Operating Decisions and the Income Statement

1. OperatingDecisionsand theIncome Statement Chapter 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. Learning Objectives Describe a typical business operating cycle and explain the necessity for the time period assumption. LO1

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

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?

6. To meet the needs of decision makers, we report financial information for relatively short time periods(monthly, quarterly, annually). The Time Period Assumption Life of the Business 1999 2000 2001 2002 2003 2004 2005 2006 Annual Accounting Periods

7. Learning Objectives Explain how business activities affect the elements of the income statement. LO2

8. Elements on 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. Losses Decreases in assets or increases in liabilities from peripheral transactions.

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

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

11. Earnings Per Share Net IncomeWeighted Average Number of Common Shares Outstanding

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

13. Learning Objectives Explain the accrual basis of accounting and apply the revenue and matching principles to measure income. LO3

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

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 - GenerallyAcceptableAccountingPrinciples GAAP

16. 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. Revenue Principle

17. Cash (+A) xxx Unearned revenue (+L) xxx 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 - CashReceived

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

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

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

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

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

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

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.

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

26. Prepaid expense (+A) xxx Cash (-A) xxx 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 ExpenseIncurred Expense will be recorded when incurred.

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

28. Expense (+E) xxx Payable (+L) xxx 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 - ExpenseIncurred

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

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

31. Learning Objectives Apply transaction analysis to examine and record the effects of operating activities on the financial statements. LO4

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

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

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

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.

36. Identify & Classify the Accounts 1. Cash (asset) 2. Franchise fee revenue (revenue) 3. Unearned franchise fees (liability) 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. 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.

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

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

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

40. Learning Objectives Prepare financial statements. LO5

41. Beginning Retained Earnings+ Net Income- Dividends Declared Ending Retained Earnings Statement ofRetainedEarnings BalanceSheet Assets = Liabilities + Stockholders’ Equity Contributed CapitalRetained Earnings ChangeinCash = Cash from Operating Activities+ Cash from Investing Activities+ Cash from Financing Activities Statementof Cash Flows How are Financial Statements Prepared? IncomeStatement Revenues – Expenses = Net Income

42. Income Statement

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

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

45. Cash Outflows Cash Inflows Focus on Cash Flows

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

47. Learning Objectives Compute and interpret the total asset turnover ratio. LO6

48. AssetTurnoverRatio Sales (or Operating) Revenues Average Total Assets = 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.

49. End of Chapter 3