The document discusses accounting principles related to the income statement. It explains the operating cycle of a typical business and how revenues and expenses are recognized and reported on the income statement under accrual accounting. It also covers the revenue principle, which dictates when revenue is recognized, and the matching principle, which matches expenses to the period in which they are used. Financial statements including the income statement, balance sheet, and statement of retained earnings are prepared using transaction data.

1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Operating
Decisions
and the
Income Statement
Chapter 3

2. 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. 3-3
Learning Objectives
Describe a typical business operating cycle
and explain the necessity for the time period
assumption.

4. 3-4
The Operating Cycle
Purchase or
manufacture
products or
supplies on
credit.
Deliver product
or provide service
to customers on
credit.
Pay
suppliers.
Receive payment
from customers.
Begin

5. 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?

6. 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).
1999 2000 2001 2002 2003 2004 2005 2006
Life of the Business
Annual Accounting Periods

7. 3-7
Learning Objectives
Explain how business activities affect the
elements of the income statement.

8. 3-8
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.

9. 3-9
Revenues
Restaurant and commissary sales 66,000
$
Franchise royalties and development fees 2,800
Total revenues 68,800
Costs and expenses
Cost of sales 30,000
Salaries and benefits expense 14,000
General and administrative expenses 7,000
Total costs and expenses 51,000
Operating income 17,800
Other revenues and gains (expense and losses)
Investment income 1,000
Interest expense -
Gain on sale of land 3,000
Income before income taxes 21,800
Income tax expense -
Net income 21,800
$
Earnings per share 1.21
$
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Month Ended January 31, 2004
(In thousands)
Papa John’s Primary
Operating Activity is
selling pizza and selling
franchises.
Operating Activities
Peripheral Activities

10. 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)
Revenues
Restaurant and commissary sales 66,000
$
Franchise royalties and development fees 2,800
Total revenues 68,800
Costs and expenses
Cost of sales 30,000
Salaries and benefits expense 14,000
General and administrative expenses 7,000
Total costs and expenses 51,000
Operating income 17,800
Other revenues and gains (expense and losses)
Investment income 1,000
Interest expense -
Gain on sale of land 3,000
Income before income taxes 21,800
Income tax expense -
Net income 21,800
$
Earnings per share 1.21
$
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Month Ended January 31, 2004
(In thousands)

11. 3-11
Earnings Per Share
Net Income
Weighted Average
Number of Common
Shares Outstanding
Revenues
Restaurant sales 66,000
$
Franchise royalties and development fees 2,800
Total revenues 68,800
Costs and expenses
Cost of sales 30,000
Salaries and benefits expense 14,000
General and administrative expenses 7,000
Total costs and expenses 51,000
Operating income 17,800
Other revenues and gains (expense and losses)
Investment income 1,000
Interest expense -
Gain on sale of land 3,000
Income before income taxes 21,800
Income tax expense -
Net income 21,800
$
Earnings per share 1.21
$
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Month Ended January 31, 2004
(In thousands)

12. 3-12
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
$
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Year Ended December 28, 2003
(In thousands)

13. 3-13
Learning Objectives
Explain the accrual basis of accounting and
apply the revenue and matching principles to
measure income.

14. 3-14
Cash Basis Accounting
Revenue is recorded
when cash is received.
Expenses are recorded
when cash is paid.

15. 3-15
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
Accrual Accounting

16. 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.

17. 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) xxx
Unearned revenue (+L) xxx

18. 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
Company
Delivers
Cash (+A) xxx
Unearned revenue (+L) xxx
Revenue will be recorded when
earned.

19. 3-19
Revenue Principle
CASH COLLECTED
(Goods or services due to
customers)
over time will
become
REVENUE
(Earned when goods
or services provided)
Rent collected in advance Rent revenue
Unearned air traffic revenue Air traffic revenue
Deferred subscription revenue Subscription revenue
Typical liabilities that become
revenue when earned include . . .

20. 3-20
Revenue Principle
When cash is received on the date
the revenue is earned, the
following entry is made:
Cash
Received
Company
Delivers
Cash (+A) xxx
Revenue (+R) xxx
AND

21. 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 -
Accounts receivable (+A) xxx
Revenue (+R) xxx
Company
Delivers

22. 3-22
Revenue Principle
Cash
Received
Accounts receivable (+A) xxx
Revenue (+R) xxx
Cash received after revenue is earned -
Company
Delivers
When the cash is received the ACCOUNTS
RECEIVABLE is reduced.
Cash will be collected.

23. 3-23
The Revenue Principle
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
Assets reflecting revenues earned but
not yet received in cash include . . .

24. 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.

25. 3-25
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

26. 3-26
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
Prepaid expense (+A) xxx
Cash (-A) xxx
Expense will be recorded when
incurred.

27. 3-27
The Matching Principle
When cash is paid on the date the
expense is incurred, the following
entry is made:
Cash
Paid
Expense
Incurred
Expense (+E) xxx
Cash (-A) xxx
AND

28. 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 (+E) xxx
Payable (+L) xxx
Expense
Incurred

29. 3-29
The Matching Principle
Cash
Paid
When cash is paid the PAYABLE is reduced.
Cash paid after expense is incurred -
Expense
Incurred
Expense (+E) xxx
Payable (+L) xxx
Cash will be paid.

30. 3-30
The Matching Principle
CASH PAID FOR
as used over
time becomes EXPENSE
Supplies inventory Supplies expense
Prepaid insurance Insurance expense
Buildings and equipment Depreciation expense
Typical assets and their related
expense accounts include. . .

31. 3-31
Learning Objectives
Apply transaction analysis to examine and
record the effects of operating activities on the
financial statements.

32. 3-32
Expanded Transaction Analysis Model
Let’s look at an expanded
transaction analysis model that
includes the recording of
revenues and expenses.

33. 3-33
A = L + SE
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
Next, let’s see
how Revenues
and Expenses
affect Retained
Earnings.

34. 3-34
EXPENSES
Debit
for
Increase
Credit
for
Decrease
REVENUES
Debit
for
Decrease
Credit
for
Increase
RETAINED
EARNINGS
Debit
for
Decrease
Credit
for
Increase
Expanded Transaction Analysis Model
Dividends decrease
Retained Earnings.
Net Income increases
Retained Earnings.

35. 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.

36. 3-36
Identify & Classify the Accounts
1. Cash (asset)
2. Franchise fee revenue
(revenue)
3. Unearned franchise fees
(liability)
Determine the Direction of the Effect
1. 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 Accounts
1. Cash (asset).
2. Franchise fee revenue
(revenue).
3. Unearned franchise fees
(liability).
Determine the Direction of the Effect
1. Cash increases.
2. Franchise fee revenue
increases.
3. Unearned franchise fees
increases.

37. 3-37
= +
Cash 400 Unearned franchise
revenue
300 Franchise fees
revenue
100
Stockholders' Equity
Liabilities
Assets
Debit Credit
Cash 400
Unearned franchise revenue 300
Franchise fees revenue 100
Description
General Journal
Papa John’s sold franchises for $400 cash. The
company earned $100 immediately. The rest will
be earned over several months.

38. 3-38
Identify & Classify the Accounts
1. Cash (asset)
2. Restaurant sales revenue
(revenue)
3. Cost of sales- restaurant
(expense)
4. Inventories (asset)
Determine the Direction of the Effect
1. 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 Accounts
1. Cash (asset).
2. Restaurant sales revenue
(revenue).
3. Cost of sales- restaurant
(expense).
4. Inventories (asset).
Determine the Direction of the Effect
1. Cash increases.
2. Restaurant sales revenue
increases.
3. Cost of sales- restaurant
increases.
4. Inventories decrease.

39. 3-39
Debit Credit
Cash 36,000
Restaurant sales revenue 36,000
Cost of sales - restaurant 9,600
Inventories 9,600
Description
General Journal
= +
Cash 36,000 Restaurant sales
revenue
36,000
Inventory (9,600) Cost of sales (9,600)
Stockholders' Equity
Liabilities
Assets
The company sold $36,000 of pizzas for cash.
The costs of the pizza ingredients for those
sales were $9,600.

40. 3-40
Learning Objectives
Prepare financial statements.

41. 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
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

42. 3-42
Revenues
Restaurant and commissary sales 66,000
$
Franchise royalties and development fees 2,800
Total revenues 68,800
Costs and expenses
Cost of sales 30,000
Salaries and benefits expense 14,000
General and administrative expenses 7,000
Total costs and expenses 51,000
Operating income 17,800
Other revenues and gains (expense and losses)
Investment income 1,000
Interest expense -
Gain on sale of land 3,000
Income before income taxes 21,800
Income tax expense -
Net income 21,800
$
Earnings per share 1.21
$
Papa John's International, Inc. and Subsidiaries
Consolidated Statement of Income
For the Month Ended January 31, 2004
(In thousands)
Income Statement

43. 3-43
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 SUBSIDIARIES
Consolidated 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
Statement just prepared.

44. 3-44
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 balance from
the Statement of Retained
Earnings flows into the
equity section of the
Balance Sheet.

45. 3-45
Focus on Cash Flows
Effect on
Cash Flows
Cash received from: Customers +
Investments +
Cash paid to: Suppliers -
Employees -
Interest paid -
Income taxes paid -
Nature of Operating Activity
Cash Inflows
Cash Outflows

46. 3-46
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
balance agrees
with the amount
on the Balance
Sheet.
Statement of
Cash Flows

47. 3-47
Learning Objectives
Compute and interpret the total asset
turnover ratio.

48. 3-48
Key Ratio Analysis
Measures the sales
generated per dollar
of assets.
Creditors and analysts use
this ratio to assess a
company’s effectiveness at
controlling current and
noncurrent assets.
Asset
Turnover
Ratio
Sales (or Operating) Revenues
Average Total Assets
=

49. 3-49
End of Chapter 3