Libby Libby Short

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Chapter 3
Operating Decisions and the Income Statement
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Business Background
Businesses develop . . .
The goals include elements of income.
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Business Background
What 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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The Operating Cycle
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Underlying Accounting Assumptions
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)?
Measurement Issues What amounts should be
recognized?
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The Periodicity Assumption

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

Life of the Business
1998
1999
2000
2001
2002
2003
2004
2005
Annual Accounting Periods
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Elements on the Income Statement
Revenue Increases in assets or settlement of
liabilities from ongoing operations.
Expense Decreases in assets or increases in
liabilities from ongoing operations.
Gains Increase in assets or settlement of
liabilities from peripheral transactions.
Losses Decreases in assets or increases in
liabilities from peripheral transactions.
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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 GAAP
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Principles Affecting Income Determination

• Revenue Principle
• Matching Principle
• Cost Principle

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The Revenue Principle

• Recognize revenues when . . .
• The earnings process is complete or nearly
  complete.
• An exchange transaction takes place.
• Collection is reasonably assured.

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The Revenue Principle
Typical liabilities that become revenue when
earned include . . .
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The Revenue Principle
Assets reflecting revenues earned but not yet
received in cash include . . .
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The Matching Principle

• 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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The Matching Principle
Typical assets and their related expense accounts
include. . .
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The Matching Principle
Typical liabilities and their related expense
accounts include . . .
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A L SE

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

Dividends decrease Retained Earnings.
Net Income increases Retained Earnings.
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Transaction Analysis Rules
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 25 franchises for 500 cash.
The company earned 175 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 25 franchises for 500 cash.
The company earned 175 immediately. The rest
will be earned over several months.
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The company received 35,200 for pizza sales.
The cost of the pizza ingredients for those sales
was 9,600.
Identify Classify the Accounts
Determine the Direction of the Effect
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The company received 35,200 for pizza sales.
The cost of the pizza ingredients for those sales
was 9,600.
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Preparation of the Unadjusted Financial Statements
After posting all of the January transactions to
T-accounts, we can prepare Papa Johns unadjusted
financial statements.
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Notice that income tax expense is not determined
at this point.

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Preparation of the Unadjusted Financial Statements

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

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Notice that the ending balance from the Statement
of Retained Earnings flows into the equity
section of the Balance Sheet.


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Focus on Cash Flows
Remember We discussed Investing and Financing
Activities in Chapter 2.
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Notice that the ending cash balance agrees with
the amount on the Balance Sheet.


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Financial Leverage Ratio
Sales Average Total Assets
Asset Turnover Ratio
Creditors and analysts used this ratio to assess
a companys effectiveness at controlling current
and noncurrent assets.
This ratio measures the sales generated per
dollar of assets.
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End of Chapter 3