© mcgraw-hill ryerson limited, 2003 mcgraw-hill ryerson chapter 3 operating decisions and the...

© McGraw-Hill Ryerson Limited, 2003McGraw-Hill Ryerson

Chapter 3

Operating Decisions and the Income Statement


Business Background

Goals Plans

StrategiesMeasurableindicators

Businesses develop . . .Businesses develop . . .

The goals include elements of income.The goals include elements of income.


Business Background

What business activitiesaffect the income statement?

How are these activities recognized and measured?

How are these activities reported on the

income statement?


The Operating Cycle

Purchase products or supplies on

credit.

Deliver product or provide service to

customers on credit.

Pay suppliers.

Receive payment from

customers.

Begin


Underlying Accounting Assumptions

Periodicity: The long life of a company can be reported over a series of short time periods.

Periodicity: The long life of a company can be reported over a series of short time periods.

Recognition Issues : When should the effects of operating activities be recognized (recorded)?

Recognition Issues : When should the effects of operating activities be recognized (recorded)?

Measurement Issues: What amounts should be recognized?

Measurement Issues: What amounts should be recognized?


The Periodicity Assumption

To meet the needs of decision makers, we report financial information for relatively short time relatively short time

periods periods (monthly, quarterly, annually).

1998 1999 2000 2001 2002 2003 2004 2005

Life of the BusinessLife of the Business

Annual Accounting Periods


Elements on the Income Statement

LossesDecreases in assets or increases in

liabilities from peripheral transactions.

LossesDecreases in assets or increases in


RevenueIncreases in assets or settlement of liabilities from ongoing operations.

RevenueIncreases in assets or settlement of liabilities from ongoing operations.

ExpenseDecreases in assets or increases in liabilities from ongoing operations.

ExpenseDecreases in assets or increases in liabilities from ongoing operations.

GainsIncrease in assets or settlement of


GainsIncrease in assets or settlement of



Revenues: Restaurant sales 456,600$ Franchise royalties and development fees 58,000 Commissary, equipment and other sales 430,000 Investment income 1,900 Total revenues 946,500 Costs and expenses: Restaurant expenses: Cost of sales 111,600 Salaries and benefits 127,300 Advertising and related costs 41,700 Occupancy costs and other operating expenses 88,300

368,900 Commissary, equipment and other expenses: Cost of sales 304,300 Salaries, benefits, and other operating expenses 58,400

362,700 General, Other & administrative expenses 94,100 Depreciation and amortization 34,200 Other costs and expenses 35,000 Total costs and expenses 894,900 Income before income taxes 51,600 Income tax expense 19,800 Net income 31,800$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESConsolidated Statement of Income

For the Year Ended December 31, 2000(In thousands)

Papa John’s Primary Operating

Activities

Sell pizza

Sell franchises

Sell supplies and

equipment to franchisees


Cash Basis Accounting

Revenue is recordedwhen cash is received.

Expenses are recordedwhen cash is paid.


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 GAAP


Principles Affecting Income Determination

Revenue PrincipleMatching PrincipleCost Principle


The Revenue Principle

Recognize revenues when . . .The earnings process is complete or

nearly complete.An exchange transaction takes place. Collection is reasonably assured.



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 . . .



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 . . .


The Matching Principle

Resources consumed to earn revenues in an accounting period should be

recorded in that period, regardless of when cash is paid.



CASH PAID FORas used over

time becomes EXPENSE

Supplies inventory Supplies expense

Prepaid insurance Insurance expense

Buildings and equipment Amortization expense

Typical assets and their relatedTypical assets and their relatedexpense accounts include. . .expense accounts include. . .



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 . . .


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

SHARE SHARE CAPITALCAPITAL

Debit for

Decrease

Credit for

Increase

Next, let’s see how Revenues and Expenses affect Retained

Earnings.


EXPENSESEXPENSES

Debit for

Increase

Credit for

Decrease

REVENUESREVENUES

Debit for

Decrease

Credit for

Increase

RETAINED RETAINED EARNINGSEARNINGS

Debit for

Decrease

Credit for

Increase

The Expanded Transaction Analysis Model

Dividends decrease Retained Earnings.

Net Income increases Retained Earnings.


Transaction Analysis Rules

Let’s apply the complete transaction analysis model to

some of Papa John’s transactions.

All amounts are in thousands of dollars.


Identify & Classify the AccountsIdentify & Classify the Accounts

Determine the Direction of the EffectDetermine the Direction of the Effect

Papa John’s sold 25 franchises for $500 cash. The company earned $175 immediately. The rest will be

earned over several months.

Identify & Classify the Accounts1. Cash (asset)2. Franchise royalties and development fees (revenue)3. Unearned franchise and development fees (liability)

Identify & Classify the Accounts1. Cash (asset)2. Franchise royalties and development fees (revenue)3. Unearned franchise and development fees (liability)

Determine the Direction of the Effect1. Cash increases.2. Franchise royalties and development fees increase.3. Unearned franchise and development fees increase.

Determine the Direction of the Effect1. Cash increases.2. Franchise royalties and development fees increase.3. Unearned franchise and development fees increase.


Papa John’s sold 25 franchises for $500 cash. The company earned $175 immediately. The rest will be

earned over several months.

= +Cash 500 Unearned franchise

and development fees325 Franchise royalties

and development fees175

Shareholders' EquityLiabilitiesAssets


The company received $35,200 for pizza sales. The cost of the pizza ingredients for those sales was

$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.


The company received $35,200 for pizza sales. The cost of the pizza ingredients for those sales was

$9,600.

= +Cash 35,200 Restaurant sales

revenue35,200

Inventory (9,600) Cost of sales (9,600)

Shareholders' EquityLiabilitiesAssets


Preparation of the Unadjusted Financial Statements

After posting all of the January transactions to

T-accounts, we can prepare Papa John’s unadjusted financial

statements.


Revenues: Restaurant sales 35,200$ Franchise royalties and development fees 2,875 Commissary, equipment and other sales 34,500 Investment income 125 Total revenues 72,700 Costs and expenses: Restaurant expenses: Cost of sales 9,600 Salaries and benefits 8,000 Advertising and related costs - Occupancy costs and other operating expenses 4,700

22,300 Commissary, equipment and other expenses: Cost of sales 3,800 Salaries, benefits, and other operating expenses 3,700

7,500 General and administrative expenses 4,410 Depreciation and amortization - Other costs and expenses - Total costs and expenses 34,210 Income before income taxes 38,490

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESUnadjusted Consolidated Statement of Income

For the Month Ended Janaury 31, 2001(Dollars in thousands)

Notice that income tax expense is not determined at this

point.


Beginning balance, December 31, 2000 166,000$ Income before income taxes 38,490 Dividends (200) Ending balance, January 31, 2001 204,290$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESUnadjusted Consolidated Statement of Retained Earnings

For the Month Ended January 31, 2001(Dollars in thousands)

Preparation of the Unadjusted Financial Statements

The income before income taxes comes from the Income Statement just prepared.


AssetsCurrent assets: Cash and cash equivalents 27,415$ Short-term investments 5,700 Accounts receivable 20,450 Inventories 33,900 Prepaid expenses 14,800 Other current assets 4,800 Total current assets 107,065 Investments 3,000 Net property and equipment 248,100 Notes receivable 21,150 Other assets 67,500 Total assets 446,815$

Liabilities and Shareholders' EquityCurrent liabilities: Accounts payable 33,600$ Accrued expenses payable 45,300 Notes payable & Other 2,200 Total current liabilities 81,100 Unearned franchise and development fees 6,325 Other long-term liabilities 7,800 Long Term Debt 145,700 Share capital 1,600 Retained earnings 204,290 Total shareholders' equity 205,890 Total liabilities and shareholders' equity 446,815$

Unadjusted Consolidated Balance SheetsJanuary 31, 2001

(Dollars in thousands)

Notice that the ending balance from the

Statement of Retained Earnings flows into the

equity section of the Balance Sheet.


Focus on Cash Flows

Effect on Cash Flows

Cash received from: Customers +Investments +

Cash paid: to suppliers -to employees -for interest -for income taxes -

Operating Activities

Remember: We discussed Investing and Financing Activities in Chapter 2.


Operating ActivitiesCash received from:Customers and franchises 71,350$

Interest and dividends 125 Operating cash inflows 71,475

Cash paid to: Suppliers (33,710) Employees (13,500) Operating cash outflows (47,210)

Net cash provided by operating activities 24,265 Investing ActivitiesPurchased property and equipment (1,500) Purchased investments (3,000) Lent funds to franchisees (450)

Received payment on loans to franchisees 300 Net cash used in investing activities (4,650) Financing ActivitiesIssued shares 1,300 Borrowings 1,000 Paid dividends (200) Payments on borrowings (400) Net cash provided by financing activities 1,700 Change in cash 21,315 Beginning cash balance 6,100 Ending cash balance 27,415$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESUnadjusted Consolidated Statement of Cash Flows

For the Month Ended Janaury 31, 2001(Dollars in thousands)

Notice that the ending cash

balance agrees with the amount on the

Balance Sheet.


Financial Leverage Ratio

Asset Turnover Ratio =Sales

Average Total Assets

This ratio measures the sales generated per dollar

of assets.

Creditors and analysts used this ratio to assess

a company’s effectiveness at

controlling current and noncurrent assets.


End of Chapter 3

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