Chapter 3 Operating Decisions and theIncome Statement

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Business BackgroundHow do business activitiesaffect the income statement?How are these activities recognized and measured?How are these activities reported on theincome statement?

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Elements on the Income StatementLossesDecreases in assets or increases in liabilities from peripheral transactions.RevenueIncreases in assets or settlement of liabilities from ongoing operations.ExpenseDecreases in assets or increases in liabilities from ongoing operations.GainsIncrease in assets or settlement of liabilities from peripheral transactions.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Papa Johns Primary Operating ActivitiesSell pizzaSell franchises

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Papa Johns Primary Operating ExpensesCost of sales (used inventory)Salaries and benefits to employeesOther costs (like advertising, insurance, and depreciation)

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

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

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Accrual AccountingAssets, 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 Accepted Accounting Principles

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Cash Basis AccountingRevenue is recordedwhen cash is received.Expenses are recordedwhen cash is paid.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Revenue and matching principlesThere are two basic accounting principles that determine when revenues and expenses are recorded under ACCRUAL ACCOUNTINGRevenue principleMatching principle

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Revenue PrincipleIf cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE is recorded.Cash received before revenue is earned -$ Received

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Revenue PrincipleIf cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE is recorded.Cash received before revenue is earned -$ ReceivedCompany Delivers

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Revenue PrincipleTypical liabilities that becomerevenue when earned include . . .

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Revenue PrincipleWhen cash is received on the date the revenue is earned, the following entry is made:$ ReceivedCompany DeliversAND

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Revenue PrincipleIf cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded.Cash received after revenue is earned -Company Delivers

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Revenue Principle$ ReceivedCash received after revenue is earned -Company DeliversIf cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

The Revenue PrincipleAssets reflecting revenues earned butnot yet received in cash include . . .

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

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

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Matching PrincipleIf 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

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Matching PrincipleExpense IncurredIf 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

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Matching PrincipleTypical assets and their relatedexpense accounts include. . .

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Matching PrincipleWhen cash is paid on the date the expense is incurred, the following entry is made:$ PaidExpense IncurredAND

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Matching PrincipleIf cash is paid after the company receives goods or services, an liability PAYABLE is recorded.Cash paid after expense is incurred -Expense Incurred

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Matching Principle$ PaidIf cash is to be paid after the company receives goods or services, a liability account PAYABLE is recorded.Cash paid after expense is incurred -Expense Incurred

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Matching PrincipleTypical liabilities and their relatedexpense accounts include . . .

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Expanded Transaction Analysis ModelLets look at an expanded transaction analysis model that includes the recording of revenues and expenses.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

A = L + SE Next, lets see how Revenues and Expenses affect Retained Earnings.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Expanded Transaction Analysis Model Dividends decrease Retained Earnings.Net Income increases Retained Earnings.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Analyzing Papa Johns TransactionLets apply the complete transaction analysis model to some of Papa Johns transactions.

All amounts are in thousands of dollars.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Identify & Classify the Accounts

Determine the Direction of the Effect

Papa Johns sold pizzas for $36,000 cash. They also sold $30,000 in supplies to restaurants, receiving $ 21,000 cash with the rest due on account.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Papa Johns sold pizzas for $36,000 cash. They also sold $30,000 in supplies to restaurants, receiving $ 21,000 cash with the rest due on account.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

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

Determine the Direction of the Effect

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

The company received $36,000 for pizza sales. The cost of the pizza ingredients for those sales was $9,600.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

How are Unadjusted Financial Statements Prepared?After posting all of the January transactions to T-accounts, we can prepare Papa Johns unadjusted financial statements.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Several expenses, including income tax expense, have not determined at this point in the accounting process.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Unadjusted Statement of Retained Earnings The unadjusted net income comes from the Income Statement just prepared.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

UnadjustedBalance Sheet The ending balance from the Statement of Retained Earnings flows into the equity section of the Balance Sheet.

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

Focus on Cash Flows

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

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

2004** The McGraw-Hill CompaniesMcGraw-Hill/Irwin

End of Chapter 3