Chapter 3 Operating Decisions and the Income Statement 9/07/04

Chapter 3

Operating Decisions and theIncome Statement9/07/04

© 200422 The McGraw-Hill CompaniesMcGraw-Hill/Irwin

3-2

Business Background

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

affect the income statement?affect the income statement?

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

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?

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

income statement?income statement?


3-3

Underlying Accounting Assumptions

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..

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)?

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?

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


3-4

The Time Period Assumption

To meet the needs of decision makers, we report financial information for

relatively short time periodsrelatively short time periods (monthly, quarterly, annually).

1996 1997 1998 1999 2000 2001 2002 2003

Life of the BusinessLife of the Business

Annual Accounting Periods


3-5

Papa John’s Primary Papa John’s Primary Operating ActivitiesOperating Activities

Papa John’s Primary Papa John’s Primary Operating ActivitiesOperating Activities

Sell pizzaSell pizzaSell pizzaSell pizza

Sell Sell franchisesfranchises

Sell Sell franchisesfranchises


3-6

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

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

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

Salaries and benefits Salaries and benefits to employeesto employees

Salaries and benefits Salaries and benefits to employeesto employees

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

and depreciation)and depreciation)

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

and depreciation)and depreciation)


3-7

Corporations are taxable Corporations are taxable entities. Income tax entities. Income tax

expense is expense is Income Before Income Before Income Taxes (as adjusted Income Taxes (as adjusted for book/tax differences)for book/tax differences) × × Tax RateTax Rate (Federal, State, (Federal, State,

Local and Foreign).Local and Foreign).

Point: Income before taxes Point: Income before taxes does not equal taxable does not equal taxable

incomeincome

Corporations are taxable Corporations are taxable entities. Income tax entities. Income tax

expense is expense is Income Before Income Before Income Taxes (as adjusted Income Taxes (as adjusted for book/tax differences)for book/tax differences) × × Tax RateTax Rate (Federal, State, (Federal, State,

Local and Foreign).Local and Foreign).

Point: Income before taxes Point: Income before taxes does not equal taxable does not equal taxable

incomeincome


3-8

Earnings Per ShareEarnings Per ShareEarnings Per ShareEarnings Per Share

Net IncomeWeighted Average

Number of Common Shares Outstanding


3-9

Cash Basis Accounting

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

when cash is received.when cash is received.Expenses are recordedExpenses are recorded

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

when cash is paid.when cash is paid.


3-10

Assets, liabilities, revenues, and expenses Assets, liabilities, revenues, and expenses should be recognized when the transaction should be recognized when the transaction that causes them occurs, that causes them occurs, not necessarily not necessarily

when cash is paid or received.when cash is paid or received.

Assets, liabilities, revenues, and expenses Assets, liabilities, revenues, and expenses should be recognized when the transaction should be recognized when the transaction that causes them occurs, that causes them occurs, not necessarily not necessarily

when cash is paid or received.when cash is paid or received.

Required by -

Generally

Acceptable

Accounting

Principles

Required by -

Generally

Acceptable

Accounting

Principles

Accrual Accounting


3-11

Revenue Principle (largest source of fraud)

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

have been rendered.have 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.

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

have been rendered.have 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.


3-12

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.

$Received

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


3-13

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.

When the goods or services are delivered:

$Received

Company Delivers

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

Unearned Revenue (-L) x,xxx Fee Revenue (+R) x,xxx


3-14

Revenue Principle - Examples

CASH COLLECTED (Goods or services due to

customers)over time will

become

REVENUE (Earned when goods or services provided)

Rent collected in advance Rent revenue

Unearned air traffic revenue Air traffic revenue

Deferred subscription revenue Subscription revenue

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


3-15

Revenue Principle

When cash is received on the date the When cash is received on the date the revenue is earned, then both cash and revenue is earned, then both cash and

revenue are recorded as follows:revenue are recorded as follows:

$Received

Company Delivers

Cash (+A) x,xxx Fee revenue (+R) x,xxx

AND


3-16

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.

Accounts receivable (+A) x,xxx Fee revenue (+R) x,xxx

Company Delivers


3-17

Revenue Principle

$Received

Cash (+A) x,xxx Accounts receivable (-A) x,xxx

Accounts receivable (+A) x,xxx Fee revenue (+R) x,xxx

When cash is received -

Company Delivers

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.


3-18

The Revenue Principle - Examples

CASH TO BE COLLECTED

(Owed by customers)

and already earned as

REVENUE (Earned when

goods or services provided)

Interest receivable Interest revenue

Rent receivable Rent revenue

Royalties receivable Royalty revenue

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


3-19

Revenue Principle

• Self-Study Quiz – Page 110• A Question of Ethics – Page 111


3-20The Matching Principle – Revenues and Expenses

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..

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..


3-21

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.

$Paid

Prepaid rent expense (+A) x,xxx Cash (-A) x,xxx


3-22

Matching Principle

ExpenseIncurred

Rent expense (-R) x,xxx Prepaid rent expense (-A) x,xxx

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.

When the expense is actually incurred:

$Paid

Prepaid rent expense (+A) x,xxx Cash (-A) x,xxx


3-23

Matching Principle - Examples

CASH PAID FORas used over

time becomes EXPENSE

Supplies inventory Supplies expense

Prepaid insurance Insurance expense

Buildings and equipment Depreciation expense

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


3-24

Matching Principle

When cash is paid on the date the When cash is paid on the date the expense is incurred, the CASH and expense is incurred, the CASH and

EXPENSE is recorded as follows:EXPENSE is recorded as follows:

$Paid

ExpenseIncurred

Rent expense (+E) x,xxx Cash (-A) x,xxx

AND


3-25

Matching Principle

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

recorded.recorded.

Wages expense (+E) x,xxx Wages payable (+L) x,xxx

ExpenseIncurred


3-26

Matching Principle

$Paid

Wages payable (-L) x,xxx Cash (-A) x,xxx

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

recorded.recorded.

Cash paid after expense is incurred:

Wages expense (+E) x,xxx Wages payable (+L) x,xxx

ExpenseIncurred


3-27

Matching Principle - Examples

CASH TO BE PAIDand already incurred as EXPENSE

Salaries payable Salaries expense

Interest payable Interest expense

Property taxes payable Property tax expense

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


3-28

Matching Principle

• Self-study Quiz – Page 113


3-29

Expanded Transaction Analysis Model

Let’s look at an expanded transaction analysis model that

includes the recording of revenues and expenses.


3-30

A = L + SEA = 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 Next, let’s see how Revenues how Revenues and Expenses and Expenses affect Retained affect Retained

Earnings.Earnings.


3-31

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.


3-32

Analyzing Papa John’s Transaction

Let’s apply the complete transaction analysis model to

some of Papa John’s transactions.

All amounts are in thousands of dollars.


3-33

Identify & Classify the AccountsIdentify & Classify the Accounts

Determine the Direction of the EffectDetermine the Direction of the Effect

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)

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.

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


3-34

= +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.


3-35The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients for those

sales were $9,600.

Identify & Classify the AccountsIdentify & Classify the Accounts

Determine the Direction of the EffectDetermine the Direction of the Effect

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

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.

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


3-36

= +Cash 36,000 Restaurant sales

revenue36,000

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

Stockholders' EquityLiabilitiesAssets

The company received $36,000 for pizza sales. The cost of the pizza ingredients for those sales

was $9,600.


3-37

More Papa John’s Transactions

• Review transactions a through h on pages 116 and 117.

• Do self-study quiz page 118• Record entries to T accounts

See page 119 Trace T account balances to financial

statements on pages 120 - 122


3-38

How are Unadjusted Financial Statements Prepared? They’re not!What you get is a Trial Balance.

After posting all of the After posting all of the January transactions to January transactions to

T-accounts, we can T-accounts, we can prepare Papa John’s prepare Papa John’s unadjusted financial unadjusted financial statementsstatements. Note: . Note: They are missing They are missing

month end accruals.month end accruals.

After posting all of the After posting all of the January transactions to January transactions to

T-accounts, we can T-accounts, we can prepare Papa John’s prepare Papa John’s unadjusted financial unadjusted financial statementsstatements. Note: . Note: They are missing They are missing

month end accruals.month end accruals.


3-39

Demonstration Case

• See required steps – pages 125 – 129

• Do this prior to attempting the homework

• (Note: The date on the beginning Balance Sheet is incorrect. It should be the prior month end, March 31, 2003)


3-40

End of Chapter 3

Documents

Chapter 3 Operating Decisions and the Income Statement 9/07/04