Operating Decisions and the Income Statement

Operating Decisions and the Income Statement McGraw-Hill/Irwin Chapter 3 2009 The McGraw-Hill Companies, Inc.

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? McGraw-Hill/Irwin Slide 2

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

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? McGraw-Hill/Irwin Slide 4

Time Periods Annual Time Periods Calendar year Year Ending December 31 Fiscal year Year Ending June 30 Year Ending September 30 Year Ending January 31 (?) Quarterly time periods Publicly-trade companies Monthly time periods McGraw-Hill/Irwin Slide 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? McGraw-Hill/Irwin Slide 6

When is Revenue Recognized (Earned)? 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren McGraw-Hill/Irwin Slide 7 3-7

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? McGraw-Hill/Irwin Slide 8

Measurement The amount of revenue to record equals the cash value of the goods or services transferred to the customer Amount of cash received Amount billed to customer or client McGraw-Hill/Irwin Slide 9

Elements on the Income Statement 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. Losses Decreases in assets or increases in liabilities from peripheral transactions. McGraw-Hill/Irwin Slide 10

Papa John s Primary Operating Activity is selling pizza and selling franchises. Operating Activities Peripheral Activities Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Year Ended December 31, 2006 (dollars in thousands) Revenues Restaurant and commissary sales $ 884,000 Franchise royalties and development fees 117,000 Total revenues 1,001,000 Costs and expenses Cost of sales 425,000 Salaries and benefits expense 164,000 General and administrative expenses 314,000 Total costs and expenses 903,000 Operating income 98,000 Other revenues and gains (expense and losses) Investment income 1,000 Interest expense (3,000) Income before income taxes 96,000 Income tax expense 33,000 Net income $ 63,000 Earnings per share $ 1.96 McGraw-Hill/Irwin Slide 11

Papa John s Primary Operating Expenses Cost of sales (used inventory) Salaries and benefits to employees Other costs (like advertising, insurance, and depreciation) Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Year Ended December 31, 2006 (dollars in thousands) Revenues Restaurant and commissary sales $ 884,000 Franchise royalties and development fees 117,000 Total revenues 1,001,000 Costs and expenses Cost of sales 425,000 Salaries and benefits expense 164,000 General and administrative expenses 314,000 Total costs and expenses 903,000 Operating income 98,000 Other revenues and gains (expense and losses) Investment income 1,000 Interest expense (3,000) Income before income taxes 96,000 Income tax expense 33,000 Net income $ 63,000 Earnings per share $ 1.96 McGraw-Hill/Irwin Slide 12

Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Year Ended December 31, 2006 (dollars in thousands) Earnings Per Share Net Income Weighted Average Number of Common Shares Outstanding Revenues Restaurant and commissary sales $ 884,000 Franchise royalties and development fees 117,000 Total revenues 1,001,000 Costs and expenses Cost of sales 425,000 Salaries and benefits expense 164,000 General and administrative expenses 314,000 Total costs and expenses 903,000 Operating income 98,000 Other revenues and gains (expense and losses) Investment income 1,000 Interest expense (3,000) Income before income taxes 96,000 Income tax expense 33,000 Net income $ 63,000 Earnings per share $ 1.96 McGraw-Hill/Irwin Slide 13

Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Year Ended December 31, 2006 (dollars in thousands) Corporations are taxable entities. Income tax expense computed as Income Before Income Taxes Tax Rate (Federal, State, Local and Foreign). Revenues Restaurant and commissary sales $ 884,000 Franchise royalties and development fees 117,000 Total revenues 1,001,000 Costs and expenses Cost of sales 425,000 Salaries and benefits expense 164,000 General and administrative expenses 314,000 Total costs and expenses 903,000 Operating income 98,000 Other revenues and gains (expense and losses) Investment income 1,000 Interest expense (3,000) Income before income taxes 96,000 Income tax expense 33,000 Net income $ 63,000 Earnings per share $ 1.96 McGraw-Hill/Irwin Slide 14

Two Types of Accounting (and some others ) Cash Basis Accrual Basis Others Tax Basis OCBOA Regulatory Traditional McGraw-Hill/Irwin Slide 15

Cash Basis Accounting Revenue is recorded when cash is received. Expenses are recorded when cash is paid. McGraw-Hill/Irwin Slide 16

Accrual Accounting 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 McGraw-Hill/Irwin Slide 17

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. McGraw-Hill/Irwin Slide 18

Three Scenarios for Revenues McGraw-Hill/Irwin Slide 19

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) Unearned revenue (+L) xxx xxx McGraw-Hill/Irwin Slide 20

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) Unearned revenue (+L) xxx xxx Revenue will be recorded when earned. McGraw-Hill/Irwin Slide 21

Revenue Principle Typical liabilities that become revenue when earned include... CASH COLLECTED (Goods or services due to customers) Rent collected in advance Unearned air traffic revenue Deferred subscription revenue over time will become REVENUE (Earned when goods or services provided) Rent revenue Air traffic revenue Subscription revenue McGraw-Hill/Irwin Slide 22

Revenue Principle When cash is received on the date the revenue is earned, the following entry is made: Company Delivers AND Cash Received Cash (+A) Revenue (+R) xxx xxx McGraw-Hill/Irwin Slide 23

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) Revenue (+R) xxx xxx McGraw-Hill/Irwin Slide 24

Revenue Principle When the cash is received the ACCOUNTS RECEIVABLE is reduced. Cash received after revenue is earned - Company Delivers Cash Received Accounts receivable (+A) Revenue (+R) xxx xxx Cash will be collected. McGraw-Hill/Irwin Slide 25

Revenue Principle Assets reflecting revenues earned but not yet received in cash include... CASH TO BE COLLECTED (Owed by customers) Interest receivable Rent receivable Royalties receivable and already earned as REVENUE (Earned when goods or services provided) Interest revenue Rent revenue Royalty revenue McGraw-Hill/Irwin Slide 26

The Matching Principle Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid. McGraw-Hill/Irwin Slide 27

Three Scenarios for Expenses

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) Cash (-A) xxx xxx McGraw-Hill/Irwin Slide 29

The Matching Principle When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded. Cash is paid before expense is incurred - $ Paid Expense Incurred Prepaid expense (+A) Cash (-A) xxx xxx Expense will be recorded when incurred. McGraw-Hill/Irwin Slide 30

The Matching Principle When cash is paid on the date the expense is incurred, the following entry is made: Expense Incurred AND Cash Paid Expense (+E) Cash (-A) xxx xxx McGraw-Hill/Irwin Slide 31

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) Payable (+L) xxx xxx McGraw-Hill/Irwin Slide 32

The Matching Principle When cash is paid the PAYABLE is reduced. Cash paid after expense is incurred - Expense Incurred Cash Paid Expense (+E) Payable (+L) xxx xxx Cash will be paid. McGraw-Hill/Irwin Slide 33

The Matching Principle Typical assets and their related expense accounts include... CASH PAID FOR Supplies inventory Prepaid insurance Buildings and equipment as used over time becomes EXPENSE Supplies expense Insurance expense Depreciation expense McGraw-Hill/Irwin Slide 34

A = L + SE ASSETS LIABILITIES Debit for Increase Credit for Decrease Debit for Decrease Credit for Increase Next, let s see how Revenues and Expenses affect Retained Earnings. CONTRIBUTED CAPITAL Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase McGraw-Hill/Irwin Slide 35

Expanded Transaction Analysis Model Dividends decrease Retained Earnings. RETAINED EARNINGS Debit for Decrease Credit for Increase Net Income increases Retained Earnings. REVENUES EXPENSES Debit for Decrease Credit for Increase Debit for Increase Credit for Decrease McGraw-Hill/Irwin Slide 36

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. McGraw-Hill/Irwin Slide 37

Papa John s sold franchises for $400 cash. The company earned $100 immediately. The rest will be earned over several months. Assets Cash 400 Unearned franchise revenue = Liabilities + Stockholders' Equity 300 Franchise fees revenue 100 General Journal Description Debit Credit Cash (+A) 400 Unearned franchise revenue (+L) 300 Franchise fees revenue (+R, +SE) 100 McGraw-Hill/Irwin Slide 38

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. McGraw-Hill/Irwin Slide 39

The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients for those sales were $9,600. Assets = Liabilities + Stockholders' Equity Cash 36,000 Restaurant sales 36,000 revenue Inventory (9,600) Cost of sales (9,600) General Journal Description Debit Credit Cash (+A) 36,000 Restaurant sales revenue (+R, +SE) 36,000 Cost of sales - restaurant (+E, -SE) 9,600 Inventories (-A) 9,600 McGraw-Hill/Irwin Slide 40

How are Financial Statements Prepared? Income Statement Revenues Expenses = Net Income Statement of Retained Earnings Balance Sheet Statement of Cash Flows Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Assets = Liabilities + Stockholders Equity Change in Cash Contributed Capital Retained Earnings = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities McGraw-Hill/Irwin Slide 41

Income Statement Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Month Ended January 31, 2007 (dollars in thousands) Revenues Restaurant sales revenue $ 66,000 Franchise fee revenue 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 Gain on sale of land 3,000 Income before income taxes 21,800 Income tax expense - Net income $ 21,800 Earnings per share $ 0.68 McGraw-Hill/Irwin Slide 42

Statement of Retained Earnings PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES Consolidated Statement of Retained Earnings For the Month Ended Janaury 31, 2007 (Dollars in thousands) Beginning balance, December 28, 2006 $ 147,000 Net income 21,800 Dividends (3,000) Ending balance, January 31, 2007 $ 165,800 The net income comes from the Income Statement just prepared. McGraw-Hill/Irwin Slide 43

Balance Sheet The ending balance from the Statement of Retained Earnings flows into the equity section of the Balance Sheet. PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES Consolidated Balance Sheets (Dollars in thousands) Assets Jan. 31, 2007 Current assets: Cash $ 43,900 Accounts receivable 19,200 Supplies 26,000 Prepaid expenses 17,000 Other current assets 14,000 Total current assets 120,100 Long-term investments 2,000 Property and equipment, net of depreciation 207,000 Long-term notes receivable 15,000 Intangibles 67,000 Other assets 17,000 Total assets $ 428,100 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 39,000 Dividends payable 3,000 Accrued expenses payable 73,000 Total current liabilities 115,000 Unearned franchise fees 7,300 Long-term notes payable 110,000 Other long-term liabilities 27,000 Total liabilities 259,300 Stockholders' equity: Contributed capital 3,000 Retained earnings 165,800 Total stockholders' equity 168,800 Total liabilities and stockholders' equity $ 428,100 McGraw-Hill/Irwin Slide 44

Focus on Cash Flows Effect on Nature of Operating Activity Cash Flows Cash received from: Customers + Investments + Cash paid to: Suppliers - Employees - Interest paid - Income taxes paid - Cash Inflows Cash Outflows McGraw-Hill/Irwin Slide 45

Key Ratio Analysis Total Asset Turnover Ratio = Sales (or Operating) Revenues Average Total Assets 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. McGraw-Hill/Irwin Slide 46

Key Ratio Analysis Total Asset Sales (or Operating) Revenues Turnover = Ratio Average Total Assets Creditors and analysts use this ratio to assess a company s effectiveness at controlling current and noncurrent assets. McGraw-Hill/Irwin Slide 47

End of Chapter 3 2008 The McGraw-Hill Companies, Inc.

Father Jim Riehle, C.S.C. Fr. Riehle was the rector of Pangborn for my first two years there. He could be a little gruff at times, but had a sly grin (usually accented by a cigar) that could bring a smile to your face. Some saw him as a hard-ass due to his Dean of Students days, but he was a true gift to ND. He told us more than once that D of S was the worst job in the university and that he did not enjoy his time in that position. He was like a second father to many of us from Pangborn. Fr. Riehle was definitely old school. He let you have your fun, but let you know when you crossed the line too. His mantra was "everything in moderation men." He generally kept any issues in house. He really made it feel like a family. He had a great sense of humor. 2008 The McGraw-Hill Companies, Inc.

2008 The McGraw-Hill Companies, Inc.

Baby Squeek celebrates an ND victory!!!