Operating

Decisions
and the
Income Statement

Chapter 3

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

 3-2

Business Background

How do business activities

affect the income statement?

How are these activities

recognized and measured?

How are these activities

reported on the
income statement?
 3-3

Learning Objectives

Describe
Describe aa typical
typical business
business operating
operating cycle
cycle
and
and explain
explain the
the necessity
necessity for
for the
the time
time period
period
assumption.
assumption.
 3-4

The Operating Cycle

Begin
Purchase or
manufacture
products or
supplies on
credit.

Receive payment
Pay
from customers.
suppliers.

Deliver product
or provide service
to customers on
credit.
 3-5

The Operating Cycle

Time
Time Period:
Period: The
The long
long life
life of
of aa company
company can
can be
be
reported
reported over
over aa series
series of
of shorter
shorter time
time periods
periods..

Recognition
Recognition Issues
Issues :: When
When should
should the
the effects
effects of
of
operating
operating activities
activities be
be recognized
recognized (recorded)?
(recorded)?

Measurement
Measurement Issues:
Issues: What
What amounts
amounts should
should be
be
recognized?
recognized?
 3-6

The Time Period Assumption

To meet the needs of decision makers, we report

financial information for relatively short time
periods (monthly, quarterly, annually).

Life of the Business

1999 2000 2001 2002 2003 2004 2005 2006

Annual Accounting Periods

 3-7

Learning Objectives

Explain
Explain how
how business
business activities
activities affect
affect the
the
elements
elements of
of the
the income
income statement.
statement.
 3-8

Elements on the Income Statement

Revenues
Revenues
Increases
Increases in in assets
assets or
or settlement
settlement of
of
liabilities
liabilities from
from ongoing
ongoing operations.
operations.
Expenses
Expenses
Decreases
Decreases in in assets
assets or
or increases
increases in
in
liabilities
liabilities from
from ongoing
ongoing operations.
operations.
Gains
Gains
Increases
Increases in in assets
assets or
or settlement
settlement ofof
liabilities
liabilities from
from peripheral
peripheral transactions
transactions..
Losses
Losses
Decreases
Decreases in in assets
assets or
or increases
increases in
in
liabilities
liabilities from
from peripheral
peripheral transactions.
transactions.
 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
Explain the
the accrual
accrual basis
basis of
of accounting
accounting and
and
apply
apply the
the revenue
revenue and
and matching
matching principles
principles to
to
measure
measure income.
income.
 3-14

Cash Basis Accounting

Revenue is recorded Expenses are recorded

when cash is received. when cash is paid.
 3-15

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
 3-16

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.

 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 Company
Received 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 . . .
CASH COLLECTED REVENUE
(Goods or services due to over time will (Earned when goods
customers) become or services provided)
Rent collected in advance Rent revenue
Unearned air traffic revenue Air traffic revenue
Deferred subscription revenue Subscription revenue
 3-20

Revenue Principle

When cash is received on the date

the revenue is earned, the
following entry is made:
Company
Delivers
AND
Cash
Received

Cash (+A) xxx

Revenue (+R) xxx
 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 -

Company
Delivers

Accounts receivable (+A) xxx

Revenue (+R) xxx
 3-22

Revenue Principle

When the cash is received the ACCOUNTS

RECEIVABLE is reduced.

Cash received after revenue is earned -

Company Cash
Delivers Received

Accounts receivable (+A) xxx

Revenue (+R) xxx

Cash will be collected.

 3-23

The Revenue Principle

Assets reflecting revenues earned but

not yet received in cash include . . .
CASH TO BE REVENUE
COLLECTED (Earned when
(Owed by and already goods or services
customers) earned as provided)
Interest receivable Interest revenue
Rent receivable Rent revenue
Royalties receivable Royalty revenue
 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

When the expense is incurred PREPAID

EXPENSE is reduced and an EXPENSE is
recorded.
Cash is paid before expense is incurred -

$ Expense
Paid Incurred

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:
Expense
Incurred
AND
Cash
Paid

Expense (+E) xxx

Cash (-A) xxx
 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
Incurred

Expense (+E) xxx

Payable (+L) xxx
 3-29

The Matching Principle

When cash is paid the PAYABLE is reduced.

Cash paid after expense is incurred -

Expense Cash
Incurred Paid

Expense (+E) xxx

Payable (+L) xxx

Cash will be paid.

 3-30

The Matching Principle

Typical assets and their related

expense accounts include. . .
as used over
CASH PAID FOR time becomes EXPENSE
Supplies inventory Supplies expense
Prepaid insurance Insurance expense
Buildings and equipment Depreciation expense
 3-31

Learning Objectives

Apply
Apply transaction
transaction analysis
analysis to
to examine
examine andand
record
record the
the effects
effects of
of operating
operating activities
activities on
on the
the
financial
financial statements.
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 LIABILITIES
Debit Credit Debit Credit
for for for for
Increase Decrease Decrease Increase

Next, let’s see CONTRIBUTED RETAINED

how Revenues CAPITAL EARNINGS
and Expenses Debit Credit Debit Credit
affect Retained for for for for
Earnings. Decrease Increase Decrease Increase
 3-34

Expanded Transaction Analysis Model

RETAINED
Dividends decrease EARNINGS
Net Income increases
Retained Earnings. Retained Earnings.
Debit Credit
for for
Decrease Increase

REVENUES EXPENSES
Debit Credit Debit Credit
for for for for
Decrease Increase Increase Decrease
 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

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).
(asset)
2. Franchise fee revenue
(revenue)
(revenue).
3. Unearned franchise fees
(liability)
(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.

Assets = Liabilities + Stockholders' Equity

Cash 400 Unearned franchise 300 Franchise fees 100
revenue revenue
 3-38

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).
(asset)
2. Restaurant sales revenue
(revenue)
(revenue).
3. Cost of sales- restaurant
(expense)
(expense).
4. Inventories (asset).
(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.
Assets = Liabilities + Stockholders' Equity
Cash 36,000 Restaurant sales 36,000
revenue
Inventory (9,600) Cost of sales (9,600)
 3-40

Learning Objectives

Prepare
Prepare financial
financial statements.
statements.
 3-41

How are Financial Statements Prepared?

Income
Revenues – Expenses = Net Income
Statement

Beginning Retained Earnings

Statement of
+ Net Income
Retained
- Dividends Declared
Earnings
Ending Retained Earnings

Balance Assets = Liabilities + Stockholders’ Equity

Sheet
Contributed Capital
Retained Earnings

Statement Change = Cash from Operating Activities

of Cash Flows in + Cash from Investing Activities
Cash + Cash from Financing Activities
 3-42

Income Statement
 3-43

Statement of Retained Earnings

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES

Consolidated Statement of Retained Earnings
For the Month Ended Janaury 31, 2004
(Dollars in thousands)

Beginning balance, December 28, 2003 $ 158,000

Net income 21,800
Dividends (3,000)
Ending balance, January 31, 2004 $ 176,800

The net income comes from the Income

Statement just prepared.
 PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES3-44
Consolidated Balance Sheets

Balance Sheet Assets

(Dollars in thousands)
Jan. 31, 2004
Current assets:
Cash $ 37,900
Accounts receivable 16,200
Supplies 16,000
Prepaid expenses 20,000
Other current assets 7,000
Total current assets 97,100
Long-term investments 9,000
Property and equipment, net of depreciation 213,000
Long-term notes receivable 14,000
Intangibles 49,000
Other assets 13,000

The ending balance from Total assets $ 395,100

Liabilities and Stockholders' Equity
the Statement of Retained Current liabilities:
Accounts payable $ 38,000
Earnings flows into the Dividends payable 3,000

equity section of the Accrued expenses payable

Total current liabilities
53,000
94,000
Balance Sheet. Unearned franchise fees 6,300
Long-term notes payable 75,000
Other long-term liabilities 40,000
Total liabilities 215,300
Stockholders' equity:
Contributed capital 3,000
Retained earnings 176,800
Total stockholders' equity 179,800
Total liabilities and stockholders' equity $ 395,100
 3-45

Focus on Cash Flows

Effect on
Nature of Operating Activity Cash Flows
Cash received from: Customers +
Investments +
Cash paid to: Suppliers -
Employees -
Interest paid -
Income taxes paid -

Cash Outflows

Cash Inflows
 3-46
PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES
Statement of Consolidated Statement of Cash Flows
For the Month Ended Janaury 31, 2004
Cash Flows (Dollars in thousands)

Operating Activities
Cash from: Customers $ 69,000
Franchises 3,900
Interest on investments 1,000
Cash to: Suppliers (35,000)
Employees (14,000)
Net cash provided by operating activities 24,900
Investing Activities
Sold land 4,000
The ending cash Purchased property and equipment (2,000)
balance agrees Purchased investments (1,000)
with the amount Lent funds to franchisees (3,000)
Net cash used in investing activities (2,000)
on the Balance Financing Activities
Sheet. Issued common stock 2,000
Borrowed from banks 6,000
Net cash provided by financing activities 8,000
Net increase in cash 30,900
Cash at beginning of month 7,000
Cash at end of month $ 37,900
 3-47

Learning Objectives

Compute
Compute and
and interpret
interpret the
the total
total asset
asset
turnover
turnover ratio.
ratio.
 3-48

Key Ratio Analysis

Asset Sales (or Operating) Revenues

Turnover =
Ratio Average Total Assets

Measures the sales Creditors and analysts use

this ratio to assess a
generated per dollar company’s effectiveness at
of assets. controlling current and
noncurrent assets.
 3-49

End of Chapter 3