Operating Decisions and

the Income Statement

Chapter 3

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.

Understanding the Business

How do business activities
affect the income statement?

How are these activities

recognized and measured?

How are these activities

reported on the
income statement?

3-2

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.

3-3

The Operating Cycle

Time
Time Period:
Period: The
The long
long life
life of
of aa company
company can
can be
be
reported
reported over
over aa series
series of
of shorter
shorter time
time periods
periods..
Recognition
Recognition Issues
Issues :: When
When should
should the
the effects
effects of
of
operating
operating activities
activities be
be recognized
recognized (recorded)?
(recorded)?
Measurement
Measurement Issues:
Issues: What
What amounts
amounts should
should be
be
recognized?
recognized?

3-4

Elements on the Income Statement

Revenues
Revenues
Increases
Increases in
in assets
assets or
or settlement
settlement of
of
liabilities
liabilities from
from ongoing
ongoing operations.
operations.
Expenses
Expenses
Decreases
Decreases in
in assets
assets or
or increases
increases in
in
liabilities
liabilities from
from ongoing
ongoing operations.
operations.
Gains
Gains
Increases
Increases in
in assets
assets or
or settlement
settlement of
of
liabilities
liabilities from
from peripheral
peripheral transactions
transactions..
Losses
Losses
Decreases
Decreases in
in assets
assets or
or increases
increases in
in
liabilities
liabilities from
from peripheral
peripheral transactions.
transactions.
3-5

Papa Johns Primary

Operating Activity is
selling pizza and selling
franchises.

Operating Activities

Peripheral Activities

3-6

Papa
Papa Johns
Johns Primary
Primary
Operating
Operating Expenses
Expenses

Cost of sales
(used inventory)

Salaries and
benefits to
employees
employees
Other costs
costs (like
(like
advertising,
advertising,
insurance,
insurance, and
and
depreciation)
depreciation)

3-7

Earnings Per Share

Share
Net Income
Weighted Average
Number of Common
Shares Outstanding

3-8

Corporations
Corporations are
are
taxable
taxable entities.
entities.
Income
Income tax
tax expense
expense
computed
computed as
as Income
Income
Before
Before Income
Income Taxes
Taxes

Tax
Tax Rate
Rate (Federal,
(Federal,
State,
State, Local
Local and
and
Foreign).
Foreign).

3-9

Cash Basis Accounting

Revenue is recorded
when cash is received.

Expenses are recorded

when cash is paid.

3-10

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
3-11

Revenue Principle

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

have
have been
been rendered.
rendered.
There
There is
is persuasive
persuasive evidence
evidence of
of
an
an arrangement
arrangement for
for customer
customer
payment.
payment.
The
The price
price is
is fixed
fixed or
or determinable.
determinable.
Collection
Collection is
is reasonably
reasonably assured.
assured.

3-12

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

3-13

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.

3-14

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

3-15

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

3-16

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

3-17

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.

3-18

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

3-19

The Matching Principle

Resources
consumed to earn
revenues in an
accounting period
should be recorded
in that period,
regardless of when
cash is paid.

3-20

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

3-21

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.
3-22

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

3-23

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

3-24

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.

3-25

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

3-26

A = L + SE
ASSETS

LIABILITIES

Debit
Credit
for
for
Increase Decrease

Debit
Credit
for
for
Decrease Increase

Next, lets see how

Revenues and
Expenses affect
Retained Earnings.

CONTRIBUTED
CAPITAL

RETAINED
EARNINGS

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Decrease Increase
3-27

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

3-28

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.
3- 29

Papa Johns sold franchises for $400 cash. The company earned
$100 immediately. The rest will be earned over several months.

3-30

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.

3-31

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?
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
3-33

Income Statement

3-34

Statement of Retained Earnings

The net income comes from the Income

Statement just prepared.

3-35

Balance Sheet

The ending balance from

the Statement of Retained
Earnings flows into the
equity section of the
Balance Sheet.

3-36

Focus on Cash Flows

Cash Outflows
Cash Inflows
3-37

Key Ratio Analysis

Total 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
companys effectiveness at
controlling current and
noncurrent assets.

3-38

End of Chapter 3

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.