Week 5, Chap3 Accounting 1A, Financial Accounting Instructor: Michael Booth
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?
Typical business operating cycle and the necessity for the time period assumption.
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.
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?
The Time Period Assumption To meet the needs of decision makers (investors and creditors), reporting of financial information is for relatively short time periods (monthly, quarterly, annually). Life of the Business 2004 2005 2005 2006 2007 2008 2009 2010 Annual Accounting Periods
How business activities affect the elements of the income statement.
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.
PG & E s Primary Operating Activity is Electricity and Gas energy distribution Operating Activities Peripheral Activities
PG & E Primary Operating Expenses Cost of sales (gas inventory used for sales) Salaries and benefits to employees Other costs (like Amortization, decommissioning and depreciation)
Earnings Per Share Net Income Weighted Average Number of Common Shares Outstanding
PG & E Corporation Earning Per Share EARNINGS PER SHARE PG&E Corporation applies the treasury stock method of reflecting the dilutive effect of outstanding stock-based compensation in the calculation of diluted earnings per common share ( EPS ) in accordance with SFAS No. 128, Earnings Per Share ( SFAS No. 128 ). Under SFAS No. 128, PG&E Corporation is required to assume that shares underlying stock options, other stock-based compensation, and warrants are issued and that the proceeds received by PG&E Corporation from the exercise of these options and warrants are assumed to be used to purchase common shares at the average market price during the reported period.
Corporations are taxable entities. Income tax expense is Income Before Income Taxes Tax Rate (Federal, State, Local and Foreign).
Accrual basis of accounting and application to revenue and matching principles to measure income.
Cash Basis Accounting Revenue is recorded when cash is received. Expenses are recorded when cash is paid.
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
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.
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
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.
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
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
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
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.
The Revenue Principle Assets reflecting revenues earned but not yet received in cash include... CASH TO BE COLLECTED (Owed by customers) and already earned as REVENUE (Earned when goods or services provided) Rent receivable Royalties receivable Rent revenue Royalty revenue
The Matching Principle Resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid. Revenue Cost & Expense Net Income (profit) Matched to the accounting Period
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
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.
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
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
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.
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
Depreciation is the process of allocating the cost of long-term assets over their useful lives.
The cost of a long-term asset such as equipment... $ COST... is NOT recorded as an expense at the time of purchase. $ EXPENSE
Instead the cost is recorded as an asset and charged to expense over the time the asset is used for the business. $ ASSET Expense Expense This expense is called depreciation. Jan. 2009 Expense
Depreciation Methods Straight-Line Declining-Balance Sum-of-the-Years -Digits Units-of-Output
Straight-Line Method Formula: Depreciation = Cost Salvage Value Estimated Useful Life The same dollar amount of depreciation is taken each year as an expense.
Apply transaction analysis to examine and record the effects of operating activities on the financial statements.
Expanded Transaction Analysis Model An expanded transaction analysis model includes the recording of revenues and expenses.
A = L + SE ASSETS LIABILITIES Debit for Increase Credit for Decrease Debit for Decrease Credit for Increase How Revenues and Expenses affect Retained Earnings. CONTRIBUTED CAPITAL Debit for Decrease Credit for Increase RETAINED EARNINGS Debit for Decrease Credit for Increase
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
Application of a complete transaction analysis model to some of Papa John s transactions. All amounts are in $ 000 s
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.
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 400 Unearned franchise revenue 300 Franchise fees revenue 100
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.
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 36,000 Restaurant sales revenue 36,000 Cost of sales - restaurant 9,600 Inventories 9,600
AP 3-1 Solution
AP3-1 cont.
Preparation of financial statements.
How are Financial Statements Prepared? Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows Revenues Expenses = Net Income 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
Income Statement Papa John's International, Inc. and Subsidiaries Consolidated Statement of Income For the Month Ended January 31, 2010 (In thousands) 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
Statement of Retained Earnings PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES Consolidated Statement of Retained Earnings For the Month Ended Janaury 31, 2010 (Dollars in thousands) Beginning balance, December 28, 2009 $ 158,000 Net income 21,800 Dividends (3,000) Ending balance, January 31, 2010 $ 176,800 The net income comes from the Income Statement just prepared.
PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES Consolidated Balance Sheets (Dollars in thousands) Balance Sheet Assets Jan. 31, 2010 Current assets: Cash $ 37,900 The ending balance from the Statement of Retained Earnings flows into the equity section of the Balance Sheet. 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
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
Statement of Cash Flows The ending cash balance agrees with the amount on the Balance Sheet. PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES Consolidated Statement of Cash Flows For the Month Ended Janaury 31, 2010 (Dollars in thousands) 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
Asset Turnover Ratio Net Sales Average Total Assets The higher the ratio, the more efficient the business is in utilizing the Economic resource ASSETS to generate Revenue(Sales) Note: Should be compare period to period Within industry With competitors
Asset Turnover Ratio Total assets turnover - if asset turnover is high, the firm is presumably using its assets effectively to generate sales - the higher the total asset turnover, the more impact the firm is getting out of its total assets Fixed asset turnover - removes current assets from the total asset turnover calculation. Questions a.) What can we conclude if a clothing retailer has a fixed assets turnover of 10?.we probably can't conclude much of anything even if we compare the ratio to industry averages. Why?.because clothing retailers have very little in the way of fixed assets; therefore, the FAT is not an important financial ratio for them.
Asset Turnover Ratio What can we conclude if an automobile manufacturer has a fixed assets turnover of 10?.we can't conclude anything until we compare the ratio to industry averages, but we know that the FAT is an important variable. If the FAT is significantly below industry average, the firm may be in some trouble. What can we conclude if a clothing retailer has a total assets turnover of 10? again, we need to compare to the industry average. The TAT is important for clothing retailers because it includes short-term assets such as inventory.
Financial Statement Analysis Financial accounting numbers are only meaningful when compared to other relevant numbers (Is a reported income of $1 billion large or small?). Comparisons across time - GAAP requires disclosure of account numbers for current and preceding years (Balance sheet 2 years, all others 3 years) - Often even longer time-series are published by the companies - Historic trends as indicator of future trends Comparisons within the industry - Compare accounting numbers to those of similar companies (e.g. in same industry) - Industry surveys report information concerning industry averages - Different industries typically have different normal accounting numbers (e.g. retailers have high inventory, pharmaceutical firms have large R&D costs) Comparisons within the Financial Statements - Common-size Financial Statements Facilitates identification of changes in the structure of financial flows and stocks - Financial Ratios Many ratios possible, no fixed rules Typically, averages are used for stock numbers, i.e. balance sheet accounts
Assignments: See web: http//cabrillo.edu/~mbooth This will be updated weekly as required Update your weekly journal Work weekly on your final project, do the analysis with information learned during the week Note: Use McGrawHill CONNECT to submit assignments