1. Operating Decisions and the Income Statement
Chapter 3: Operating Decisions and the Income Statement.
Chapter 3
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc.

2. Understanding the Business
How do business activities
affect the income statement?
How are these activities
recognized and measured?
In this chapter we will discuss how business activities affect the income statement of a company. We will also look at how these activities are recognized, recorded and measured. Finally, we will look at the preparation of an income statement.
How are these activities
reported on the
income statement?

3. The Operating Cycle Begin
Purchase or manufacture products or supplies on credit.
Receive payment from customers.
Pay
suppliers.
The business cycle begins with the purchase or manufacture of a product for sale. When products are purchased from suppliers, those suppliers must be paid. After a sale has been made, the company must deliver the product or service to the customer. Many business sales are made on credit. If credit is extended, payment must be received from customers. Once the cash has been collected from customers, the business cycle begins all over again.
We never want to confuse the business operating cycle with the accounting cycle.
Deliver product or provide service to customers on credit.

4. Measurement Issues: What amounts should be recognized?
The Accounting Cycle
Time Period: The long life of a company is normally 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?
We know that most successful companies operate for a very long period of time, and managers and investors need financial information on a timely basis. For accountants to provide this information, we have to divide the life of the business into relatively short, arbitrary time periods. We usually divide the life of a business into months, quarters, and annual time periods. When we establish these relatively short time periods, we create many measurement issues, for example, problems of revenue and expense recognition.

5. Elements of the Income Statement
Revenues
Increases in assets or settlement of liabilities from ongoing operations.
Expenses
Decreases in assets or increases in liabilities from ongoing operations.
Gains
Increases in assets or settlement of liabilities from peripheral transactions.
The income statement contains revenues, expenses, gains and losses. We have provided you with definitions of each of the terms. Take a few minutes and read through the definitions. Notice that revenues and expenses are an integral part of the ongoing operations of the business, while gains and losses are only incidental to the operations of the business.
Losses
Decreases in assets or increases in liabilities from peripheral transactions.

6. Here is an income statement for Papa John’s for the year ended December 31, Notice that the company separates it operating activities, that is, its normal revenues and expenses from selling of pizzas and franchises, from the peripheral activities that include investment income, interest expense, and loss due to restaurants sold. Income taxes are shown on a separate line. Most financial analysts concentrate on operating income because it represents the income earned from normal operations before taxes.

7. Cash Basis Accounting Revenue is recorded when cash is received.
Companies that use the cash accounting basis recognize revenue only when cash is received, and recognize expenses only when cash is paid. A cash basis is not considered part of generally accepted accounting principles.
Revenue is recorded
when cash is received.
Expenses are recorded
when cash is paid.

8. GAAP 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 - Generally Acceptable Accounting Principles
GAAP
Generally accepted accounting principles require that assets, liabilities, revenues, and expenses be recognized when the transaction that causes them occurs. The date when cash is paid or received is not necessarily the same as the date upon which a transaction occurs. Generally accepted accounting principles require the use of the accrual method.

9. Recognize revenues when . . .
Revenue Principle
Recognize revenues when . . .
Delivery has occurred or services have been rendered.
There is persuasive evidence of an arrangement for customer payment.
The price is fixed or determinable.
Collection is reasonably assured.
The revenue principle states that revenue should be recognized when a product has been delivered or service has been rendered. In addition, there must be some agreement as to how the customer will pay for the product or service, and there must be a fixed or determinable price associated with the transaction. Finally, the collection of the amount involved must be reasonably assured.

10. The Matching Principle
Resources consumed to earn revenues (i.e.expenses) in an accounting period should be recorded in that period, regardless of when cash is paid.
The matching principle requires that we recognize expenses in the same period in which the revenue that was generated by those expenses is recognized.

11. Sometimes cash is received before the good or service is delivered
Revenue Principle
Sometimes cash is received before the
good or service is delivered
Here are three typical transactions where cash is collected before the revenue is earned.

12. 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
Under the revenue principle, if cash is received before the goods are delivered or the services provided, a liability account must be established. When this event occurs, we debit the cash account and credit a liability account called “unearned revenue.”
Cash (+A) xxx Unearned revenue (+L) xxx

13. Revenue will be recorded when earned.
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
When the product is delivered or the service provided, revenue will be recorded. When the company delivers the goods or services the liability, unearned revenue, is reduced, and the revenue account, service revenue, is increased.
Revenue will be recorded when earned.
Unearned revenue (-L) xxx Service revenue (+R) xxx

14. Revenue Principle
When cash is received on the date the revenue is earned, the following entry is made:
Company Delivers
AND
Cash Received
Cash can be received on the date the product is delivered or the services provided. The journal entry is to debit cash and credit revenue.
Cash (+A) xxx Revenue (+R) xxx

15. Sometimes cash is received after the good or service is delivered
Revenue Principle
Sometimes cash is received after the
good or service is delivered
Here are three examples where revenue has been earned but cash has not yet been received.

16. 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 -
Company Delivers
In many cases, cash is received after the goods are delivered or the services provided. In this example, we establish an asset account, accounts receivable. The journal entry is to debit accounts receivable and credit the revenue account.
Accounts receivable (+A) xxx Revenue (+R) xxx

17. When the cash is received the ACCOUNTS RECEIVABLE is reduced.
Revenue Principle
When the cash is received the ACCOUNTS RECEIVABLE is reduced.
Cash received after revenue is earned -
Cash Received
Company Delivers
Accounts receivable (+A) xxx Revenue (+R) xxx
When the customer finally pays the cash, the receivable will be eliminated. When the cash is collected by the company the journal entry is to increase the asset account, cash, and decrease the asset account, accounts receivable.
Cash will be collected.
Cash (+A) xxx Accounts receivable (-A) xxx

18. The Matching Principle
Resources consumed to earn revenues (i.e.expenses) in an accounting period should be recorded in that period, regardless of when cash is paid.
The matching principle requires that we recognize expenses in the same period in which the revenue that was generated by those expenses is recognized.

19. The Matching Principle
Sometimes cash is paid before the
expense is incurred
Here are three examples where cash is typically paid before the expense is recognized.

20. 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
If cash is paid before goods are received or services are provided, the company establishes a prepaid expense. A prepaid expense is an asset account. The journal entry on the date of transaction is to debit prepaid expense and credit cash.
Prepaid expense (+A) xxx Cash (-A) xxx

21. The Matching Principle
When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded.
Cash is paid before expense is incurred -
$ Paid
Expense Incurred
Prepaid expense (+A) xxx Cash (-A) xxx
The expense will be recorded when incurred. After the expense has been incurred, the journal entry is to increase the expense account and decrease the asset account, prepaid expense.
Expense will be recorded when incurred.
Expense (+E) xxx Prepaid expense (-A) xxx

22. The Matching Principle
When cash is paid on the date the expense is incurred, the following entry is made:
Expense Incurred
AND
Cash Paid
Of course, the expense can be incurred on the same day cash is paid. In this case, the journal entry is to debit the expense and credit cash.
Expense (+E) xxx Cash (-A) xxx

23. The Matching Principle
Sometimes cash is paid after the
expense is incurred
Here are three examples where cash is typically paid before the expense is recognized.

24. 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 Incurred
When cash is paid after the company receives the goods or service, a liability account must be established. The journal entry is to debit an expense account and credit a liability account for the payable.
Expense (+E) xxx Payable (+L) xxx

25. The Matching Principle
When cash is paid the PAYABLE is reduced.
Cash paid after expense is incurred -
Cash Paid
Expense Incurred
Expense (+E) xxx Payable (+L) xxx
When cash is actually paid, the payable will be eliminated.
Cash will be paid.
Payable (-L) xxx Cash (-A) xxx

26. Next, let’s see how Revenues and Expenses affect Retained Earnings.
A = L + SE
ASSETS
Debit for Increase
Credit for Decrease
LIABILITIES
Debit for Decrease
Credit for Increase
Next, let’s see how Revenues and Expenses affect Retained Earnings.
RETAINED EARNINGS
Debit for Decrease
Credit for Increase
CONTRIBUTED CAPITAL
Here is the expanded transaction analysis model. We know that stockholders’ equity consists of contributed capital and retained earnings. Let’s see how revenues and expenses impact retained earnings.

27. Expanded Transaction Analysis Model
RETAINED EARNINGS
Debit for Decrease
Credit for Increase
Dividends decrease Retained Earnings.
Net Income increases Retained Earnings.
EXPENSES
Debit for Increase
Credit for Decrease
REVENUES
Debit for Decrease
Credit for Increase
From our statement of retained earnings we know that net income increases retained earnings. Revenues increase net income and expenses decrease net income. Revenues show increases and decreases on the same sides of the T-account as retained earnings. A credit to the revenue account increases revenue, a debit to the revenue account decreases revenue. Because expenses reduce revenues in the calculation of net income, increases and decreases in expense accounts are shown on the opposite sides when compared to revenue accounts. A debit to an expense account represents an increase in expenses, a credit to an expense account represents a decrease in expenses.

28. Focus on Cash Flows Direct approach to preparing operating cash flows.
Cash inflows from operating activities include cash received from customers and from investments. Cash outflows relating to operating activities include cash paid to suppliers, employees, interest, and taxes. The net of our cash inflows and outflows is the cash flows from operating activities.
In the investing activities section of the statement we find the purchase or sale of property, plant or equipment and the purchase or sale of other long-term assets.
In the financing activities section of the statement we find issuance or retirement of long-term debt, the issuance or repurchase of contributed capital, and cash dividends paid.
At the bottom of the statement we calculate the net increase or decrease in cash during the period and reconcile the beginning and ending cash balance to that net increase or decrease.
When a transaction affects cash, it is included on the statement of cash flows. When a transaction does not affect cash, such as acquiring a building with a long-term mortgage note payable or selling goods on account to customers, there is no cash effect to include on the statement.

29. Total Asset Turnover Ratio Sales (or Operating) Revenues
Key Ratio Analysis
Total Asset Turnover Ratio
Sales (or Operating) Revenues
Average Total Assets =
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.
The total asset turnover ratio is computed by dividing total sales revenue by average total assets. The ratio is an excellent measure of the sales generated per dollar of assets owned. A high total asset turnover ratio signifies efficient management of assets and a low ratio signifies less efficient asset management.

30. Total Asset Turnover Ratio
Sales (or Operating) Revenues
Average Total Assets =
(Beginning total assets + ending total assets) ÷ 2
Papa John’s Total Asset Turnover Ratio for 2008 (dollars in thousands):
The total asset turnover ratio is computed by dividing total sales revenue by average total assets. Generally, we calculate the average total assets by adding together the beginning and ending total assets and dividing by 2. The total asset turnover ratio for Papa John’s for 2008 is 2.87 times. The ratio is an excellent measure of the sales generated per dollar of assets owned. A high total asset turnover ratio signifies efficient management of assets and a low ratio signifies less efficient asset management. Creditors and security analysts use this ratio to assess a company’s effectiveness at controlling both current and noncurrent assets. In a well-run business, creditors expect the ratio to fluctuate due to seasonal upswings and downturns.
$1,132,000
($402,000 + $386,000) ÷ 2
= 2.87

31. Finding Accounting Errors
Determine the out-of-balance amount.
Divide the out-of-balance amount by 2
(a debit treated as a credit or vice versa).
Divide the out-of-balance amount
by 9, which may indicate a slide
or a transposition.

32. End of Chapter 3
End of chapter 3.