1. Chapter 3 Operating Decisions and the Income Statement 9/07/04

2. © 200422 The McGraw-Hill Companies McGraw-Hill/Irwin 3-2 Business Background How do business activities affect the income statement? How do business activities affect the income statement? How are these activities recognized and measured? recognized and measured? How are these activities recognized and measured? recognized and measured? How are these activities reported on the income statement? How are these activities reported on the income statement?

3. © 200433 The McGraw-Hill Companies McGraw-Hill/Irwin 3-3 Underlying Accounting Assumptions 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?

4. © 200444 The McGraw-Hill Companies McGraw-Hill/Irwin 3-4 The Time Period Assumption relatively short time periods To meet the needs of decision makers, we report financial information for relatively short time periods (monthly, quarterly, annually). 19961997199819992000200120022003 Life of the Business Annual Accounting Periods

5. © 200455 The McGraw-Hill Companies McGraw-Hill/Irwin 3-5 Papa John’s Primary Operating Activities Sell pizza Sell franchises

6. © 200466 The McGraw-Hill Companies McGraw-Hill/Irwin 3-6 Papa John’s Primary Operating Expenses Cost of sales (used inventory) Salaries and benefits to employees Other costs (like advertising, insurance, and depreciation)

7. © 200477 The McGraw-Hill Companies McGraw-Hill/Irwin 3-7 Corporations are taxable entities. Income tax expense is Income Before Income Taxes (as adjusted for book/tax differences) × Tax Rate (Federal, State, Local and Foreign). Point: Income before taxes does not equal taxable income Corporations are taxable entities. Income tax expense is Income Before Income Taxes (as adjusted for book/tax differences) × Tax Rate (Federal, State, Local and Foreign). Point: Income before taxes does not equal taxable income

8. © 200488 The McGraw-Hill Companies McGraw-Hill/Irwin 3-8 Earnings Per Share Net Income Weighted Average Number of Common Shares Outstanding

9. © 200499 The McGraw-Hill Companies McGraw-Hill/Irwin 3-9 Cash Basis Accounting Revenue is recorded when cash is received. Revenue is recorded when cash is received. Expenses are recorded when cash is paid. Expenses are recorded when cash is paid.

10. © 20041010 The McGraw-Hill Companies McGraw-Hill/Irwin 3-10 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 Accrual Accounting

11. © 20041111 The McGraw-Hill Companies McGraw-Hill/Irwin 3-11 Revenue Principle ( largest source of fraud) Recognize revenues when... Delivery has occurred or services have been rendered. Delivery has occurred or services have been rendered. There is persuasive evidence of an arrangement for customer payment. There is persuasive evidence of an 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... Delivery has occurred or services have been rendered. Delivery has occurred or services have been rendered. There is persuasive evidence of an arrangement for customer payment. There is persuasive evidence of an arrangement for customer payment. The price is fixed or determinable. The price is fixed or determinable. Collection is reasonably assured. Collection is reasonably assured.

12. © 20041212 The McGraw-Hill Companies McGraw-Hill/Irwin 3-12 Revenue Principle If cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE is recorded. $ Received Cash (+A) x,xxx Unearned revenue (+L) x,xxx

13. © 20041313 The McGraw-Hill Companies McGraw-Hill/Irwin 3-13 Revenue Principle If cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE 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

14. © 20041414 The McGraw-Hill Companies McGraw-Hill/Irwin 3-14 Revenue Principle - Examples Typical liabilities that become revenue when earned include...

15. © 20041515 The McGraw-Hill Companies McGraw-Hill/Irwin 3-15 Revenue Principle When cash is received on the date the revenue is earned, then both cash and revenue are recorded as follows: $ Received Company Delivers Cash (+A) x,xxx Fee revenue (+R) x,xxx AND

16. © 20041616 The McGraw-Hill Companies McGraw-Hill/Irwin 3-16 Revenue Principle If cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded. Accounts receivable (+A) x,xxx Fee revenue (+R) x,xxx Company Delivers

17. © 20041717 The McGraw-Hill Companies McGraw-Hill/Irwin 3-17 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 delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded.

18. © 20041818 The McGraw-Hill Companies McGraw-Hill/Irwin 3-18 The Revenue Principle - Examples Assets reflecting revenues earned but not yet received in cash include...

19. © 20041919 The McGraw-Hill Companies McGraw-Hill/Irwin 3-19 Revenue Principle Self-Study Quiz – Page 110 A Question of Ethics – Page 111

20. © 20042020 The McGraw-Hill Companies McGraw-Hill/Irwin 3-20 The Matching Principle – Revenues and Expenses Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid.

21. © 20042121 The McGraw-Hill Companies McGraw-Hill/Irwin 3-21 Matching Principle If cash is paid before the company receives goods or services, an asset account PREPAID EXPENSE is recorded. $ Paid Prepaid rent expense (+A) x,xxx Cash (-A) x,xxx

22. © 20042222 The McGraw-Hill Companies McGraw-Hill/Irwin 3-22 Matching Principle Expense Incurred Rent expense (-R) x,xxx Prepaid rent expense (-A) x,xxx If cash is paid before the company receives goods or services, an asset account PREPAID EXPENSE is recorded. When the expense is actually incurred: $ Paid Prepaid rent expense (+A) x,xxx Cash (-A) x,xxx

23. © 20042323 The McGraw-Hill Companies McGraw-Hill/Irwin 3-23 Matching Principle - Examples Typical assets and their related expense accounts include...

24. © 20042424 The McGraw-Hill Companies McGraw-Hill/Irwin 3-24 Matching Principle When cash is paid on the date the expense is incurred, the CASH and EXPENSE is recorded as follows: $ Paid Expense Incurred Rent expense (+E) x,xxx Cash (-A) x,xxx AND

25. © 20042525 The McGraw-Hill Companies McGraw-Hill/Irwin 3-25 Matching Principle If cash is paid after the company receives goods or services, an liability PAYABLE is recorded. Wages expense (+E) x,xxx Wages payable (+L) x,xxx Expense Incurred

26. © 20042626 The McGraw-Hill Companies McGraw-Hill/Irwin 3-26 Matching Principle $ Paid Wages payable (-L) x,xxx Cash (-A) x,xxx If cash is paid after the company receives goods or services, an liability PAYABLE is recorded. Cash paid after expense is incurred: Wages expense (+E) x,xxx Wages payable (+L) x,xxx Expense Incurred

27. © 20042727 The McGraw-Hill Companies McGraw-Hill/Irwin 3-27 Matching Principle - Examples Typical liabilities and their related expense accounts include...

28. © 20042828 The McGraw-Hill Companies McGraw-Hill/Irwin 3-28 Matching Principle Self-study Quiz – Page 113

29. © 20042929 The McGraw-Hill Companies McGraw-Hill/Irwin 3-29 Expanded Transaction Analysis Model Let’s look at an expanded transaction analysis model that includes the recording of revenues and expenses.

30. © 20043030 The McGraw-Hill Companies McGraw-Hill/Irwin 3-30 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.

31. © 20043131 The McGraw-Hill Companies McGraw-Hill/Irwin 3-31EXPENSES 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.

32. © 20043232 The McGraw-Hill Companies McGraw-Hill/Irwin 3-32 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.

33. © 20043333 The McGraw-Hill Companies McGraw-Hill/Irwin 3-33 Identify & Classify the Accounts Determine 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 Accounts 1. Cash (asset) 2. Franchise fee revenue (revenue) 3. Unearned franchise fees (liability) 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. Determine the Direction of the Effect 1. Cash increases. 2. Franchise fee revenue increases. 3. Unearned franchise fees increases.

34. © 20043434 The McGraw-Hill Companies McGraw-Hill/Irwin 3-34 Papa John’s sold franchises for $400 cash. The company earned $100 immediately. The rest will be earned over several months.

35. © 20043535 The McGraw-Hill Companies McGraw-Hill/Irwin 3-35 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 Identify & Classify the Accounts 1. Cash (asset) 2. Restaurant sales revenue (revenue) 3. Cost of sales- restaurant (expense) 4. Inventories (asset) 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. Determine the Direction of the Effect 1. Cash increases. 2. Restaurant sales revenue increases. 3. Cost of sales- restaurant increases. 4. Inventories decrease.

36. © 20043636 The McGraw-Hill Companies McGraw-Hill/Irwin 3-36 The company received $36,000 for pizza sales. The cost of the pizza ingredients for those sales was $9,600.

37. © 20043737 The McGraw-Hill Companies McGraw-Hill/Irwin 3-37 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

38. © 20043838 The McGraw-Hill Companies McGraw-Hill/Irwin 3-38 How are Unadjusted Financial Statements Prepared? They’re not! What you get is a Trial Balance. After posting all of the January transactions to T-accounts, we can prepare Papa John’s unadjusted financial statements. Note: They are missing month end accruals.

39. © 20043939 The McGraw-Hill Companies McGraw-Hill/Irwin 3-39 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)

40. © 20044040 The McGraw-Hill Companies McGraw-Hill/Irwin 3-40 End of Chapter 3