Income Statement

Lecture 3

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Learning Objectives
1. Describe a typical business operating cycle and explain the necessity for the time period assumption. 2. Explain how business activities affect the elements of the income statement. 3. Explain the accrual basis of accounting and apply the revenue and matching principles to measure income. 4. Apply transaction analysis to examine and record the effects of operating activities on the financial statements. 5. Prepare financial statements.

6. Compute and interpret the total asset turnover ratio.

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Understanding the Business

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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The Operating Cycle

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The Operating Cycle

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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Elements on the Income Statement

Revenues Increases in assets or settlement of liabilities from ongoing operations. Expenses Decreases in assets or increases in liabilities from ongoing operations. Gains Increases in assets or settlement of liabilities from peripheral transactions.

Losses Decreases in assets or increases in liabilities from peripheral transactions.

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Income Statement Format

Single-Step Income Statement

Revenues

Expenses

Net profit

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Income Statement Format

Multi-Step Income Statement
Sales revenues Selling and Operating Cost of goods sold administrative = profit Gross profit expenses

Add: Other revenues and gains Less: Other expenses and losses
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Income Statement Format

Multi-Step Income Statement

Profit before taxes

Taxes

Net profit

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International Perspective

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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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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.

RETAINED EARNINGS Debit Credit for for Decrease Increase

Net Income increases Retained Earnings.

REVENUES Debit Credit for for Decrease Increase

EXPENSES Debit Credit for for Increase Decrease

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How Are Operating Activities Recognized and Measured?

Cash Basis

Revenue is recorded when cash is received.

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Expenses are recorded when cash is paid.

How Are Operating Activities Recognized and Measured?

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 -

Generally Acceptable Accounting Principles

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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.

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Revenue Principle
If cash is received before the company delivers goods or services, the liability account UNEARNED REVENUE is recorded.
Cash received before revenue is earned Cash Received Cash (+A) Unearned revenue (+L) xxx

xxx

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Revenue Principle
When the company delivers the goods or services UNEARNED REVENUE is reduced and REVENUE is recorded.
Cash received before revenue is earned Cash Received Cash (+A) Unearned revenue (+L) xxx Company Delivers

xxx Revenue will be recorded when earned. Unearned revenue (-L) Service revenue (+R) xxx xxx

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Revenue Principle

Typical liabilities that become revenue when earned . . .

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Revenue Principle

Typical liabilities that become revenue when earned include . . .

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

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Revenue Principle
When cash is received on the date the revenue is earned, the following entry is made:
Company Delivers AND Cash Received

Cash (+A) Revenue (+R)

xxx

xxx

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Revenue Principle
If cash is received after the company delivers goods or services, an asset ACCOUNTS RECEIVABLE is recorded.
Cash received after revenue is earned Company Delivers

Accounts receivable (+A) Revenue (+R)

xxx

xxx

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Revenue Principle
When the cash is received the ACCOUNTS RECEIVABLE is reduced.
Cash received after revenue is earned Company Delivers Accounts receivable (+A) Revenue (+R) xxx Cash Received

xxx
Cash will be collected.

Cash (+A) Accounts receivable (-A)

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xxx

xxx

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

and already earned as

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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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Matching Principle

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The Matching Principle

If cash is paid before the company receives goods or services, an asset account, PREPAID EXPENSE is recorded.
Cash is paid before expense is incurred $ Paid Prepaid expense (+A) Cash (-A) xxx

xxx

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The Matching Principle

When the expense is incurred PREPAID EXPENSE is reduced and an EXPENSE is recorded.
Cash is paid before expense is incurred $ Expense Paid Incurred Prepaid expense (+A) Cash (-A) xxx

xxx Expense will be recorded when incurred. Expense (+E) Prepaid expense (-A) xxx xxx

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The Matching Principle

When cash is paid on the date the expense is incurred, the following entry is made:
Expense Incurred AND Cash Paid

Expense (+E) Cash (-A)

xxx

xxx

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The Matching Principle

If cash is paid after the company receives goods or services, a liability PAYABLE is recorded.
Cash paid after expense is incurred Expense Incurred

Expense (+E) Payable (+L)

xxx

xxx

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The Matching Principle

When cash is paid the PAYABLE is reduced.
Cash paid after expense is incurred Expense Incurred Expense (+E) Payable (+L) xxx Cash Paid

xxx

Cash will be paid.

Payable (-L) Cash (-A)
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xxx

xxx

The Matching Principle Typical assets and their related expense accounts include. . .
CASH PAID FOR Supplies inventory Prepaid insurance Buildings and equipment as used over time becomes EXPENSE Supplies expense Insurance expense Depreciation expense

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The Accrual Basis of Accounting

Current Accounting Period
Jan. 1, 2009 Dec. 1, 2009

Future Accounting Period

Jan. 1, 2010 Dec. 1, 2010

Cash is received or paid here OR

But . . .

The income statement reports revenue or expense here

The income statement reports revenue or expenses here

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But . . .

Cash is received or paid here

Analyzing Some of Papa Johns Transactions

(a) Papa Johns restaurants sold pizza to customers for $36,000 cash and sold $30,000 in supplies to franchised restaurants, receiving $21,000 cash with the rest due on account.

Equality checks: 1. Debits $66,000 equal Credits $66,000, 2. The accounting equation is in balance.
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Analyzing Some of Papa Johns Transactions

(b) The cost of the dough, sauce, cheese, and other supplies for the restaurant sales in (a) on the previous screen was $30,000.

Equality checks: 1. Debits $30,000 equal Credits $30,000, 2. The accounting equation is in balance.
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Analyzing Some of Papa Johns Transactions

(c) Papa Johns sold new franchises for $400 cash, earning $100 immediately by performing services for franchisees; the rest will be earned over the next several months.

Equality checks: 1. Debits $400 equal Credits $400, 2. The accounting equation is in balance.
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Analyzing Some of Papa Johns Transactions

(d) In January, Papa Johns paid $7,000 for utilities, repairs, and fuel for delivery vehicles, all considered general and administrative expenses incurred during the month.

Equality checks: 1. Debits $7,000 equal Credits $7,000, 2. The accounting equation is in balance.
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The balances in the balance sheet accounts and income statement accounts (all income accounts begin with a zero balance).

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How are Financial Statements Prepared and Analyzed?

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Income Statement

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Statement of Stockholders Equity

The net income ($21,800) comes from the Income Statement we just prepared.

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Balance Sheet

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Focus on Cash Flows

Direct approach to preparing operating cash flows.
Operating activities Cash received: Customers Interest and div idends on investments Cash paid: Suppliers Employees Interest on debt obligations Income taxes Cash Flows from Operating Activities Investing Activities Purchase of property, plant or equipment Purchase of other long-term assets Sale of property, plant or equipment Sale of other long-term assets Cash Flows from Investing Activities Financing Activities Issuance of long-term debt Issuance of contributed capital Dividends paid Repurchase of long-term debt Repurchase of contributed capital Cash Flows from Financing Activities Net increase or (decrease) in cash Beginning balance in cash account Ending balance in cash account Effect on Cash Flows + + Total + + Total + + Total

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Total Asset Turnover Ratio

Total Asset Turnover Ratio Sales (or Operating) Revenues Average Total Assets

(Beginning total assets + ending total assets) 2

Papa Johns Total Asset Turnover Ratio for 2008 (dollars in thousands): $1,132,000 ($402,000 + $387,000) 2

= 2.87

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The End

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