Operating Decisions and the

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Chapter 3

• Operating Decisions and the
• Income Statement
• 9/07/04

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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?
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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?
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The Time Period Assumption

• To meet the needs of decision makers, we report
  financial information for relatively short time
  periods (monthly, quarterly, annually).

Life of the Business
1996
1997
1998
1999
2000
2001
2002
2003
Annual Accounting Periods
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Papa Johns Primary Operating Activities
Sell pizza
Sell franchises
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Papa Johns Primary Operating Expenses
Cost of sales(used inventory)
Salaries and benefits to employees
Other costs (like advertising, insurance, and
depreciation)
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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
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Cash Basis Accounting
Revenue is recorded when cash is received.
Expenses are recorded when cash is paid.
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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 - GenerallyAcceptableAccountingPrin
ciples
GAAP
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Revenue Principle (largest source of fraud)

• 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.

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Revenue Principle
If cash is received before the company delivers
goods or services, the liability account UNEARNED
REVENUE is recorded.
Received
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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
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Revenue Principle - Examples
Typical liabilities that become revenue when
earned include . . .
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Revenue Principle
When cash is received on the date the revenue is
earned, then both cash and revenue are recorded
as follows
Company Delivers
AND
Received
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Revenue Principle
If cash is received after the company delivers
goods or services, an asset ACCOUNTS RECEIVABLE
is recorded.
Company Delivers
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Revenue Principle
If cash is received after the company delivers
goods or services, an asset ACCOUNTS RECEIVABLE
is recorded.
When cash is received -
Received
Company Delivers
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The Revenue Principle - Examples
Assets reflecting revenues earned but not yet
received in cash include . . .
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Revenue Principle

• Self-Study Quiz Page 110
• A Question of Ethics Page 111

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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.
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Matching Principle
If cash is paid before the company receives goods
or services, an asset account PREPAID EXPENSE is
recorded.
Paid
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Matching Principle
If cash is paid before the company receives goods
or services, an asset account PREPAID EXPENSE is
recorded.
When the expense is actually incurred
ExpenseIncurred
Paid
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Matching Principle - Examples
Typical assets and their related expense accounts
include. . .
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Matching Principle
When cash is paid on the date the expense is
incurred, the CASH and EXPENSE is recorded as
follows
ExpenseIncurred
AND
Paid
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Matching Principle
If cash is paid after the company receives goods
or services, an liability PAYABLE is recorded.
ExpenseIncurred
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Matching Principle
If cash is paid after the company receives goods
or services, an liability PAYABLE is recorded.
Cash paid after expense is incurred
Paid
ExpenseIncurred
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Matching Principle - Examples
Typical liabilities and their related expense
accounts include . . .
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Matching Principle

• Self-study Quiz Page 113

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Expanded Transaction Analysis Model
Lets look at an expanded transaction analysis
model that includes the recording of revenues and
expenses.
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A L SE

Next, lets see how Revenues and Expenses affect
Retained Earnings.
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Expanded Transaction Analysis Model

Dividends decrease Retained Earnings.
Net Income increases Retained Earnings.
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Analyzing Papa Johns Transaction
Lets apply the complete transaction analysis
model to some of Papa Johns transactions. All
amounts are in thousands of dollars.
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Papa Johns sold franchises for 400 cash. The
company earned 100 immediately. The rest will
be earned over several months.
Identify Classify the Accounts
Determine the Direction of the Effect
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Papa Johns sold franchises for 400 cash. The
company earned 100 immediately. The rest will
be earned over several months.
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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
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The company received 36,000 for pizza sales.
The cost of the pizza ingredients for those sales
was 9,600.
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More Papa Johns 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

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How are Unadjusted Financial Statements Prepared?
Theyre not!What you get is a Trial Balance.
After posting all of the January transactions to
T-accounts, we can prepare Papa Johns unadjusted
financial statements. Note They are missing
month end accruals.
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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)

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End of Chapter 3