PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Operating Decisions and theIncome Statement

Chapter 3

3-2

Understanding the Business

How do business activitiesaffect the income statement?How do business activities

affect the income statement?

How are these activities recognized and measured?

How are these activities recognized and measured?

How are these activities reported on the

income statement?

How are these activities reported on the

income statement?

3-3

The Operating CycleBegin

Purchase or manufacture products or supplies on

credit.

Purchase or manufacture products or supplies on

credit.

Deliver product or provide service to customers on

credit.

Deliver product or provide service to customers on

credit.

Pay suppliers.

Pay suppliers.

Receive payment from customers.

Receive payment from customers.

3-4

The Operating Cycle

Time Period: The long life of a company can be reported over a series of shorter time periods.

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)?

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?

3-5

Elements on the Income Statement

LossesDecreases in assets or increases in

liabilities from peripheral transactions.

LossesDecreases in assets or increases in

liabilities from peripheral transactions.

RevenuesIncreases in assets or settlement of liabilities from ongoing operations.

RevenuesIncreases in assets or settlement of liabilities from ongoing operations.

ExpensesDecreases in assets or increases in liabilities from ongoing operations.

ExpensesDecreases in assets or increases in liabilities from ongoing operations.

GainsIncreases in assets or settlement of

liabilities from peripheral transactions.

GainsIncreases in assets or settlement of

liabilities from peripheral transactions.

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3-7

Papa John’s Primary Operating ExpensesPapa John’s Primary Operating Expenses

Cost of sales(used inventory)

Cost of sales(used inventory)

Salaries and benefits to employees

Salaries and benefits to employees

Other costs (like advertising,

insurance, and depreciation)

Other costs (like advertising,

insurance, and depreciation)

3-8

How Are Operating Activities Recognized and Measured?

Revenue is recordedwhen cash is received.Revenue is recorded

when cash is received.Expenses are recorded

when cash is paid.Expenses are recorded

when cash is paid.

Cash Basis

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Assets, liabilities, revenues, and expenses should be recognized when the transaction that causes them

occurs, not necessarily when cash is paid or received.

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

Required by -

Generally

Acceptable

Accounting

Principles

How Are Operating Activities Recognized and Measured?

Accrual Accounting

3-10

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.

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.

3-11

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 revenue

Unearned air traffic revenue Air traffic revenue

Deferred subscription revenue Subscription revenue

Typical liabilities that becomerevenue when earned include . . .

3-12

Revenue Principle

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 butnot yet received in cash include . . .

3-13

The Matching Principle

Resources consumed to earn

revenues in an accounting period should be recorded

in that period, regardless of when

cash is paid.

Resources consumed to earn

revenues in an accounting period should be recorded

in that period, regardless of when

cash is paid.

3-14

The Matching Principle

CASH PAID FORas used over

time becomes EXPENSE

Supplies inventory Supplies expense

Prepaid insurance Insurance expense

Buildings and equipment Depreciation expense

Typical assets and their relatedexpense accounts include. . .

3-15

A = L + SEA = L + SEASSETS

Debit for

Increase

Credit for

Decrease

LIABILITIES

Debit for

Decrease

Credit for

Increase

RETAINED EARNINGS

Debit for

Decrease

Credit for

Increase

CONTRIBUTED CAPITAL

Debit for

Decrease

Credit for

Increase

Next, let’s see how Revenues and

Expenses affect Retained Earnings.

3-16

EXPENSES

Debit for

Increase

Credit for

Decrease

REVENUES

Debit for

Decrease

Credit for

Increase

RETAINED EARNINGS

Debit for

Decrease

Credit for

Increase

Expanded Transaction Analysis Model

Dividends decrease Retained Earnings.

Net Income increases Retained Earnings.

3-17

End of Chapter 3