Operating Decisions andOperating Decisions andthe Income Statementthe Income Statement

Chapter 3

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

3-2

Understanding the Business

How do business activitiesHow do business activitiesaffect the income statement?affect the income statement?

How are these activitiesHow are these activities recognized and measured?recognized and measured?

How are these activities How are these activities reported on thereported on the

income statement?income statement?

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The Operating Cycle

Purchase or Purchase or manufacture manufacture products or products or supplies on supplies on

credit.credit.

Deliver product Deliver product or provide service or provide service to customers on to customers on

credit.credit.

Pay Pay suppliers.suppliers.

Receive payment Receive payment from customers.from customers.

BeginBegin

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The Operating Cycle

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

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

Measurement Issues:Measurement Issues: What amounts should be What amounts should be recognized?recognized?

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Elements on the Income Statement

LossesLossesDecreases in assets or increases in Decreases in assets or increases in

liabilities from peripheral transactions.liabilities from peripheral transactions.

RevenuesRevenuesIncreases in assets or settlement of Increases in assets or settlement of liabilities from ongoing operations.liabilities from ongoing operations.

ExpensesExpensesDecreases in assets or increases in Decreases in assets or increases in liabilities from ongoing operations.liabilities from ongoing operations.

GainsGainsIncreases in assets or settlement of Increases in assets or settlement of

liabilities from peripheral transactionsliabilities from peripheral transactions..

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Papa John’s Primary Operating Activity is

selling pizza and selling franchises.

Operating Activities

Peripheral Activities

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Papa John’s Primary Papa John’s Primary Operating ExpensesOperating Expenses

Cost of salesCost of sales(used inventory)(used inventory)

Salaries and Salaries and benefits to benefits to employeesemployees

Other costs (like Other costs (like advertising, advertising,

insurance, and insurance, and depreciation)depreciation)

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Earnings Per ShareEarnings Per Share

Net IncomeWeighted Average

Number of Common Shares Outstanding

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Corporations are Corporations are taxable entities. taxable entities.

Income tax expense Income tax expense computed as computed as Income Income Before Income TaxesBefore Income Taxes × × Tax RateTax Rate (Federal, (Federal,

State, Local and State, Local and Foreign).Foreign).

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Cash Basis Accounting

Revenue is recordedRevenue is recordedwhen cash is received.when cash is received.

Expenses are recordedExpenses are recordedwhen cash is paid.when cash is paid.

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Assets, liabilities, revenues, and expenses should be Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them recognized when the transaction that causes them

occurs, occurs, not necessarily when cash is paid or received.not necessarily when cash is paid or received.

Required by - GenerallyAcceptableAccountingPrinciples

Accrual Accounting

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Revenue Principle

Recognize revenues when . . .Recognize revenues when . . .Delivery has occurred or services have Delivery has occurred or services have

been rendered.been rendered.There is persuasive evidence of an There is persuasive evidence of an

arrangement for customer payment. arrangement for customer payment. The price is fixed or determinable.The price is fixed or determinable.Collection is reasonably assured.Collection is reasonably assured.

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Revenue Principle

If cash is received before the company If cash is received before the company delivers goods or services, the liability delivers goods or services, the liability

account account UNEARNED REVENUEUNEARNED REVENUE is recorded. is recorded.Cash received before revenue is earned -

CashReceived

Cash (+A) xxx Unearned revenue (+L) xxx

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Revenue Principle

When the company delivers the goods or When the company delivers the goods or services services UNEARNED REVENUEUNEARNED REVENUE is reduced is reduced

and and REVENUEREVENUE is recorded.is recorded.Cash received before revenue is earned -

CashReceived

Company Delivers

Cash (+A) xxx Unearned revenue (+L) xxx

Revenue will be recorded when earned.

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Revenue Principle

CASH COLLECTED (Goods or services due to

customers)over time will

become

REVENUE (Earned when goods or services provided)

Rent collected in advance Rent revenueUnearned air traffic revenue Air traffic revenueDeferred subscription revenue Subscription revenue

Typical liabilities that becomeTypical liabilities that becomerevenue when earned include . . .revenue when earned include . . .

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Revenue Principle

When cash is received on the date When cash is received on the date the revenue is earned, the the revenue is earned, the following entry is made:following entry is made:

CashReceived

Company Delivers

Cash (+A) xxx Revenue (+R) xxx

ANDAND

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Revenue Principle

If cash is received after the company If cash is received after the company delivers goods or services, an asset delivers goods or services, an asset ACCOUNTS RECEIVABLEACCOUNTS RECEIVABLE is recorded. is recorded.

Cash received after revenue is earned -

Accounts receivable (+A) xxx Revenue (+R) xxx

Company Delivers

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Revenue Principle

CashReceived

Accounts receivable (+A) xxx Revenue (+R) xxx

Cash received after revenue is earned -Company Delivers

When the cash is received the When the cash is received the ACCOUNTS ACCOUNTS RECEIVABLERECEIVABLE is reduced. is reduced.

Cash will be collected.

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Revenue Principle

CASH TO BE COLLECTED

(Owed by customers)

and already earned as

REVENUE (Earned when

goods or services provided)

Interest receivable Interest revenueRent receivable Rent revenueRoyalties receivable Royalty revenue

Assets reflecting revenues earned butAssets reflecting revenues earned butnot yet received in cash include . . .not yet received in cash include . . .

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The Matching Principle

Resources Resources consumed to earn consumed to earn

revenues in an revenues in an accounting period accounting period

should be recorded should be recorded in that period, in that period,

regardless of when regardless of when cash is paidcash is paid..

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The Matching Principle

If cash is paid before the company receives If cash is paid before the company receives goods or services, an asset account, goods or services, an asset account,

PREPAID EXPENSEPREPAID EXPENSE is recorded. is recorded.Cash is paid before expense is incurred -

$Paid

Prepaid expense (+A) xxx Cash (-A) xxx

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The Matching Principle

ExpenseIncurred

When the expense is incurred When the expense is incurred PREPAID PREPAID EXPENSEEXPENSE is reduced and an is reduced and an EXPENSEEXPENSE is is

recorded.recorded.Cash is paid before expense is incurred -

$Paid

Prepaid expense (+A) xxx Cash (-A) xxx

Expense will be recorded when incurred.

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The Matching Principle

When cash is paid on the date the When cash is paid on the date the expense is incurred, the following expense is incurred, the following

entry is made:entry is made:

CashPaid

ExpenseIncurred

Expense (+E) xxx Cash (-A) xxx

AND

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The Matching Principle

If cash is paid after the company receives If cash is paid after the company receives goods or services, a liability goods or services, a liability PAYABLEPAYABLE is is

recorded.recorded.Cash paid after expense is incurred -

Expense (+E) xxx Payable (+L) xxx

ExpenseIncurred

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The Matching Principle

CashPaid

When cash is paid the When cash is paid the PAYABLEPAYABLE is reduced. is reduced.

Cash paid after expense is incurred -ExpenseIncurred

Expense (+E) xxx Payable (+L) xxx

Cash will be paid.

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The Matching Principle

CASH PAID FORas used over

time becomes EXPENSESupplies inventory Supplies expensePrepaid insurance Insurance expenseBuildings and equipment Depreciation expense

Typical assets and their relatedTypical assets and their relatedexpense accounts include. . .expense accounts include. . .

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A = L + SEASSETSASSETS

Debit for

Increase

Credit for

Decrease

LIABILITIESLIABILITIES

Debit for

Decrease

Credit for

Increase

RETAINED RETAINED EARNINGSEARNINGS

Debit for

Decrease

Credit for

Increase

CONTRIBUTED CONTRIBUTED CAPITALCAPITAL

Debit for

Decrease

Credit for

Increase

Next, let’s see how Next, let’s see how Revenues and Revenues and

Expenses affect Expenses affect Retained Earnings.Retained Earnings.

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EXPENSESEXPENSES

Debit for

Increase

Credit for

Decrease

REVENUESREVENUES

Debit for

Decrease

Credit for

Increase

RETAINED RETAINED EARNINGSEARNINGS

Debit for

Decrease

Credit for

Increase

Expanded Transaction Analysis Model

Dividends decrease Dividends decrease Retained Earnings.Retained Earnings.

Net Income increases Net Income increases Retained Earnings.Retained Earnings.

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Identify & Classify the Accounts1. Cash (asset)2. Franchise fee revenue (revenue)3. Unearned franchise fees (liability)

Determine the Direction of the Effect1. 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 Accounts1. Cash (asset).2. Franchise fee revenue (revenue).3. Unearned franchise fees (liability).

Determine the Direction of the Effect1. Cash increases.2. Franchise fee revenue increases.3. Unearned franchise fees increases.

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= +Cash 400 Unearned franchise

revenue300 Franchise fees

revenue100

Stockholders' EquityLiabilitiesAssets

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

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Identify & Classify the Accounts1. Cash (asset)2. Restaurant sales revenue (revenue)3. Cost of sales- restaurant (expense)4. Inventories (asset)

Determine the Direction of the Effect1. 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 Accounts1. Cash (asset).2. Restaurant sales revenue (revenue).3. Cost of sales- restaurant (expense).4. Inventories (asset).

Determine the Direction of the Effect1. Cash increases.2. Restaurant sales revenue increases.3. Cost of sales- restaurant increases. 4. Inventories decrease.

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= +Cash 36,000 Restaurant sales

revenue36,000

Inventory (9,600) Cost of sales (9,600)

Stockholders' EquityLiabilitiesAssets

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

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How are Financial Statements Prepared?IncomeIncome

StatementStatement Revenues – Expenses = Net Income

Statement ofStatement ofRetainedRetainedEarningsEarnings

Beginning Retained Earnings+ Net Income- Dividends Declared Ending Retained Earnings

BalanceBalanceSheetSheet

Assets = Liabilities + Stockholders’ Equity

Contributed CapitalRetained Earnings

StatementStatementof Cash Flowsof Cash Flows

Changein

Cash

= Cash from Operating Activities+ Cash from Investing Activities+ Cash from Financing Activities

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Income Statement

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Beginning balance, December 28, 2006 147,000$ Net income 21,800 Dividends (3,000) Ending balance, January 31, 2007 165,800$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESConsolidated Statement of Retained Earnings

For the Month Ended Janaury 31, 2007(Dollars in thousands)

Statement of Retained Earnings

The net income comes from the Income The net income comes from the Income Statement just prepared.Statement just prepared.

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Balance Sheet

Assets Jan. 31, 2007Current assets: Cash 43,900$ Accounts receivable 19,200 Supplies 26,000 Prepaid expenses 17,000 Other current assets 14,000 Total current assets 120,100 Long-term investments 2,000 Property and equipment, net of depreciation 207,000 Long-term notes receivable 15,000 Intangibles 67,000 Other assets 17,000 Total assets 428,100$ Liabilities and Stockholders' EquityCurrent liabilities: Accounts payable 39,000$ Dividends payable 3,000 Accrued expenses payable 73,000 Total current liabilities 115,000 Unearned franchise fees 7,300 Long-term notes payable 110,000 Other long-term liabilities 27,000 Total liabilities 259,300 Stockholders' equity:Contributed capital 3,000 Retained earnings 165,800 Total stockholders' equity 168,800 Total liabilities and stockholders' equity 428,100$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESConsolidated Balance Sheets

(Dollars in thousands)

The ending balance from The ending balance from the Statement of Retained the Statement of Retained

Earnings flows into the Earnings flows into the equity section of the equity section of the

Balance Sheet.Balance Sheet.

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Focus on Cash Flows

Effect on Cash Flows

Cash received from: Customers +Investments +

Cash paid to: Suppliers -Employees -Interest paid -Income taxes paid -

Nature of Operating Activity

Cash InflowsCash Inflows

Cash OutflowsCash Outflows

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Key Ratio Analysis

Measures the sales Measures the sales generated per dollar generated per dollar

of assets.of assets.

Creditors and analysts use Creditors and analysts use this ratio to assess a this ratio to assess a

company’s effectiveness at company’s effectiveness at controlling current and controlling current and

noncurrent assets.noncurrent assets.

Total AssetTotal AssetTurnoverTurnover

RatioRatio

Sales (or Operating) RevenuesSales (or Operating) Revenues

Average Total AssetsAverage Total Assets==

© 2009 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

End of Chapter 3