Chapter 3

Operating Decisions and

the Income Statement
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 Business Background
Businesses develop . . .

Goals Plans

Measurable
Strategies indicators

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
Begin
Purchase or
manufacture
products or
supplies on
credit.

Receive
Pay
payment from
suppliers.
customers.

Deliver product
or provide
service to
customers on
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 Underlying Accounting
Assumptions
Time
Time Period:
Period: The
The long
longlife
lifeof
ofaacompany
companycan
canbe
be
reported
reportedover
overaaseries
seriesofofshorter
shortertime
timeperiods.
periods.

Recognition
RecognitionIssues
Issues:: When
Whenshould
shouldthe
theeffects
effectsof
of
operating
operatingactivities
activitiesbe
berecognized
recognized(recorded)?
(recorded)?

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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 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

1993 1994 1995 1996 1997 1998 1999 2000

Annual Accounting Periods

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 Elements on the Income
Statement
Revenue
Revenue
Increases
Increasesin inassets
assetsor
orsettlement
settlementof
of
liabilities
liabilitiesfrom
fromongoing
ongoingoperations.
operations.
Expense
Expense
Decreases
Decreasesin inassets
assetsor
orincreases
increasesin
in
liabilities
liabilitiesfrom
fromongoing
ongoingoperations.
operations.
Gains
Gains
Increase
Increasein inassets
assetsor
orsettlement
settlementofof
liabilities
liabilitiesfrom
fromperipheral
peripheraltransactions.
transactions.
Losses
Losses
Decreases
Decreasesin inassets
assetsor
orincreases
increasesinin
liabilities
liabilitiesfrom
fromperipheral
peripheraltransactions.
transactions.
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 PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES
Consolidated Statement of Income
Papa John’s For the Year Ended December 27, 1998
(In thousands)
Primary Operating
Revenues:
Activities Restaurant sales $ 324,900
Franchise royalties and development fees 38,500
Commissary, equipment and other sales 306,400
Investment income 4,400
Total revenues 674,200
Sell pizza Costs and expenses:
Restaurant expenses:
Cost of sales 87,500
Salaries and benefits 87,000
Advertising and related costs 28,400
Sell Occupancy costs and other operating expenses 58,500
franchises 261,400
Commissary, equipment and other expenses:
Cost of sales 240,700
Salaries, benefits, and other operating expenses 39,500
280,200
Sell supplies General and administrative expenses 50,500
and Depreciation and amortization 19,400
Other costs and expenses 5,300
equipment to Total costs and expenses 616,800
franchisees Income before income taxes 57,400
Income tax expense 22,200
Irwin/McGraw-Hill Net income $ Inc.,
© The McGraw-Hill Companies, 35,200
2001
 Cash Basis Accounting

Revenue is recorded Expenses are recorded

when cash is received. 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.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Principles Affecting Income
Determination
!Revenue Principle
"Matching Principle
#Cost Principle

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 The Revenue Principle

Recognize revenues when . . .

$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 . . .
CASH COLLECTED REVENUE
(Goods or services due to over time will (Earned when goods
customers) become or services provided)
Rent collected in advance Rent revenue
Unearned air traffic revenue Air traffic revenue
Deferred subscription revenue Subscription revenue

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 The Revenue Principle
Assets reflecting revenues earned but
not yet received in cash include . . .
CASH TO BE REVENUE
COLLECTED (Earned when
(Owed by and already goods or services
customers) earned as provided)
Interest receivable Interest revenue
Rent receivable Rent revenue
Royalties receivable Royalty revenue

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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. . .
as used over
CASH PAID FOR time becomes EXPENSE
Supplies inventory Supplies expense
Prepaid insurance Insurance expense
Buildings and equipment Depreciation expense

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 The Matching Principle

Typical liabilities and their related

expense accounts include . . .
and already
CASH TO BE PAID incurred as EXPENSE
Salaries payable Salaries expense
Interest payable Interest expense
Property taxes payable Property tax expense

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 A = L + SE
ASSETS LIABILITIES
Debit Credit Debit Credit
for for for for
Increase Decrease Decrease Increase

CONTRIBUTED RETAINED
Next, let’s see CAPITAL EARNINGS
how Revenues
Debit Credit Debit Credit
and Expenses
for for for for
affect Retained
Decrease Increase Decrease Increase
Earnings.
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 The Expanded Transaction
Analysis Model
RETAINED
Dividends decrease
EARNINGS Net Income increases
Retained Earnings. Retained Earnings.
Debit Credit
for for
Decrease Increase

REVENUES EXPENSES
Debit Credit Debit Credit
for for for for
Decrease Increase Increase Decrease
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 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.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

Papa John’s sold 25 franchises for $400 cash. The
company earned $175 immediately. The rest will be
earned over several months.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset)
(asset)
2.
2. Franchise
Franchiseroyalties
royaltiesand
and
development
developmentfees
fees(revenue)
(revenue)
3.
3. Unearned
Unearnedfranchise
franchiseand
and
development
developmentfees
fees(liability)
(liability)

Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1. Cash increases.
1. Cash increases.
2.
2. Franchise
Franchiseroyalties
royaltiesandand
development
developmentfees
feesincrease.
increase.
3.
3. Unearned
Unearnedfranchise
franchiseandand
development
developmentfees
feesincrease.
increase.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
Papa John’s sold 25 franchises for $400 cash. The
company earned $175 immediately. The rest will be
earned over several months.
Assets = Liabilities + Stockholders' Equity
Cash 400 Unearned franchise 225 Franchise royalties 175
and development fees and development fees

GENERAL JOURNAL Page 1

Date Description Debit Credit

Cash 400
Unearned franchise and 225
development fees
Franchise royalties and 175
development fees

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

The company received $35,200 for pizza sales. The
cost of the pizza ingredients for those sales was
$9,600.
Identify
Identify
Identify &
& Classify
Classify the
the Accounts
Accounts
Identify & Classify theAccounts
& Classify the Accounts
1. Cash
1. Cash (asset)(asset)
2.
2. Restaurant
Restaurantsales salesrevenue
revenue
(revenue)
(revenue)
3.
3. Cost
Costof ofsales-
sales- restaurant
restaurant
(expense)
(expense)
4.
4. Inventories
Inventories(asset)
(asset)
Determine
Determinethe theDirection
Directionof ofthetheEffect
Effect
Determine
Determine
1. the Direction of the
the Direction of the Effect Effect
1. Cash
Cashincreases.
increases.
2.
2. Restaurant
Restaurantsales
salesrevenue
revenue
increases.
increases.
3.
3. Cost
Costof
ofsales-
sales- restaurant
restaurant
increases.
increases.
Irwin/McGraw-Hill
4.
4. Inventories
Inventoriesdecrease.
decrease.
© The McGraw-Hill Companies, Inc., 2001
 The company received $35,200 for pizza sales. The
cost of the pizza ingredients for those sales was
$9,600.
Assets = Liabilities + Stockholders' Equity
Cash 35,200 Restaurant sales 35,200
revenue
Inventory (9,600) Cost of sales (9,600)

GENERAL JOURNAL Page 1

Date Description Debit Credit

Cash 35,200
Restaurant sales 35,200
revenue
Cost of sales - restaurant 9,600
Inventories 9,600

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 End of Chapter 3

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001