Chapter 3 Operating Decisions and the Income Statement 9/07/04.
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Transcript of Chapter 3 Operating Decisions and the Income Statement 9/07/04.
© 200422 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
3-2
Business Background
How do business activitiesHow do business activitiesaffect the income statement?affect the income statement?How do business activitiesHow do business activities
affect the income statement?affect the income statement?
How are these activitiesHow are these activities recognized and measured?recognized and measured?
How are these activitiesHow are these activities recognized and measured?recognized and measured?
How are these activities How are these activities reported on thereported on the
income statement?income statement?
How are these activities How are these activities reported on thereported on the
income statement?income statement?
© 200433 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Underlying Accounting Assumptions
Time Period:Time Period: The long life of a company can be The long life of a company can be reported over a series of shorter time periodsreported over a series of shorter time periods..
Time Period:Time Period: The long life of a company can be The long life of a company can be reported over a series of shorter time periodsreported over a series of shorter time periods..
Recognition Issues :Recognition Issues : When should the effects of When should the effects of operating activities be recognized (recorded)?operating activities be recognized (recorded)?
Recognition Issues :Recognition Issues : When should the effects of When should the effects of operating activities be recognized (recorded)?operating activities be recognized (recorded)?
Measurement Issues:Measurement Issues: What amounts should be What amounts should be recognized?recognized?
Measurement Issues:Measurement Issues: What amounts should be What amounts should be recognized?recognized?
© 200444 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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The Time Period Assumption
To meet the needs of decision makers, we report financial information for
relatively short time periodsrelatively short time periods (monthly, quarterly, annually).
1996 1997 1998 1999 2000 2001 2002 2003
Life of the BusinessLife of the Business
Annual Accounting Periods
© 200455 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Papa John’s Primary Papa John’s Primary Operating ActivitiesOperating Activities
Papa John’s Primary Papa John’s Primary Operating ActivitiesOperating Activities
Sell pizzaSell pizzaSell pizzaSell pizza
Sell Sell franchisesfranchises
Sell Sell franchisesfranchises
© 200466 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Papa John’s Primary Papa John’s Primary Operating ExpensesOperating ExpensesPapa John’s Primary Papa John’s Primary Operating ExpensesOperating Expenses
Cost of salesCost of sales(used inventory)(used inventory)
Cost of salesCost of sales(used inventory)(used inventory)
Salaries and benefits Salaries and benefits to employeesto employees
Salaries and benefits Salaries and benefits to employeesto employees
Other costs (like Other costs (like advertising, insurance, advertising, insurance,
and depreciation)and depreciation)
Other costs (like Other costs (like advertising, insurance, advertising, insurance,
and depreciation)and depreciation)
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Corporations are taxable Corporations are taxable entities. Income tax entities. Income tax
expense is expense is Income Before Income Before Income Taxes (as adjusted Income Taxes (as adjusted for book/tax differences)for book/tax differences) × × Tax RateTax Rate (Federal, State, (Federal, State,
Local and Foreign).Local and Foreign).
Point: Income before taxes Point: Income before taxes does not equal taxable does not equal taxable
incomeincome
Corporations are taxable Corporations are taxable entities. Income tax entities. Income tax
expense is expense is Income Before Income Before Income Taxes (as adjusted Income Taxes (as adjusted for book/tax differences)for book/tax differences) × × Tax RateTax Rate (Federal, State, (Federal, State,
Local and Foreign).Local and Foreign).
Point: Income before taxes Point: Income before taxes does not equal taxable does not equal taxable
incomeincome
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Earnings Per ShareEarnings Per ShareEarnings Per ShareEarnings Per Share
Net IncomeWeighted Average
Number of Common Shares Outstanding
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Cash Basis Accounting
Revenue is recordedRevenue is recordedwhen cash is received.when cash is received.Revenue is recordedRevenue is recorded
when cash is received.when cash is received.Expenses are recordedExpenses are recorded
when cash is paid.when cash is paid.Expenses are recordedExpenses are recorded
when cash is paid.when cash is paid.
© 20041010 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Assets, liabilities, revenues, and expenses Assets, liabilities, revenues, and expenses should be recognized when the transaction should be recognized when the transaction that causes them occurs, that causes them occurs, not necessarily not necessarily
when cash is paid or received.when cash is paid or received.
Assets, liabilities, revenues, and expenses Assets, liabilities, revenues, and expenses should be recognized when the transaction should be recognized when the transaction that causes them occurs, that causes them occurs, not necessarily not necessarily
when cash is paid or received.when cash is paid or received.
Required by -
Generally
Acceptable
Accounting
Principles
Required by -
Generally
Acceptable
Accounting
Principles
Accrual Accounting
© 20041111 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Revenue Principle (largest source of fraud)
Recognize revenues when . . .Recognize revenues when . . .Delivery has occurred or services Delivery has occurred or services
have been rendered.have been rendered.There is persuasive evidence of an There is persuasive evidence of an
arrangement for customer payment. arrangement for customer payment. The price is fixed or determinable.The price is fixed or determinable.Collection is reasonably assured.Collection is reasonably assured.
Recognize revenues when . . .Recognize revenues when . . .Delivery has occurred or services Delivery has occurred or services
have been rendered.have been rendered.There is persuasive evidence of an There is persuasive evidence of an
arrangement for customer payment. arrangement for customer payment. The price is fixed or determinable.The price is fixed or determinable.Collection is reasonably assured.Collection is reasonably assured.
© 20041212 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Revenue Principle
If cash is received before the company If cash is received before the company delivers goods or services, the liability delivers goods or services, the liability
account account UNEARNED REVENUEUNEARNED REVENUE is recorded. is recorded.
$Received
Cash (+A) x,xxx Unearned revenue (+L) x,xxx
© 20041313 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Revenue Principle
If cash is received before the company If cash is received before the company delivers goods or services, the liability delivers goods or services, the liability
account account UNEARNED REVENUEUNEARNED REVENUE is recorded. is recorded.
When the goods or services are delivered:
$Received
Company Delivers
Cash (+A) x,xxx Unearned revenue (+L) x,xxx
Unearned Revenue (-L) x,xxx Fee Revenue (+R) x,xxx
© 20041414 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Revenue Principle - Examples
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 becomeTypical liabilities that becomerevenue when earned include . . .revenue when earned include . . .
© 20041515 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Revenue Principle
When cash is received on the date the When cash is received on the date the revenue is earned, then both cash and revenue is earned, then both cash and
revenue are recorded as follows:revenue are recorded as follows:
$Received
Company Delivers
Cash (+A) x,xxx Fee revenue (+R) x,xxx
AND
© 20041616 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Revenue Principle
If cash is received after the company If cash is received after the company delivers goods or services, an asset delivers goods or services, an asset ACCOUNTS RECEIVABLEACCOUNTS RECEIVABLE is recorded. is recorded.
Accounts receivable (+A) x,xxx Fee revenue (+R) x,xxx
Company Delivers
© 20041717 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Revenue Principle
$Received
Cash (+A) x,xxx Accounts receivable (-A) x,xxx
Accounts receivable (+A) x,xxx Fee revenue (+R) x,xxx
When cash is received -
Company Delivers
If cash is received after the company If cash is received after the company delivers goods or services, an asset delivers goods or services, an asset ACCOUNTS RECEIVABLEACCOUNTS RECEIVABLE is recorded. is recorded.
© 20041818 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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The Revenue Principle - Examples
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 butAssets reflecting revenues earned butnot yet received in cash include . . .not yet received in cash include . . .
© 20041919 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Revenue Principle
• Self-Study Quiz – Page 110• A Question of Ethics – Page 111
© 20042020 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
3-20The Matching Principle – Revenues and Expenses
Resources Resources consumed to earn consumed to earn
revenues in an revenues in an accounting period accounting period
should be recorded should be recorded in that period, in that period,
regardless of when regardless of when cash is paidcash is paid..
Resources Resources consumed to earn consumed to earn
revenues in an revenues in an accounting period accounting period
should be recorded should be recorded in that period, in that period,
regardless of when regardless of when cash is paidcash is paid..
© 20042121 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Matching Principle
If cash is paid before the company receives If cash is paid before the company receives goods or services, an asset account goods or services, an asset account
PREPAID EXPENSEPREPAID EXPENSE is recorded. is recorded.
$Paid
Prepaid rent expense (+A) x,xxx Cash (-A) x,xxx
© 20042222 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Matching Principle
ExpenseIncurred
Rent expense (-R) x,xxx Prepaid rent expense (-A) x,xxx
If cash is paid before the company receives If cash is paid before the company receives goods or services, an asset account goods or services, an asset account
PREPAID EXPENSEPREPAID EXPENSE is recorded. is recorded.
When the expense is actually incurred:
$Paid
Prepaid rent expense (+A) x,xxx Cash (-A) x,xxx
© 20042323 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Matching Principle - Examples
CASH PAID FORas used over
time becomes EXPENSE
Supplies inventory Supplies expense
Prepaid insurance Insurance expense
Buildings and equipment Depreciation expense
Typical assets and their relatedTypical assets and their relatedexpense accounts include. . .expense accounts include. . .
© 20042424 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Matching Principle
When cash is paid on the date the When cash is paid on the date the expense is incurred, the CASH and expense is incurred, the CASH and
EXPENSE is recorded as follows:EXPENSE is recorded as follows:
$Paid
ExpenseIncurred
Rent expense (+E) x,xxx Cash (-A) x,xxx
AND
© 20042525 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Matching Principle
If cash is paid after the company receives If cash is paid after the company receives goods or services, an liability goods or services, an liability PAYABLEPAYABLE is is
recorded.recorded.
Wages expense (+E) x,xxx Wages payable (+L) x,xxx
ExpenseIncurred
© 20042626 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Matching Principle
$Paid
Wages payable (-L) x,xxx Cash (-A) x,xxx
If cash is paid after the company receives If cash is paid after the company receives goods or services, an liability goods or services, an liability PAYABLEPAYABLE is is
recorded.recorded.
Cash paid after expense is incurred:
Wages expense (+E) x,xxx Wages payable (+L) x,xxx
ExpenseIncurred
© 20042727 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Matching Principle - Examples
CASH TO BE PAIDand already incurred as EXPENSE
Salaries payable Salaries expense
Interest payable Interest expense
Property taxes payable Property tax expense
Typical liabilities and their relatedTypical liabilities and their relatedexpense accounts include . . .expense accounts include . . .
© 20042828 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Matching Principle
• Self-study Quiz – Page 113
© 20042929 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Expanded Transaction Analysis Model
Let’s look at an expanded transaction analysis model that
includes the recording of revenues and expenses.
© 20043030 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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A = L + SEA = L + SEASSETSASSETS
Debit for
Increase
Credit for
Decrease
LIABILITIESLIABILITIES
Debit for
Decrease
Credit for
Increase
RETAINED RETAINED EARNINGSEARNINGS
Debit for
Decrease
Credit for
Increase
CONTRIBUTED CONTRIBUTED CAPITALCAPITAL
Debit for
Decrease
Credit for
Increase
Next, let’s see Next, let’s see how Revenues how Revenues and Expenses and Expenses affect Retained affect Retained
Earnings.Earnings.
© 20043131 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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EXPENSESEXPENSES
Debit for
Increase
Credit for
Decrease
REVENUESREVENUES
Debit for
Decrease
Credit for
Increase
RETAINED RETAINED EARNINGSEARNINGS
Debit for
Decrease
Credit for
Increase
Expanded Transaction Analysis Model
Dividends decrease Dividends decrease Retained Earnings.Retained Earnings.
Net Income increases Net Income increases Retained Earnings.Retained Earnings.
© 20043232 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Analyzing Papa John’s Transaction
Let’s apply the complete transaction analysis model to
some of Papa John’s transactions.
All amounts are in thousands of dollars.
© 20043333 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Identify & Classify the AccountsIdentify & Classify the Accounts
Determine the Direction of the EffectDetermine the Direction of the Effect
Papa John’s sold franchises for $400 cash. The company earned $100 immediately. The rest will
be earned over several months.
Identify & Classify the Accounts1. Cash (asset)2. Franchise fee revenue (revenue)3. Unearned franchise fees (liability)
Identify & Classify the Accounts1. Cash (asset)2. Franchise fee revenue (revenue)3. Unearned franchise fees (liability)
Determine the Direction of the Effect1. Cash increases.2. Franchise fee revenue increases.3. Unearned franchise fees increases.
Determine the Direction of the Effect1. Cash increases.2. Franchise fee revenue increases.3. Unearned franchise fees increases.
© 20043434 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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= +Cash 400 Unearned franchise
revenue300 Franchise fees
revenue100
Stockholders' EquityLiabilitiesAssets
Papa John’s sold franchises for $400 cash. The company earned $100 immediately. The rest will
be earned over several months.
© 20043535 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
3-35The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients for those
sales were $9,600.
Identify & Classify the AccountsIdentify & Classify the Accounts
Determine the Direction of the EffectDetermine the Direction of the Effect
Identify & Classify the Accounts1. Cash (asset)2. Restaurant sales revenue (revenue)3. Cost of sales- restaurant (expense)4. Inventories (asset)
Identify & Classify the Accounts1. Cash (asset)2. Restaurant sales revenue (revenue)3. Cost of sales- restaurant (expense)4. Inventories (asset)
Determine the Direction of the Effect1. Cash increases.2. Restaurant sales revenue increases.3. Cost of sales- restaurant increases. 4. Inventories decrease.
Determine the Direction of the Effect1. Cash increases.2. Restaurant sales revenue increases.3. Cost of sales- restaurant increases. 4. Inventories decrease.
© 20043636 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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= +Cash 36,000 Restaurant sales
revenue36,000
Inventory (9,600) Cost of sales (9,600)
Stockholders' EquityLiabilitiesAssets
The company received $36,000 for pizza sales. The cost of the pizza ingredients for those sales
was $9,600.
© 20043737 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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More Papa John’s Transactions
• Review transactions a through h on pages 116 and 117.
• Do self-study quiz page 118• Record entries to T accounts
See page 119 Trace T account balances to financial
statements on pages 120 - 122
© 20043838 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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How are Unadjusted Financial Statements Prepared? They’re not!What you get is a Trial Balance.
After posting all of the After posting all of the January transactions to January transactions to
T-accounts, we can T-accounts, we can prepare Papa John’s prepare Papa John’s unadjusted financial unadjusted financial statementsstatements. Note: . Note: They are missing They are missing
month end accruals.month end accruals.
After posting all of the After posting all of the January transactions to January transactions to
T-accounts, we can T-accounts, we can prepare Papa John’s prepare Papa John’s unadjusted financial unadjusted financial statementsstatements. Note: . Note: They are missing They are missing
month end accruals.month end accruals.
© 20043939 The McGraw-Hill CompaniesMcGraw-Hill/Irwin
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Demonstration Case
• See required steps – pages 125 – 129
• Do this prior to attempting the homework
• (Note: The date on the beginning Balance Sheet is incorrect. It should be the prior month end, March 31, 2003)