Chap003

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  • Chapter 3: Operating Decisions and the Income Statement. To understand how business plans and the results of operations are reflected on the income statement, we need to answer the following questions: How do business activities affect the income statement? How are business activities measured? How are business activities reported on the income statement?
  • In this chapter we will discuss how business activities affect the income statement of a company. We will also look at how these activities are recognized, recorded and measured. Finally, we will look at the preparation of an income statement.
  • The business cycle begins with the purchase or manufacture of a product for sale. When products are purchased from suppliers, those suppliers must be paid. After a sale has been made, the company must deliver the product or service to the customer. Many business sales are made on credit. If credit is extended, payment must be received from customers. Once the cash has been collected from customers, the business cycle begins all over again. We never want to confuse the business operating cycle with the accounting cycle. Companies (1) acquire inventory and the services of employees and (2) sell inventory or services to customers. The operating (or cash-to-cash) cycle begins when a company receives goods to sell (or, in the case of a service company, has employees work), pays for them, and sells to customers, then ends when customers pay cash to the company. The length of time for completion of the operating cycle depends on the nature of the business.
  • We know that most successful companies operate for a very long period of time, and managers and investors need financial information on a timely basis. For accountants to provide this information, we have to divide the life of the business into relatively short, arbitrary time periods. We usually divide the life of a business into months, quarters, and annual time periods. When we establish these relatively short time periods, we create many measurement issues, for example, problems of revenue and expense recognition.
  • The income statement contains revenues, expenses, gains and losses. Operating revenues result from the sale of goods or services. When Papa John’s sells pizza to consumers or supplies to franchisees, it has earned revenue. When revenue is earned, assets, usually Cash or Accounts Receivables, often increase. Sometimes if a customer pays for goods or services in advance, a liability account, usually Unearned (or Deferred) Revenue, is created. Expenses are decreases in assets or increases in liabilities from ongoing operations incurred to generate revenues during the period. Papa John’s pays employees to make and serve food, uses electricity to operate equipment and light its facilities, advertises its pizza, and uses food and paper supplies. Without incurring these expenses, Papa John’s could not generate revenues. Gains (with an account called Gain on Sale of Assets) result in an increase in assets or decrease in liabilities from a peripheral transaction. Losses are decreases in assets or increases in liabilities from peripheral transactions.
  • Here is an income statement for Papa John’s for the year ended December 31, 2008. Notice that the company separates it operating activities, that is, its normal revenues and expenses from selling of pizzas and franchises, from the peripheral activities that include investment income, interest expense, and loss due to restaurants sold. Income taxes are shown on a separate line. Most financial analysts concentrate on operating income because it represents the income earned from normal operations before taxes.
  • The primary expenses of Papa John’s include cost of sales, the cost of inventory items sold, salaries and benefits paid to employees, and administrative, selling, and general expenses.
  • Similar expenses are required to be reported but may be grouped in different ways. GAAP general requires that expenses by classified by business function like production, marketing, etc. The IFRS permits companies to categorize expenses by either function or nature.
  • Companies that use the cash accounting basis recognize revenue only when cash is received, and recognize expenses only when cash is paid. Your financial performance is measured as the difference between your cash balance at the beginning of the period and the cash balance at the end of the period (that is, whether you end up with more or less cash). Many local retailers, medical offices, and other small businesses use cash basis accounting. A cash basis is not considered part of generally accepted accounting principles.
  • Generally accepted accounting principles require that assets, liabilities, revenues, and expenses be recognized when the transaction that causes them occurs. The date when cash is paid or received is not necessarily the same as the date upon which a transaction occurs. Generally accepted accounting principles require the use of the accrual method. In accrual basis accounting, revenues and expenses are recognized when the transaction that causes them occurs, not necessarily when cash is received or paid. That is, revenues are recognized when they are earned and expenses when they are incurred. The two basic accounting principles that determine when revenues and expenses are recorded under accrual basis accounting are the revenue principle and the matching principle .
  • The revenue principle states that revenue should be recognized when a product has been delivered or service has been rendered. In addition, there must be some agreement as to how the customer will pay for the product or service, and there must be a fixed or determinable price associated with the transaction. Finally, the collection of the amount involved must be reasonably assured.
  • Under the revenue principle, four criteria or conditions must normally be met for revenue to be recognized. If any of the following criteria is no t met, revenue normally is not recognized and cannot be recorded. Delivery has occurred or services have been rendered . The company has performed or substantially performed the acts promised to the customer by providing goods or services. There is persuasive evidence of an arrangement for customer payment . In exchange for the company’s performance, the customer has provided cash or a promise to pay cash (a receivable). The price is fixed or determinable . There are no uncertainties as to the amount to be collected. Collection is reasonably assured . For cash sales, collection is not an issue since it is received on the date of the exchange. For sales on credit, the company reviews the customer’s ability to pay. If the customer is considered creditworthy, collecting cash from the customer is reasonably likely. These conditions normally occur when the title, risks, and rewards of ownership have transferred to the customers. For most businesses, these conditions are met at the point of delivery of goods or services, regardless of when cash is received.
  • When the product is delivered or the service provided, revenue will be recorded. When the company delivers the goods or services the liability, unearned revenue, is reduced, and the revenue account, service revenue, is increased.
  • Here are three typical transactions where cash is collected before the revenue is earned.
  • Cash can be received on the date the product is delivered or the services provided. The journal entry is to debit cash and credit revenue.
  • In many cases, cash is received after the goods are delivered or the services provided. In this example, we establish an asset account, accounts receivable. The journal entry is to debit accounts receivable and credit the revenue account.
  • When the customer finally pays the cash, the receivable will be eliminated. When the cash is collected by the company the journal entry is to increase the asset account, cash, and decrease the asset account, accounts receivable.
  • Here are three examples where revenue has been earned but cash has not yet been received.
  • The matching principle requires that costs incurred to generate revenues be recognized in the same period—a matching of costs with benefits. For example, when Papa John’s restaurants provide food service to customers, revenue is earned. The costs of generating the revenue include expenses incurred such as these: Wages to employees who worked during the period (Wages Expense) Utilities for the electricity used during the period (Utilities Expense) Food and paper products used during the period (Cost of Sales) Facilities rental during the period (Rent Expense) The use of ovens and other equipment during the period (Depreciation Expense)
  • If cash is paid before goods are received or services are provided, the company establishes a prepaid expense. A prepaid expense is an asset account. The journal entry on the date of transaction is to debit prepaid expense and credit cash.
  • The expense will be recorded when incurred. After the expense has been incurred, the journal entry is to increase the expense account and decrease the asset account, prepaid expense.
  • Of course, the expense can be incurred on the same day cash is paid. In this case, the journal entry is to debit the expense and credit cash.
  • When cash is paid after the company receives the goods or service, a liability account must be established. The journal entry is to debit an expense account and credit a liability account for the payable.
  • When cash is actually paid, the payable will be eliminated.
  • Here are three examples where cash is typically paid before the expense is recognized.
  • Consider the unethical and illegal activities entered into by leaders at companies with little or no internal or external oversight. 1-
  • Here is the expanded transaction analysis model. We know that stockholders’ equity consists of contributed capital and retained earnings. Let’s see how revenues and expenses impact retained earnings.
  • From our statement of retained earnings we know that net income increases retained earnings. Revenues increase net income and expenses decrease net income. Revenues show increases and decreases on the same sides of the T-account as retained earnings. A credit to the revenue account increases revenue, a debit to the revenue account decreases revenue. Because expenses reduce revenues in the calculation of net income, increases and decreases in expense accounts are shown on the opposite sides when compared to revenue accounts. A debit to an expense account represents an increase in expenses, a credit to an expense account represents a decrease in expenses.
  • In our first transaction, Papa John’s restaurants sold pizza to customers for $36,000 cash and sold $30,000 in supplies to franchised restaurants, receiving $21,000 cash with the rest due on account. The proper journal entry is to debit the asset account Cash for $57,000, ($36,000 plus $21,000); debit the asset account Accounts Receivable for $9,000; and credit the revenue account Restaurant Sales Revenue for $66,000. Notice that the accounting equation is in balance after recording the transaction.
  • The cost of the dough, sauce, cheese, and other supplies for the restaurant sales in (a) on the previous screen was $30,000. The proper journal entry is to debit the expense account Cost of Sales for $30,000, and credit the asset account Supplies for $30,000. The accounting equation is still in balance after the second transaction.
  • Next, Papa John’s sold new franchises for $400 cash, earning $100 immediately by performing services for franchisees; the rest will be earned over the next several months. The proper journal entry is to debit the asset account Cash for $400; credit the liability account Unearned Franchise Fees for $300; and credit the stockholders’ equity account Franchise Fee Revenue for $100. The accounting equation is still in balance after this transaction.
  • In January, Papa John’s paid $7,000 for utilities, repairs, and fuel for delivery vehicles, all considered general and administrative expenses incurred during the month. Because these costs are not part of cost of goods sold, or another specific expense, they are classified as General and Administrative Expenses (G and A). The proper journal entry is to debit, or increase, the expense account General and Administrative Expenses (which reduces stockholders’ equity) for $7,000, and credit, or decrease, the asset account Cash for the same amount. The accounting equation is still in balance after this transaction. Papa John’s will continue to record transactions as shown in your text until the end of the accounting period.
  • After all the transactions for the period have been recorded the balances in the T-Accounts for the balance sheet and income statement will appear as shown on this screen. Notice that all income statement accounts start each period with a zero balance. We will use these account balances to prepare the financial statements of Papa John’s for the month ended January 31, 2009.
  • The first statement we prepare is the income statement. The income statement shows revenues minus expenses. The second financial statement we prepare is the statement of retained earnings. In preparing the statement of retained earnings, we start with beginning retained earnings, we add net income and subtract dividends declared to arrive at ending retained earnings. The third financial statement we prepare is the balance sheet. The balance sheet shows assets, liabilities and stockholders’ equity. Stockholders’ equity is comprised of contributed capital and retained earnings. The final statement we prepare is the statement of cash flows. The statement of cash flows determines the change in our cash balance during the period. The statement is divided into three major sections, cash from operating activities, cash from investing activities, and cash from financing activities.
  • We must prepare the Income Statement first because net income is needed before we can prepare the Statement of Retained earnings. Next, we prepare the Statement of Retained Earnings because we need the ending balance in Retained Earning to show the proper balance in the stockholders’ equity section of the Balance Sheet. Recall that stockholders’ equity is composed of the sum of Contributed Capital and Retained Earnings. Next, we prepare the Balance Sheet. We need the beginning and ending cash balance to prepare the fourth, and final statement, the Statement of Cash Flows. So the order of preparation of financial statements at the end of the accounting period is: Income Statement, Statement of Retained Earnings, Balance Sheet, and finally Statement of Cash Flows.
  • Here is the income statement for Papa John’s for the one month ended January 31, 2009. It is the first financial statement prepared by the company. Notice that net income is $21,800 and Earning per Share is 78 cents for the month. The company did not incur all of its possible expenses. We will examine some of the other revenues and expenses in the next Chapter. Notice that the Income Statement is titled as “before adjustments.” In the next several chapters we will see that many financial accounts must be adjusted at the end of the period. For example, the company may have incurred interest on its debt, but the interest is not paid until the end of the year. In this case we would be required to accrue interest for one month so we do not violate the matching principle.
  • Next we prepare the Statement of Stockholders’ Equity. To the beginning balance in retained earnings we add our net income of $21,800, subtract dividends declared and arrive at our ending retained earnings. Notice that the ending balance in retained earnings is $150,800. We will need this balance to complete the balance sheet. The $150,800 will appear as the balance in the stockholders’ equity section of the balance sheet that we will prepare next.
  • The third financial statement we prepare is the Balance Sheet for Papa John’s. Since total assets equal total liabilities plus stockholders’ equity, the accounting equation is in balance. Notice that our ending stockholders’ equity of $150,800 flows from the Statement of Stockholders’ Equity to the stockholders’ equity section of the balance sheet.
  • Cash inflows from operating activities include cash received from customers and from investments. Cash outflows relating to operating activities include cash paid to suppliers, employees, interest, and taxes. The net of our cash inflows and outflows is the cash flows from operating activities. In the investing activities section of the statement we find the purchase or sale of property, plant or equipment and the purchase or sale of other long-term assets. In the financing activities section of the statement we find issuance or retirement of long-term debt, the issuance or repurchase of contributed capital, and cash dividends paid. At the bottom of the statement we calculate the net increase or decrease in cash during the period and reconcile the beginning and ending cash balance to that net increase or decrease. When a transaction affects cash, it is included on the statement of cash flows. When a transaction does not affect cash, such as acquiring a building with a long-term mortgage note payable or selling goods on account to customers, there is no cash effect to include on the statement.
  • The total asset turnover ratio is computed by dividing total sales revenue by average total assets. Generally, we calculate the average total assets by adding together the beginning and ending total assets and dividing by 2. The total asset turnover ratio for Papa John’s for 2008 is 2.87 times. The ratio is an excellent measure of the sales generated per dollar of assets owned. A high total asset turnover ratio signifies efficient management of assets and a low ratio signifies less efficient asset management. Creditors and security analysts use this ratio to assess a company’s effectiveness at controlling both current and noncurrent assets. In a well-run business, creditors expect the ratio to fluctuate due to seasonal upswings and downturns.
  • End of chapter 3. 3-
  • Chap003

    1. 1. Operating Decisions and the Income Statement Chapter 03 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
    2. 2. 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. 3. The Operating Cycle Begin Purchase or manufacture products or supplies on credit. Deliver product or provide service to customers on credit. Pay suppliers. Receive payment from customers.
    4. 4. 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?
    5. 5. Elements on the Income Statement Losses Decreases in assets or increases in liabilities from peripheral transactions. 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 .
    6. 7. Papa John’s Primary Operating Expenses Cost of sales (used inventory) Salaries and benefits to employees Other costs (like advertising, insurance, and depreciation)
    7. 8. International Perspective
    8. 9. How Are Operating Activities Recognized and Measured? Revenue is recorded when cash is received. Expenses are recorded when cash is paid. Cash Basis
    9. 10. How Are Operating Activities Recognized and Measured? 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 - G enerally A cceptable A ccounting P rinciples GAAP Accrual Accounting
    10. 11. Revenue Principle <ul><li>Recognize revenues when . . . </li></ul><ul><ul><li>Delivery has occurred or services have been rendered. </li></ul></ul><ul><ul><li>There is persuasive evidence of an arrangement for customer payment. </li></ul></ul><ul><ul><li>The price is fixed or determinable. </li></ul></ul><ul><ul><li>Collection is reasonably assured. </li></ul></ul>
    11. 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) xxx Unearned revenue (+L) xxx
    12. 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 Company Delivers Revenue will be recorded when earned. Cash (+A) xxx Unearned revenue (+L) xxx Unearned revenue (-L) xxx Service revenue (+R) xxx
    13. 14. Revenue Principle Typical liabilities that become revenue when earned include . . .
    14. 15. Revenue Principle When cash is received on the date the revenue is earned, the following entry is made: Cash Received Company Delivers AND Cash (+A) xxx Revenue (+R) xxx
    15. 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) xxx Revenue (+R) xxx
    16. 17. Revenue Principle Cash Received Cash received after revenue is earned - Company Delivers When the cash is received the ACCOUNTS RECEIVABLE is reduced. Cash will be collected. Accounts receivable (+A) xxx Revenue (+R) xxx Cash (+A) xxx Accounts receivable (-A) xxx
    17. 18. Revenue Principle Assets reflecting revenues earned but not yet received in cash include . . .
    18. 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 .
    19. 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) xxx Cash (-A) xxx
    20. 21. The Matching Principle Expense Incurred When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Expense will be recorded when incurred. Prepaid expense (+A) xxx Cash (-A) xxx Expense (+E) xxx Prepaid expense (-A) xxx
    21. 22. The Matching Principle When cash is paid on the date the expense is incurred, the following entry is made: Cash Paid Expense Incurred AND Expense (+E) xxx Cash (-A) xxx
    22. 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) xxx Payable (+L) xxx
    23. 24. The Matching Principle Cash Paid When cash is paid the PAYABLE is reduced. Cash paid after expense is incurred - Expense Incurred Cash will be paid. Expense (+E) xxx Payable (+L) xxx Payable (-L) xxx Cash (-A) xxx
    24. 25. The Matching Principle Typical assets and their related expense accounts include. . .
    25. 26. A Question of Ethics
    26. 27. A = L + SE Next, let’s see how Revenues and Expenses affect Retained Earnings. ASSETS Debit for Increase Credit for Decrease LIABILITIES Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase CONTRIBUTED CAPITAL Debit for Decrease Credit for Increase
    27. 28. Expanded Transaction Analysis Model Dividends decrease Retained Earnings. Net Income increases Retained Earnings. EXPENSES Debit for Increase Credit for Decrease REVENUES Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase
    28. 29. Analyzing Some of Papa John’s Transactions (a) Papa John’s restaurants sold pizza to customers for $36,000 cash and sold $30,000 in supplies to franchised restaurants, receiving $21,000 cash with the rest due on account. <ul><li>Equality checks: </li></ul><ul><li>Debits $66,000 equal Credits $66,000, </li></ul><ul><li>The accounting equation is in balance. </li></ul>
    29. 30. Analyzing Some of Papa John’s Transactions (b) The cost of the dough, sauce, cheese, and other supplies for the restaurant sales in (a) on the previous screen was $30,000. <ul><li>Equality checks: </li></ul><ul><li>Debits $30,000 equal Credits $30,000, </li></ul><ul><li>The accounting equation is in balance. </li></ul>
    30. 31. Analyzing Some of Papa John’s Transactions (c) Papa John’s sold new franchises for $400 cash, earning $100 immediately by performing services for franchisees; the rest will be earned over the next several months. <ul><li>Equality checks: </li></ul><ul><li>Debits $400 equal Credits $400, </li></ul><ul><li>The accounting equation is in balance. </li></ul>
    31. 32. Analyzing Some of Papa John’s Transactions (d) In January, Papa John’s paid $7,000 for utilities, repairs, and fuel for delivery vehicles, all considered general and administrative expenses incurred during the month. <ul><li>Equality checks: </li></ul><ul><li>Debits $7,000 equal Credits $7,000, </li></ul><ul><li>The accounting equation is in balance. </li></ul>
    32. 33. The balances in the balance sheet accounts and income statement accounts (all income accounts begin with a zero balance).
    33. 34. How are Financial Statements Prepared and Analyzed? Income Statement Revenues – Expenses = Net Income Statement of Stockholders’ Equity Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Balance Sheet Assets = Liabilities + Stockholders’ Equity Contributed Capital Retained Earnings Statement of Cash Flows Change in Cash = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities
    34. 35. How are Financial Statements Prepared and Analyzed? Income Statement Revenues – Expenses = Net Income Cash Statement of Stockholders’ Equity Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Balance Sheet Assets = Liabilities + Stockholders’ Equity Contributed Capital Retained Earnings Statement of Cash Flows Change in Cash = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities
    35. 36.  Income Statement
    36. 37.  Statement of Stockholders’ Equity The net income ($21,800) comes from the Income Statement we just prepared.
    37. 38.  Balance Sheet
    38. 39. Focus on Cash Flows Direct approach to preparing operating cash flows.
    39. 40. Total Asset Turnover Ratio (Beginning total assets + ending total assets) ÷ 2 Papa John’s Total Asset Turnover Ratio for 2008 (dollars in thousands): Total Asset Turnover Ratio Sales (or Operating) Revenues Average Total Assets = $1,132,000 ($402,000 + $386,000) ÷ 2 = 2.87
    40. 41. End of Chapter 03

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