Transcript Slide 1

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 a typical business operating cycle
and explain the necessity for the time period
assumption.
3-4
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.
3-5
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?
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
Annual Accounting Periods
2005
2006
3-7
Learning Objectives
Explain how business activities affect the
elements of the income statement.
3-8
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.
3-9
Papa John’s Primary
Operating Activity is
selling pizza and selling
franchises.
Operating Activities
Peripheral Activities
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Month Ended January 31, 2004
(In thousands)
Revenues
Restaurant and commissary sales
Franchise royalties and development fees
Total revenues
Costs and expenses
Cost of sales
Salaries and benefits expense
General and administrative expenses
Total costs and expenses
Operating income
Other revenues and gains (expense and losses)
Investment income
Interest expense
Gain on sale of land
Income before income taxes
Income tax expense
Net income
Earnings per share
$
66,000
2,800
68,800
30,000
14,000
7,000
51,000
17,800
$
1,000
3,000
21,800
21,800
$
1.21
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)
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Month Ended January 31, 2004
(In thousands)
Revenues
Restaurant and commissary sales
Franchise royalties and development fees
Total revenues
Costs and expenses
Cost of sales
Salaries and benefits expense
General and administrative expenses
Total costs and expenses
Operating income
Other revenues and gains (expense and losses)
Investment income
Interest expense
Gain on sale of land
Income before income taxes
Income tax expense
Net income
Earnings per share
$ 66,000
2,800
68,800
30,000
14,000
7,000
51,000
17,800
1,000
3,000
21,800
$ 21,800
$
1.21
3-11
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Month Ended January 31, 2004
(In thousands)
Earnings Per Share
Net Income
Weighted Average
Number of Common
Shares Outstanding
Revenues
Restaurant sales
Franchise royalties and development fees
Total revenues
Costs and expenses
Cost of sales
Salaries and benefits expense
General and administrative expenses
Total costs and expenses
Operating income
Other revenues and gains (expense and losses)
Investment income
Interest expense
Gain on sale of land
Income before income taxes
Income tax expense
Net income
Earnings per share
$ 66,000
2,800
68,800
30,000
14,000
7,000
51,000
17,800
1,000
3,000
21,800
$ 21,800
$
1.21
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Year Ended December 28, 2003
(In thousands)
Corporations are taxable
entities. Income tax
expense is Income Before
Income Taxes × Tax Rate
(Federal, State, Local and
Foreign).
3-12
Revenues
Restaurant and commissary sales
$ 811,000
Franchise royalties and development fees
106,000
Total revenues
917,000
Costs and expenses
Cost of sales
385,000
Salaries and benefits
164,000
Rent expense
26,000
Advertising expense
38,000
General and administrative expenses
67,000
Depreciation expense
31,000
Restaurant closure costs
3,000
Other operating costs
141,000
Total costs and expenses
855,000
Operating income
62,000
Other revenues and gains (expense and losses)
Investment income
1,000
Interest expense
(7,000)
Restaurant disposition and impairment losses
(2,000)
Income before income taxes
54,000
Income tax expense
20,000
Net income
$ 34,000
3-13
Learning Objectives
Explain the accrual basis of accounting and
apply the revenue and matching principles to
measure income.
3-14
Cash Basis Accounting
Revenue is recorded
when cash is received.
Expenses are recorded
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)
Unearned revenue (+L)
xxx
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
Received
Cash (+A)
Unearned revenue (+L)
Company
Delivers
xxx
xxx
Revenue will be recorded when
earned.
3-19
Revenue Principle
Typical liabilities that become
revenue when earned include . . .
CASH COLLECTED
(Goods or services due to
customers)
REVENUE
over time will (Earned when goods
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)
Revenue (+R)
xxx
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)
Revenue (+R)
xxx
xxx
3-22
Revenue Principle
When the cash is received the ACCOUNTS
RECEIVABLE is reduced.
Cash received after revenue is earned Cash
Received
Company
Delivers
Accounts receivable (+A)
Revenue (+R)
xxx
xxx
Cash will be collected.
3-23
The Revenue Principle
Assets reflecting revenues earned but
not yet received in cash include . . .
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
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.
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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)
Cash (-A)
xxx
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 $
Paid
Prepaid expense (+A)
Cash (-A)
Expense
Incurred
xxx
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)
Cash (-A)
xxx
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)
Payable (+L)
xxx
xxx
3-29
The Matching Principle
When cash is paid the PAYABLE is reduced.
Cash paid after expense is incurred Cash
Paid
Expense
Incurred
Expense (+E)
Payable (+L)
xxx
xxx
Cash will be paid.
3-30
The Matching Principle
Typical assets and their related
expense accounts include. . .
CASH PAID FOR
as used over
time becomes
EXPENSE
Supplies inventory
Supplies expense
Prepaid insurance
Insurance expense
Buildings and equipment
Depreciation expense
3-31
Learning Objectives
Apply transaction analysis to examine and
record the effects of operating activities on the
financial 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
for
for
Increase Decrease
Debit
Credit
for
for
Decrease Increase
Next, let’s see
how Revenues
and Expenses
affect Retained
Earnings.
CONTRIBUTED
CAPITAL
RETAINED
EARNINGS
Debit
Credit
for
for
Decrease Increase
Debit
Credit
for
for
Decrease Increase
3-34
Expanded Transaction Analysis Model
Dividends decrease
Retained Earnings.
RETAINED
EARNINGS
Debit
Credit
for
for
Decrease Increase
Net Income increases
Retained Earnings.
REVENUES
EXPENSES
Debit
Credit
for
for
Decrease Increase
Debit
Credit
for
for
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
Cash
=
400
Liabilities
Unearned franchise
revenue
+
300
Stockholders' Equity
Franchise fees
100
revenue
General Journal
Description
Cash
Unearned franchise revenue
Franchise fees revenue
Debit
400
Credit
300
100
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
Cash
Inventory
=
Liabilities
+
36,000
(9,600)
Stockholders' Equity
Restaurant sales
36,000
revenue
Cost of sales
(9,600)
General Journal
Description
Cash
Debit
36,000
Restaurant sales revenue
Cost of sales - restaurant
Inventories
Credit
36,000
9,600
9,600
3-40
Learning Objectives
Prepare financial statements.
3-41
How are Financial Statements Prepared?
Income
Statement
Revenues – Expenses = Net Income
Statement of
Retained
Earnings
Beginning Retained Earnings
+ Net Income
- Dividends Declared
Ending Retained Earnings
Balance
Sheet
Statement
of Cash Flows
Assets = Liabilities + Stockholders’ Equity
Contributed Capital
Retained Earnings
Change =
Cash from Operating Activities
in
+ Cash from Investing Activities
Cash
+ Cash from Financing Activities
3-42
Income Statement
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Month Ended January 31, 2004
(In thousands)
Revenues
Restaurant and commissary sales
Franchise royalties and development fees
Total revenues
Costs and expenses
Cost of sales
Salaries and benefits expense
General and administrative expenses
Total costs and expenses
Operating income
Other revenues and gains (expense and losses)
Investment income
Interest expense
Gain on sale of land
Income before income taxes
Income tax expense
Net income
Earnings per share
$ 66,000
2,800
68,800
30,000
14,000
7,000
51,000
17,800
1,000
3,000
21,800
$ 21,800
$
1.21
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
Net income
Dividends
Ending balance, January 31, 2004
$
$
The net income comes from the Income
Statement just prepared.
158,000
21,800
(3,000)
176,800
Balance Sheet
The ending balance from
the Statement of Retained
Earnings flows into the
equity section of the
Balance Sheet.
PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES3-44
Consolidated Balance Sheets
(Dollars in thousands)
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
Dividends payable
Accrued expenses payable
Total current liabilities
Unearned franchise fees
Long-term notes payable
Other long-term liabilities
Total liabilities
Stockholders' equity:
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$
$
38,000
3,000
53,000
94,000
6,300
75,000
40,000
215,300
3,000
176,800
179,800
395,100
3-45
Focus on Cash Flows
Nature of Operating Activity
Cash received from: Customers
Investments
Cash paid to:
Suppliers
Employees
Interest paid
Income taxes paid
Effect on
Cash Flows
+
+
-
Cash Outflows
Cash Inflows
3-46
Statement of
Cash Flows
The ending cash
balance agrees
with the amount
on the Balance
Sheet.
PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES
Consolidated Statement of Cash Flows
For the Month Ended Janaury 31, 2004
(Dollars in thousands)
Operating Activities
Cash from: Customers
Franchises
Interest on investments
Cash to:
Suppliers
Employees
Net cash provided by operating activities
Investing Activities
Sold land
Purchased property and equipment
Purchased investments
Lent funds to franchisees
Net cash used in investing activities
Financing Activities
Issued common stock
Borrowed from banks
Net cash provided by financing activities
Net increase in cash
Cash at beginning of month
Cash at end of month
$ 69,000
3,900
1,000
(35,000)
(14,000)
24,900
4,000
(2,000)
(1,000)
(3,000)
(2,000)
2,000
6,000
8,000
30,900
7,000
$ 37,900
3-47
Learning Objectives
Compute and interpret the total asset
turnover ratio.
3-48
Key Ratio Analysis
Asset
Turnover
Ratio
=
Sales (or Operating) Revenues
Measures the sales
generated per dollar
of assets.
Average Total Assets
Creditors and analysts use
this ratio to assess a
company’s effectiveness at
controlling current and
noncurrent assets.
3-49
End of Chapter 3