paid.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Accrual Accounting 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 GAAP

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Principles Affecting Income Determination  Revenue Principle  Matching Principle  Cost Principle

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Revenue Principle Recognize revenues when... The earnings process is complete or nearly complete. An exchange transaction takes place. Collection is reasonably assured.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Revenue Principle Typical liabilities that become revenue when earned include...

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Revenue Principle Assets reflecting revenues earned but not yet received in cash include...

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Matching Principle Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Matching Principle Typical assets and their related expense accounts include...

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The Matching Principle Typical liabilities and their related expense accounts include...

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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 SHARE CAPITAL Debit for Decrease Credit for Increase Next, let’s see how Revenues and Expenses affect Retained Earnings.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson EXPENSES Debit for Increase Credit for Decrease REVENUES Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase The Expanded Transaction Analysis Model Dividends decrease Retained Earnings. Net Income increases Retained Earnings.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Transaction Analysis Rules Let’s apply the complete transaction analysis model to some of Papa John’s transactions. All amounts are in thousands of dollars.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s sold 25 franchises for $500 cash. The company earned $175 immediately. The rest will be earned over several months. Identify & Classify the Accounts 1. Cash (asset) 2. Franchise royalties and development fees (revenue) 3. Unearned franchise and development fees (liability) Identify & Classify the Accounts 1. Cash (asset) 2. Franchise royalties and development fees (revenue) 3. Unearned franchise and development fees (liability) Determine the Direction of the Effect 1. Cash increases. 2. Franchise royalties and development fees increase. 3. Unearned franchise and development fees increase. Determine the Direction of the Effect 1. Cash increases. 2. Franchise royalties and development fees increase. 3. Unearned franchise and development fees increase.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Papa John’s sold 25 franchises for $500 cash. The company earned $175 immediately. The rest will be earned over several months.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The company received $35,200 for pizza sales. The cost of the pizza ingredients for those sales was $9,600. Identify & Classify the Accounts Determine the Direction of the Effect Identify & Classify the Accounts 1. Cash (asset) 2. Restaurant sales revenue (revenue) 3. Cost of sales - restaurant (expense) 4. Inventories (asset) 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. Determine the Direction of the Effect 1. Cash increases. 2. Restaurant sales revenue increases. 3. Cost of sales - restaurant increases. 4. Inventories decrease.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson The company received $35,200 for pizza sales. The cost of the pizza ingredients for those sales was $9,600.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Preparation of the Unadjusted Financial Statements After posting all of the January transactions to T-accounts, we can prepare Papa John’s unadjusted financial statements.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Notice that income tax expense is not determined at this point.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Preparation of the Unadjusted Financial Statements The income before income taxes comes from the Income Statement just prepared.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Notice that the ending balance from the Statement of Retained Earnings flows into the equity section of the Balance Sheet.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Focus on Cash Flows Remember: We discussed Investing and Financing Activities in Chapter 2.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Notice that the ending cash balance agrees with the amount on the Balance Sheet.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Financial Leverage Ratio Asset Turnover Ratio = Sales Average Total Assets This ratio measures the sales generated per dollar of assets. Creditors and analysts used this ratio to assess a company’s effectiveness at controlling current and noncurrent assets.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson End of Chapter 3