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

OperatingDecisions

and theIncome Statement

Chapter 3

3-2

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..

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?

3-3

The Time Period Assumption

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

periodsperiods (monthly, quarterly, annually).

1999 2000 2001 2002 2003 2004 2005 2006

Life of the BusinessLife of the Business

Annual Accounting Periods

3-4

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.

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.

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.

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..

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

liabilities from peripheral transactionsliabilities from peripheral transactions..

3-5

Papa John’s Primary Operating Activity is

selling pizza and selling franchises.

Papa John’s Primary Operating Activity is

selling pizza and selling franchises.

Operating Activities

Peripheral Activities

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, advertising,

insurance, and insurance, and depreciation)depreciation)

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

insurance, and insurance, and depreciation)depreciation)

3-7

Earnings Per ShareEarnings Per ShareEarnings Per ShareEarnings Per Share

Net IncomeWeighted Average

Number of Common Shares Outstanding

3-8

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

expense is expense is Income Before Income Before Income TaxesIncome Taxes × × Tax RateTax Rate (Federal, State, Local and (Federal, State, Local and

Foreign).Foreign).

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

expense is expense is Income Before Income Before Income TaxesIncome Taxes × × Tax RateTax Rate (Federal, State, Local and (Federal, State, Local and

Foreign).Foreign).

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 economic should be recognized when the economic transaction that causes them occurs, transaction that causes them occurs, not not

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

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

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

Required by -

Generally

Acceptable

Accounting

Principles

Required by -

Generally

Acceptable

Accounting

Principles

Accrual Accounting

3-11

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.

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.

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.

Cash received before revenue is earned -

CashReceived

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

3-13

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.

3-14

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

3-15

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

3-16

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.

3-17

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..

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..

3-18

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

3-19

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.

3-20

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

3-21

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

3-22

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.

3-23

The Matching Principle

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

Expanded Transaction Analysis Model

Let’s look at an expanded transaction analysis model that

includes the recording of revenues and expenses.

3-25

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.

3-26

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.

3-27

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.

3-28

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.

3-29

= +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.

3-30

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.

3-31

= +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.

3-32

How are Financial Statements Prepared?

IncomeIncomeStatementStatement 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

3-33

Income Statement

3-34

Beginning balance, December 28, 2003 158,000$ Net income 21,800 Dividends (3,000) Ending balance, January 31, 2004 176,800$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESConsolidated 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$

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

For the Month Ended Janaury 31, 2004(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.

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

3-35

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

Purchased property and equipment (2,000)

Purchased investments (1,000)

Lent funds to franchisees (3,000)

Net cash used in investing activities (2,000)

Financing Activities

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$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES

Consolidated Statement of Cash Flows

For the Month Ended Janaury 31, 2004

(Dollars in thousands)

The ending cash The ending cash balance agrees balance agrees with the amount with the amount on the Balance on the Balance

Sheet.Sheet.

The ending cash The ending cash balance agrees balance agrees with the amount with the amount on the Balance on the Balance

Sheet.Sheet.

Statement of Cash Flows

3-36

Balance Sheet

Assets 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

Total assets 395,100$

Liabilities and Stockholders' Equity

Current liabilities:

Accounts payable 38,000$

Dividends payable 3,000

Accrued expenses payable 53,000

Total current liabilities 94,000

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$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(Dollars in thousands)

The ending RE balance The ending RE balance from the Statement of from the Statement of

Retained Earnings and the Retained Earnings and the ending Cash balance from ending Cash balance from

the Statement of Cash the Statement of Cash Flows feed into the asset Flows feed into the asset and equity sections of the and equity sections of the

Balance Sheet.Balance Sheet.

The ending RE balance The ending RE balance from the Statement of from the Statement of

Retained Earnings and the Retained Earnings and the ending Cash balance from ending Cash balance from

the Statement of Cash the Statement of Cash Flows feed into the asset Flows feed into the asset and equity sections of the and equity sections of the

Balance Sheet.Balance Sheet.