Operating Decisions and the Income Statement

Chapter 3

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

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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?

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Learning Objectives
Describe a typical business operating cycle and explain the necessity for the time period assumption.

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The Operating Cycle

Begin
Purchase or manufacture products or supplies on credit. Pay suppliers.
Deliver product or provide service to customers on credit.

Receive payment from customers.

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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?

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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 2005 2006

Annual Accounting Periods

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Learning Objectives

Explain how business activities affect the elements of the income statement.

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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.

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Papa Johns Primary Operating Activity is selling pizza and selling franchises.

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

Operating Activities

Peripheral Activities

$ $

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Papa Johns Primary Operating Expenses

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

Cost of sales (used inventory)

$ 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

Salaries and benefits to employees

Other costs (like advertising, insurance, and depreciation)

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Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Month Ended January 31, 2004 (In thousands) 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

Earnings Per Share

Net Income Weighted Average Number of Common Shares Outstanding

Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Year Ended December 28, 2003 (In thousands)

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

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

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

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Cash Basis Accounting

Revenue is recorded when cash is received.

Expenses are recorded when cash is paid.

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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

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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.

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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

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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) xxx Company Delivers

xxx Revenue will be recorded when earned.

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Revenue Principle

Typical liabilities that become revenue when earned include . . .

CASH COLLECTED (Goods or services due to customers) Rent collected in advance Unearned air traffic revenue Deferred subscription revenue REVENUE over time will (Earned when goods become or services provided) Rent revenue Air traffic revenue Subscription revenue

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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

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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

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Revenue Principle
When the cash is received the ACCOUNTS RECEIVABLE is reduced.
Cash received after revenue is earned Company Delivers Cash Received

Accounts receivable (+A) Revenue (+R)

xxx

xxx Cash will be collected.

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The Revenue Principle

Assets reflecting revenues earned but not yet received in cash include . . .
CASH TO BE COLLECTED (Owed by customers) Interest receivable Rent receivable Royalties receivable REVENUE (Earned when goods or services provided) Interest revenue Rent revenue Royalty revenue

and already earned as

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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

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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) xxx Expense Incurred

xxx Expense will be recorded when incurred.

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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

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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

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The Matching Principle

When cash is paid the PAYABLE is reduced.

Cash paid after expense is incurred Expense Incurred Cash Paid

Expense (+E) Payable (+L)

xxx

xxx Cash will be paid.

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The Matching Principle

Typical assets and their related expense accounts include. . .

CASH PAID FOR Supplies inventory Prepaid insurance Buildings and equipment as used over time becomes EXPENSE Supplies expense Insurance expense Depreciation expense

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

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Expanded Transaction Analysis Model

Lets look at an expanded transaction analysis model that includes the recording of revenues and expenses.

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A = L + SE
ASSETS Debit Credit for for Increase Decrease LIABILITIES Debit Credit for for Decrease Increase

Next, lets see how Revenues and Expenses affect Retained Earnings.

CONTRIBUTED CAPITAL Debit Credit for for Decrease Increase

RETAINED EARNINGS Debit Credit for for Decrease Increase

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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

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Analyzing Papa Johns Transactions

Lets apply the complete transaction analysis model to some of Papa Johns transactions.
All amounts are in thousands of dollars.

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Papa Johns 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.

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Papa Johns 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

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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.

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The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients for those sales were $9,600.
Assets Cash Inventory 36,000 (9,600) = Liabilities + Stockholders' Equity Restaurant sales 36,000 revenue Cost of sales (9,600)

General Journal
Description Cash Restaurant sales revenue Cost of sales - restaurant Inventories 9,600 9,600 Debit 36,000 Credit 36,000

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Learning Objectives

Prepare financial statements.

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How are Financial Statements Prepared?

Income Statement Statement of Retained Earnings Balance Sheet Revenues Expenses = Net Income Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Assets = Liabilities + Stockholders Equity Contributed Capital Retained Earnings Change = Cash from Operating Activities in + Cash from Investing Activities Cash + Cash from Financing Activities

Statement of Cash Flows

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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

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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 $ 158,000 21,800 (3,000) 176,800

The net income comes from the Income Statement just prepared.

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

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Focus on Cash Flows

Effect on Cash Flows + + -

Nature of Operating Activity Cash received from: Customers Investments Cash paid to: Suppliers Employees Interest paid Income taxes paid

Cash Outflows Cash Inflows

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Statement of Cash Flows

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

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

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Learning Objectives

Compute and interpret the total asset turnover ratio.

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Key Ratio Analysis

Asset Turnover Ratio

Sales (or Operating) Revenues Average Total Assets

Measures the sales generated per dollar of assets.

Creditors and analysts use this ratio to assess a companys effectiveness at controlling current and noncurrent assets.

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End of Chapter 3