Week 5, Chap3Accounting 1A,

Financial Accounting

Instructor: Michael Booth

Business Background

How do business activitiesHow do business activitiesaffect the income statement?affect the income statement?

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?

Typical business operating cycle and the necessity for the time period assumption.

The Operating Cycle

Purchase or Purchase or manufacture manufacture products or products or supplies on supplies on

credit.credit.

Deliver product Deliver product or provide service or provide service to customers on to customers on

credit.credit.

Pay Pay suppliers.suppliers.

Receive payment Receive payment from customers.from customers.

BeginBegin

The Operating CycleTime 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)?

Measurement Issues:Measurement Issues: What amounts should be What amounts should be recognized?recognized?

The Time Period AssumptionTo meet the needs of decision makers

(investors and creditors), reporting of financial information is for relatively relatively short time periodsshort time periods (monthly, quarterly, annually).

2004 2005 2005 2006 2007 2008 2009 2010

Life of the BusinessLife of the Business

Annual Accounting Periods

How business activities affect the elements of the income statement.

Elements on the Income Statement

LossesLossesDecreases in assets or increases in Decreases in assets or increases in

liabilities from peripheral transactions.liabilities from peripheral transactions.

RevenuesRevenuesIncreases in assets or settlement of Increases in assets or settlement of liabilities from ongoing operations.liabilities from ongoing operations.

ExpensesExpensesDecreases in assets or increases in Decreases in assets or increases in liabilities from ongoing operations.liabilities from ongoing operations.

GainsGainsIncreases in assets or settlement of Increases in assets or settlement of

liabilities from peripheral transactionsliabilities from peripheral transactions..

PG & E’s Primary Operating Activity is Electricity and Gas energy distribution

Operating Activities

Peripheral Activities

PG & E Primary PG & E Primary Operating ExpensesOperating Expenses

Cost of salesCost of sales(gas inventory used for sales)(gas inventory used for sales)

Salaries and benefits Salaries and benefits to employeesto employees

Other costs (like Other costs (like Amortization, Amortization,

decommissioning decommissioning and depreciation)and depreciation)

Earnings Per ShareEarnings Per Share

Net IncomeWeighted Average

Number of Common Shares Outstanding

PG & E Corporation Earning Per Share

EARNINGS PER SHAREPG&E Corporation applies the treasury stock method ofreflecting the dilutive effect of outstanding stock-based compensationin the calculation of diluted earnings per commonshare (“EPS”) in accordance with SFAS No. 128, “EarningsPer Share” (“SFAS No. 128”). Under SFAS No. 128, PG&ECorporation is required to assume that shares underlyingstock options, other stock-based compensation, and warrantsare issued and that the proceeds received by PG&ECorporation from the exercise of these options and warrantsare assumed to be used to purchase common shares at theaverage market price during the reported period.

Corporations are taxable Corporations are taxable entities. Income tax entities. Income tax

expense is expense is Income Before Income Before Income TaxesIncome Taxes × × Tax RateTax Rate (Federal, State, Local and (Federal, State, Local and

Foreign).Foreign).

Accrual basis of accounting and application to revenue and matching principles to measure

income.

Cash Basis Accounting

Revenue is recordedRevenue is recordedwhen cash is received.when cash is received.

Expenses are recordedExpenses are recordedwhen cash is paid.when cash is paid.

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 -GenerallyAcceptableAccountingPrinciples

Accrual Accounting

Revenue Principle

Recognize revenues when . . .Recognize revenues when . . . Delivery has occurred or services have Delivery has occurred or services have

been rendered.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.

Revenue PrincipleIf 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.Cash received before revenue is earned -

CashReceived

Cash (+A) xxx Unearned revenue (+L) xxx

Revenue PrincipleWhen the company delivers the goods or When the company delivers the goods or services services UNEARNED REVENUEUNEARNED REVENUE is reduced is reduced

and and REVENUEREVENUE is recorded.is recorded.Cash received before revenue is earned -

CashReceived

Company Delivers

Cash (+A) xxx Unearned revenue (+L) xxx

Revenue will be recorded when earned.

Revenue Principle

CASH COLLECTED (Goods or services due to

customers)over time will

become

REVENUE (Earned when goods or services provided)

Rent collected in advance Rent revenueUnearned air traffic revenue Air traffic revenueDeferred subscription revenue Subscription revenue

Typical liabilities that becomeTypical liabilities that becomerevenue when earned include . . .revenue when earned include . . .

Revenue PrincipleWhen cash is received on the date When cash is received on the date

the revenue is earned, the the revenue is earned, the following entry is made:following entry is made:

CashReceived

Company Delivers

Cash (+A) xxx Revenue (+R) xxx

ANDAND

Revenue PrincipleIf 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.

Cash received after revenue is earned -

Accounts receivable (+A) xxx Revenue (+R) xxx

Company Delivers

Revenue Principle

CashReceived

Accounts receivable (+A) xxx Revenue (+R) xxx

Cash received after revenue is earned -

Company Delivers

When the cash is received the When the cash is received the ACCOUNTS ACCOUNTS RECEIVABLERECEIVABLE is reduced. is reduced.

Cash will be collected.

CASH TO BE COLLECTED (Owed by

customers)and already earned as

REVENUE (Earned when

goods or services provided)

Rent receivable Rent revenueRoyalties receivable Royalty revenue

The Revenue PrincipleAssets reflecting revenues earned butAssets reflecting revenues earned but

not yet received in cash include . . .not yet received in cash include . . .

The Matching PrincipleResources 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..Net Income

(profit)

Cost & Expense

Revenue

Matched to the acc ounting P

eriod

The Matching PrincipleIf 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.

Cash is paid before expense is incurred -

$Paid

Prepaid expense (+A) xxx Cash (-A) xxx

The Matching Principle

ExpenseIncurred

When the expense is incurred When the expense is incurred PREPAID PREPAID EXPENSEEXPENSE is reduced and an is reduced and an EXPENSEEXPENSE is is

recorded.recorded.Cash is paid before expense is incurred -

$Paid

Prepaid expense (+A) xxx Cash (-A) xxx

Expense will be recorded when incurred.

The Matching PrincipleWhen cash is paid on the date the When cash is paid on the date the expense is incurred, the following expense is incurred, the following

entry is made:entry is made:

CashPaid

ExpenseIncurred

Expense (+E) xxx Cash (-A) xxx

AND

The Matching PrincipleIf cash is paid after the company receives If cash is paid after the company receives goods or services, a liability goods or services, a liability PAYABLEPAYABLE is is

recorded.recorded.Cash paid after expense is incurred -

Expense (+E) xxx Payable (+L) xxx

ExpenseIncurred

The Matching Principle

CashPaid

When cash is paid the When cash is paid the PAYABLEPAYABLE is reduced. is reduced.

Cash paid after expense is incurred -

ExpenseIncurred

Expense (+E) xxx Payable (+L) xxx

Cash will be paid.

The Matching Principle

CASH PAID FORas used over

time becomes EXPENSESupplies inventory Supplies expensePrepaid insurance Insurance expenseBuildings and equipment Depreciation expense

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

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

Dec.2008Expense

Jan.2009

Expense

Feb.

2009

Expense

This expense is called depreciation.

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 + 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

How Revenues How Revenues and Expenses and Expenses affect Retained affect Retained

Earnings.Earnings.

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.

Application of a complete transaction analysis model

to some of Papa John’s transactions.

All amounts are in $ 000’s

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.

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 Effect1. Cash increases.2. Franchise fee revenue increases.3. Unearned franchise fees increases.

= +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.

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.

The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients

for those sales were $9,600.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.

= +Cash 36,000 Restaurant sales

revenue36,000

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

Stockholders' EquityLiabilitiesAssets

The company sold $36,000 of pizzas for cash. The costs of the pizza ingredients

for those sales were $9,600.

Preparation of financial statements.

How are Financial Statements Prepared?

IncomeIncomeStatementStatement Revenues – Expenses = Net Income

Statement ofStatement ofRetainedRetainedEarningsEarnings

Beginning Retained Earnings+ Net Income- Dividends Declared Ending Retained Earnings

BalanceBalanceSheetSheet

Assets = Liabilities + Stockholders’ Equity

Contributed CapitalRetained Earnings

StatementStatementof Cash Flowsof Cash Flows

Changein

Cash

= Cash from Operating Activities+ Cash from Investing Activities+ Cash from Financing Activities

Income Statement

Beginning balance, December 28, 2003 158,000$ Net income 21,800 Dividends (3,000) Ending balance, January 31, 2004 176,800$

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

For the Month Ended Janaury 31, 2004(Dollars in thousands)

Statement of Retained Earnings

The net income comes from the Income The net income comes from the Income Statement just prepared.Statement just prepared.

Balance Sheet

Assets Jan. 31, 2004Current assets: Cash 37,900$ 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' EquityCurrent 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$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESConsolidated Balance Sheets

(Dollars in thousands)

The ending balance from The ending balance from the Statement of Retained the Statement of Retained

Earnings flows into the Earnings flows into the equity section of the equity section of the

Balance Sheet.Balance Sheet.

Focus on Cash FlowsEffect on

Cash FlowsCash received from: Customers +

Investments +Cash paid to: Suppliers -

Employees -Interest paid -Income taxes paid -

Nature of Operating Activity

Cash InflowsCash Inflows

Cash OutflowsCash Outflows

Operating ActivitiesCash 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$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESConsolidated Statement of Cash FlowsFor the Month Ended Janaury 31, 2004

(Dollars in thousands)

The ending cash The ending cash balance agrees balance agrees with the amount with the amount on the Balance on the Balance

Sheet.Sheet.

Statement of Cash Flows

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

In Class Exercise E3-17 page 147

E3-17

E3–17. Req. 1

Assets = Liabilities + Stockholders’ Equity $ 3,200 $ 2,400 $ 4,800 8,000 5,600 3,200 6,400 1,600 $17,600 $9,600 $ 8,000

Req. 2

Cash

Accounts Receivable

Long-Term Investments

Beg. 3,200 (a) 5,600 (b) 48,000 (c) 400 (g) 1,600

43,200 (d) 480 (f)

Beg. 8,000 (b) 8,000

5,600 (a) Beg. 6,400

15,120 10,400 6,400

Accounts Payable

Unearned Revenue

Long-Term Notes Payable

(d) 1,600 2,400 Beg. 800 (e)

5,600 Beg. 1,600 (g)

1,600 Beg.

1,600 7,200 1,600

Contributed Capital

Retained Earnings

4,800 Beg. (f) 480 3,200 Beg. 4,800 2,720

Consulting Fee

Revenue Investment

Income

0 Beg. 0 Beg. 56,000 (b) 400 (c) 56,000 400

Wages Expense Travel Expense Utilities Expense

Beg. 0 (d) 16,000

Beg. 0 (d) 16,000

Beg. 0 (e) 800

16,000 16,000 800

Rent Expense Beg. 0 (d) 9,600

9,600

Req. 3

Revenues $56,400 ($56,000 + $400) – Expenses 42,400 ($16,000 + $16,000 + $800 + $9,600) Net Income $ 14,000

Assets = Liabilities + Stockholders’ Equity $15,120 $ 1,600 $ 4,800 10,400 7,200 2,720 6,400 1,600 14,000 net income $31,920 $10,400 $21,520

Req. 4 Total Asset Turnover = Sales (Operating) Revenues = $56,000** = 2.26 Average Total Assets $24,760 * ($17,600 + $31,920) ÷ 2 ** The $400 of investment income is not an operating revenue and is not included in the computation. The increasing trend in the asset turnover ratio from 1.80 in 2010 and 2.00 in 2011 to 2.26 in 2012 suggests that the company is managing its assets more efficiently over time.