chapter 3 Operating Decisions and

the Accounting System

Financial Accounting
9e
Libby Libby Hodge

3-1
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Learning Objectives
After studying this chapter, you should be able to:
3-1 Describe a typical business operating cycle and explain the
necessity for the time period assumption.

3-2 Explain how business activities affect the elements of the

income statement.

3-3 Explain the accrual basis of accounting and apply the revenue
and expense recognition principles to measure income.

3-4 Apply transaction analysis to examine and record the effects of

operating activities on the financial statements.

3-5 Prepare a classified income statement.

3-6 Compute and interpret the net profit margin ratio.

3-2
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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 assumption: The long life of a company can be reported

over a series of shorter time periods.

Two issues arise when reporting periodic income:

1) Recognition issues: When should the effects of operating activities
be recognized (recorded)?
2) Measurement issues: What amounts should be recognized?

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Elements of the Income Statement

Revenues
Increases in assets or settlements of liabilities from
ongoing operations.

Expenses
Decreases in assets or increases in liabilities from
ongoing operations.

Gains
Increases in assets or settlements of liabilities from
peripheral transactions.

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

3-6
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Exhibit 3.1
Chipotle Mexican Grills Income Statement
*The information CHIPOTLE MEXICAN GRILL, INC.
has been adapted Consolidated Statement of Income*
from actual For the Year ended December 31, 2014
statements and
simplified for this
(in thousands of dollars, except per share data)
chapter. Restaurant sales revenue $4,108,300
Restaurant operating expenses:
Supplies expense 1,421,000
Wages expense 904,400 Includes salaries expense
Rent expense 230,900
Insurance expense 118,000
Operating Utilities expense 60,700
activities Repairs expense 35,200
(central Other operating expenses 338,300
focus of
business) General and administrative expenses:
Training expense 151,000 Includes pre-opening costs
Advertising expense 20,500
Depreciation expense 110,500
Loss on disposal of assets 7,000
Total operating expenses 3,397,500
Peripheral Income from operations 710,800
activities Other items:
(not central
focus of
Interest revenue 4,200
business) Interest expense (700)
Income before income taxes 714,300
Income tax expense 269,000 Also called Provision for Income Taxes
Net income $ 445,300
Earnings per share $14.35 = $445,300,000 Net Income 31,038,000
weighted average number of common stock
shares outstanding (per 2014 annual report)
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Operating Revenues

Operations of the business: the sale of goods or rendering of

services as the central focus of the business
e.g., When Chipotle sells tacos, it has earned revenue.

Revenues
Any increases in assets or settlements of liabilities from
ongoing operations of the business

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Operating Expenses

An expenditure is any outflow of cash for any purpose, whether to buy

equipment, pay off a bank loan, or pay employees their wages.

Operating expenses are outflows, or the using up of assets, or increases

in liabilities from ongoing operations incurred to generate revenues
during the period. Therefore, not all cash expenditures are expenses,
but expenses are necessary to generate revenues.

Cash
expenditures

Debt Asset
payments purchases

Expenses

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Examples of Chipotles Operating Expenses

Depreciation
expense

Advertising Supplies
expense expense

Utilities Wages
expense expense

Insurance
Rent expense
expense

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Other Income Statement Items

Interest revenue

Interest expense

Gain or loss on sale of investments

Income tax expense

Earnings
per
Share

3-11
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International Perspective
Income Statement Differences
Under IFRS, the income statement is usually titled the Statement of Operations. There is
also a difference in how expenses may be reported:

GAAP IFRS
Presentation of Expenses
Similar expenses are reported, Public companies categorize Companies can
but they may be grouped in expenses by business categorize expenses
different ways. function (e.g., production, by either function or
research, marketing, general nature (e.g., salaries,
operations). rent, supplies,
electricity).

In addition, foreign companies often use account titles that differ from those used by U.S.
companies. For example, GlaxoSmithKline (a UK pharmaceutical company), Parmalat (an
Italian food producer of milk, dairy products, and fruit-based beverages), and Unilever (a UK-
and Netherlands-based company supplying food, home, and personal care products such as
Hellmans mayonnaise, Dove soap, and Popsicle treats) use the term turnover to refer to sales
revenue, finance income for income from investments, and finance cost for interest expense.
BMW Group, on the other hand, reports revenues and uses financial result for the difference
between income from investments and interest expense. All four companies follow IFRS.

3-12
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How Are Operating Activities Recognized and Measured?

Cash Basis

Revenue is recorded Expenses are recorded

when cash is received. when cash is paid.

GAAP does not allow the cash The cash basis may be adequate
basis of accounting. for organizations that do not
need to report to external users.

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Cash Basis Accounting

Cade Company Income Statements Year 1 Year 2 Year 3 Total

Sales on credit $60,000 $60,000 $60,000 $180,000

Cash receipts from customers $20,000 $70,000 $90,000 $180,000

Cash disbursements for:

Salaries to employees (30,000) (30,000) (30,000) (90,000)
Insurance for 3 years (12,000) (0) (0) (12,000)
Supplies (3,000) (7,000) (5,000) (15,000)
Net operating cash flows $(25,000) $33,000 $55,000 $63,000

3-14
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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 (GAAP)

3-15
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Exhibit 3.2
Recording Revenues versus Cash Receipts

Cash may be received . . .

1 2 3
before food when food after food
delivery is delivered delivery

TIME
DELIVERY

Record REVENUE here

A company must recognize revenue:

1. When the company transfers promised goods or services to customers.
2. In the amount it expects to receive.

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Revenue Recognition Principle

If cash is received before the company delivers goods or services,

the liability account UNEARNED REVENUE is recorded.

On receipt of a $100 cash deposit:

Cash (+A) .... 100
Unearned Revenue (+L) .. 100

On delivery of ordered food:

Unearned Revenue (L).... 100
Restaurant Sales Revenue (+R, +SE) .. 100

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Revenue Recognition Principle

When cash is received on the date the revenue is earned, the

following entry is made:

On delivery of ordered food for $12 cash:

Cash (+A) .... 12
Restaurant Sales Revenue (+R, +SE) .. 12

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Revenue Recognition Principle

If cash is received after the company delivers goods or services, an

asset ACCOUNTS RECEIVABLE is recorded.

On delivery of ordered food for $50 on account:

Accounts Receivable (+A) ... 50
Restaurant Sales Revenue (+R, +SE) .. 50

On receipt of cash after delivery:

Cash (+A) .... 50
Accounts Receivable (A) ... 50

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Revenue Recognition for More Complex
Customer Contracts FINANCIAL ANALYSIS

$$$
Five steps to recognizing revenue:

Identify the contract between the company and the

customer.
Identify the performance obligations (promised goods
and services).
Determine the transaction price.
Allocate the transaction price to the performance
obligations.
Recognize revenue when each performance obligation is
satisfied (or over time if a service is provided over time).

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Exhibit 3.3
Recording Expenses versus Cash Payments

Cash may be paid . . .

1 2 3
to purchase for repairs the to employees
supplies before same day for work in the
being used (services used) prior period
TIME
USED
(INCURRED to generate revenue)
Record EXPENSE here

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Expense Recognition Principle

Cash is paid before the expense is incurred to generate revenue.

On payment of $200 cash for supplies:

Supplies (+A) .... 200
Cash (A) .. 200

On subsequent use of half of the supplies:

Supplies Expense (+E, SE) .... 100
Supplies (A) .... 100

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Expense Recognition Principle

Cash is paid in the same period as the expense is incurred to

generate revenue.

On payment of $275 cash for repair service:

Repairs Expense (+E, SE) ... 275
Cash (A) . 275

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Expense Recognition Principle

Cash is paid after the expense is incurred to generate revenue.

On use of $400 in employees services during the period:

Wages Expense (+E, SE) ..... 400
Wages Payable (+L) ... 400

On payment of cash after using employees:

Wages Payable (L) ..... 400
Cash (A) .... 400

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 A Question ofIncentives
Managements Ethics to Violate Accounting Rules

The CEO The Fraud Conviction/Plea The Outcome

Elaine Martin, 67 Failed to record sales of used materials. Convicted, February 2014 Sentenced to 7 years
MarCon, Inc.

Annette Bongiorno, 62 Recorded trades of securities in the wrong Convicted, December 2014 Sentenced to 6
and Joann Crupi, 49 accounting period as part of a Ponzi scheme. years each; forfeit a
Madoff Investment total of $188.9
Securities billion

Bernard Madoff, 71 Scammed $50 billion from investors in a Ponzi Confessed, December Sentenced to
Madoff Investment scheme (in which investors receive returns 2008 150 years
Securities from money paid by subsequent investors).

Bernie Ebbers, 65 Recorded $11 billion in operating expenses as Convicted, July 2005 Sentenced to 25 years
Worldcom if they were assets.

Sanjay Kumar, 44 Recorded sales in the wrong accounting Pleaded guilty, April 2006 Sentenced to 12 years
Computer Associates period.

Martin Grass, 49 Recorded rebates from drug companies before Pleaded guilty, June 2003 Sentenced to 8 years
Rite Aid Corporation they were earned.

Barry Minkow, 21 Made up customers and sales to show profits Convicted, December 1988 Sentenced to 25 years
ZZZZ Best when, in reality, the company was a sham.

3-25
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Exhibit 3.4
Expanded Transaction Analysis Model

Note: As expenses
increase (are debited),
net income, retained
earnings, and
stockholders equity
ASSETS = LIABILITIES
(many
+ STOCKHOLDERS EQUITY
decrease.
(many Contributed Capital Earned Capital
accounts) accounts)
(2 accounts) (1 account)
+ + Common Stock and Retained
Debit Credit Debit Credit Additional Paid-in Earnings
Capital
+ +
Debit Credit Debit Credit
Investments Dividends Net = REVENUES EXPENSES
(many
(many
by owners declared income accounts) accounts)
+ +
Credit Debit

3-26
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Exhibit 3.5
Transaction Analysis Steps

Step 1: Ask Was a revenue earned by delivering goods or services?

If so, credit the revenue account and debit the appropriate accounts
for what was received.
or Ask Was an expense incurred to generate a revenue in the current period?
If so, debit the expense account and credit the appropriate accounts for
what was given.
or Ask If no revenue was earned or expense incurred, what was received
and given?
Identify the accounts affected by title (e.g., Cash and Notes Payable).
Remember: Make sure that at least two accounts change.
Classify them by type of account: asset (A), liability (L), stockholders equity (SE),
revenue/gain (R), or expense/loss (E).
Determine the direction of the effect. Did the account increase (+) or decrease ()?

Step 2: Verify Is the accounting equation in balance? (A = L + SE)

3-27
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Exhibit 3.6
Chipotle Mexican Grills Trial Balance

CHIPOTLE MEXICAN GRILL

Trial Balance
(based on investing and financing transactions during
the first quarter ended March 31, 2015)
(in thousands) Debit Credit
Cash 323,200
Short-term investments 347,600
Accounts receivable 34,800
Supplies 15,300
Prepaid expenses 70,300
Land 21,100
Buildings 1,275,300 Accounts payable 69,600
Equipment 476,300 Unearned revenue 16,800
Accumulated depreciation 613,700 Dividends payable 3,000
Long-term investments 531,100 Wages payable 73,900
Intangible assets 68,400 Utilities payable 85,400
Short-term notes payable 0
Long-term notes payable 2,000
Other liabilities 285,900
Common stock 500
Additional paid-in capital 293,800
Retained earnings 1,718,800

Total 3,163,400 3,163,400

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Analyzing Chipotles Transactions

(1) Chipotle purchased food, beverage, and packaging supplies costing

$369,800, paying $289,800 in cash and owing the rest on account.

Debit Credit
(1) Supplies (+A) ..... 369,800
Cash (A) ............ 289,800
Accounts Payable (+L) . 80,000

Assets = Liabilities + Stockholders Equity

Supplies +369,800 Accounts payable +80,000
Cash 289,800
+ Cash (A) + Supplies (A) Accounts Payable (L) +
Bal. 323,200 Bal. 15,300 69,600 Bal.
289,800 (1) (1) 369,800 80,000 (1)

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Analyzing Chipotles Transactions

(2) At the beginning of January, Chipotle paid $79,700 cash in advance

for prepaid expenses for rent, insurance, and advertising.

Debit Credit
(2) Prepaid Expenses (+A) .... 79,700
Cash (A) ...................... 79,700

Assets = Liabilities + Stockholders Equity

Prepaid expenses +79,700
Cash 79,700
+ Cash (A) + Prepaid Expenses (A)
Bal. 323,200 298,800 (1) Bal. 70,300
79,700 (2) (2) 79,700

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Analyzing Chipotles Transactions

(3) During the first quarter, Chipotle sold food to customers for
$1,071,700; $25,700 was sold to universities on account (to be paid by
the universities next quarter), and the rest was received in cash in the
stores. NOTE: To measure revenues and expenses in a period, these
accounts begin with a $0 balance; notice they are not listed on the trial
balance in Exhibit 3.6 because they have no balance yet.
Debit Credit
(3) Cash (+A) ..... 1,046,000
Accounts Receivable (+A) 25,700
Restaurant Sales Revenue (+R, +SE) . 1,071,700

Assets = Liabilities + Stockholders Equity

Cash +1,046,000 Restaurant sales revenue (+R) +1,071,700
Accounts receivable +25,700
+ Cash (A) + Accounts Receivable (A) Restaurant Sales Revenue (R) +
Bal. 323,200 Bal. 34,800 0 Bal.
(3) 1,046,000 289,800 (1) (3) 25,700 1,071,700 (3)
79,700 (2)

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Analyzing Chipotles Transactions

(4) Chipotle paid $40,800 for management training expenses.

Debit Credit
(4) Training Expense (+E, SE) ... 40,800
Cash (A) ...... 40,800

Assets = Liabilities + Stockholders Equity

Cash 40,800 Training expense (+E) 40,800

+ Cash (A) + Training Expense (E)

Bal. 323,200 Bal. 0
(3) 1,046,000 289,800 (1) (4) 40,800
79,700 (2)
40,800 (4)

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Analyzing Chipotles Transactions

(5) Chipotle paid employees $177,000 for work this quarter and
$73,900 for work last quarter (recorded last quarter as Wages
Expense and Wages Payable).

Debit Credit
(5) Wages Expense (+E, SE) ..... 177,000
Wages Payable (L) ... 73,900
Cash (A) .... 250,900

Assets = Liabilities + Stockholders Equity

Cash 250,900 Wages payable 73,900 Wages expense (+E) 177,000

+ Cash (A) Wages Payable (L) + + Wages Expense (E)

Bal. 323,200 73,900 Bal. Bal. 0
(3) 1,046,000 289,800 (1) (5) 73,900 (5) 177,000
79,700 (2)
40,800 (4)
250,900 (5)

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Analyzing Chipotles Transactions

(6) Chipotle sold for cash land costing $9,000 at a loss of $4,200.

Debit Credit
(6) Cash (+A) .... 4,800
Loss on Disposal of Assets (+E, SE) .... 4,200
Land (A) ... 9,000

Assets = Liabilities + Stockholders Equity

Cash +4,800 Loss on disposal of assets (+E) 4,200
Property and 9,000
equipment
+ Cash (A) + Land (A) + Loss on Disposal of Assets (E)
Bal. 323,200 Bal. 21,100 Bal. 0
(3) 1,046,000 289,800 (1) 9,000 (6) (6) 4,200
(6) 4,800 79,700 (2)
40,800 (4)
250,900 (5)

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Analyzing Chipotles Transactions

(7) Chipotle received $39,000 cash from customers paying on their

accounts.

Debit Credit
(7) Cash (+A) .... 39,000
Accounts Receivable (A) .. 39,000

Assets = Liabilities + Stockholders Equity

Cash +39,000
Accounts 39,000
receivable
+ Cash (A) + Accounts Receivable (A)
Bal. 323,200 Bal. 34,800
(3) 1,046,000 289,800 (1) (3) 25,700 39,000 (7)
(6) 4,800 79,700 (2)
(7) 39,000 40,800 (4)
250,900 (5)

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Analyzing Chipotles Transactions

(8) During the quarter, Chipotle paid suppliers $73,500 on accounts

payable. It also paid $35,900 on utilities payable and $28,400 in
income taxes incurred for part of the first quarter of 2015.

Debit Credit
(8) Accounts Payable (L) ... 73,500
Utilities Payable (L) ........ 35,900
Income Tax Expense (+E, L) .. 28,400
Cash (A) . 137,800

Assets = Liabilities + Stockholders Equity

Cash 137,800 Accounts payable 73,500 Income tax expense (+E) 28,400
Utilities payable 35,900
+ Cash (A) Accounts Payable (L) +
Bal. 323,200 69,600 Bal.
(3) 1,046,000 289,800 (1) (8) 73,500 80,000 (1)
(6) 4,800 79,700 (2)
(7) 39,000 40,800 (4) + Income Tax Expense (E) Utilities Payable (L) +
250,900 (5) Bal. 0 85,400 Bal.
137,800 (8) (8) 28,400 (8) 35,900

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Analyzing Chipotles Transactions

(9) Chipotle paid $75,400 for utilities used during the quarter and paid
$18,700 for repairs and maintenance of its facilities and equipment
during the quarter.

Debit Credit
(9) Utilities Expense (+E, SE)...... 75,400
Repairs Expense (+E, SE) .... 18,700
Cash (A) ... 94,100

Assets = Liabilities + Stockholders Equity

Cash 94,100 Utilities expense (+E) 75,400
Repairs expense (+E) 18,700

+ Cash (A) + Utilities Expense (E) + Repairs Expense (E)

Bal. 323,200 Bal. 0 Bal. 0
(3) 1,046,000 289,800 (1) (9) 75,400 (9) 18,700
(6) 4,800 79,700 (2)
(7) 39,000 40,800 (4)
250,900 (5)
137,800 (8)
94,100 (9)

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Analyzing Chipotles Transactions

(10) Chipotle received $1,200 cash as interest revenue earned during the
quarter.

Debit Credit
(10) Cash (+A) .... 1,200
Interest Revenue (+R, +SE) .... 1,200

Assets = Liabilities + Stockholders Equity

Cash +1,200 Interest revenue (+R) +1,200

+ Cash (A) Interest Revenue (R) +

Bal. 323,200 0 Bal.
(3) 1,046,000 289,800 (1) 1,200 (10)
(6) 4,800 79,700 (2)
(7) 39,000 40,800 (4)
(10) 1,200 250,900 (5)
137,800 (8)
94,100 (9)

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Analyzing Chipotles Transactions

(11) During the quarter, Chipotle sold gift cards to customers for $21,900
in cash (expected to be redeemed for food next quarter).

Debit Credit
(11) Cash (+A) .... 21,900
Unearned Revenue (+L) ...... 21,900

Assets = Liabilities + Stockholders Equity

Cash +21,900 Unearned revenue +21,900

+ Cash (A) Unearned Revenue (L) +

Bal. 323,200 16,800 Bal.
(3) 1,046,000 289,800 (1) 21,900 (11)
(6) 4,800 79,700 (2)
(7) 39,000 40,800 (4)
(10) 1,200 250,900 (5)
(11) 21,900 137,800 (8)
94,100 (9)

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 Chipotles Balance Sheet Accounts
+ Cash (A) + Short-Term Investments (A) + Accounts Receivable (A) + Supplies (A)
Bal. 323,200 Bal. 347,600 Bal. 34,800 Bal. 15,300
(3) 1,046,000 289,800 (1) 347,600 (3) 25,700 39,000 (7) (1) 369,800
(6) 4,800 79,700 (2) 21,500 385,100
(7) 39,000 40,800 (4)
(10) 1,200 250,900 (5) + Prepaid Expenses (A) + Land (A) + Buildings (A)
(11) 21,900 137,800 (8) Bal. 70,300 Bal. 21,100 Bal. 1,275,300
94,100 (9) (2) 79,700 9,000 (6)
543,000 150,000 12,100 1,275,300

+ Equipment (A) Accumulated Depreciation + + Long-Term Investments (A) + Intangible Assets (A)
Bal. 476,300 613,700 Bal. Bal. 531,100 Bal. 68,400

476,300 613,700 531,100 68,400

Accounts Payable (L) + Unearned Revenue (L) + Dividends Payable (L) + Wages Payable (L) +
69,600 Bal. 16,800 Bal. 3,000 Bal. 73,900 Bal.
(8) 73,500 80,000 21,900 (11) (5) 73,900
(1) 76,100 38,700 3,000 0

Utilities Payable (L) + Long-Term Notes Payable (L) + Other Liabilities (L) +
85,400 Bal. 2,000 Bal. 285,900 Bal.
(8) 35,900
49,500 2,000 285,900

Common Stock (SE) + Additional Paid-in Capital (SE) + Retained Earnings (SE) +
500 Bal. 293,800 Bal. 1,718,800 Bal.

500 293,800 1,718,800

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 Chipotles Income Statement Accounts

Restaurant Sales Revenue (R)+ Interest Revenue (R) +

0 Bal. 0 Bal.
1,071,700 (3) 1,200 (10)
1,071,700 1,200

+ Wages Expense (E) + Utilities Expense (E) + Repairs Expense (E) + Training Expense (E)
Bal. 0 Bal. 0 Bal. 0 Bal. 0
(5) 177,000 (9) 75,400 (9) 18,700 (4) 40,800
177,000 75,400 18,700 40,800

+ Loss on Disposal of Assets (E) + Income Tax Expense (E)

Bal. 0 Bal. 0
(6) 4,200 (8) 28,400
4,200 28,400

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How Is the Income Statement Prepared and Analyzed?
CHIPOTLE MEXICAN GRILL
Unadjusted Trial Balance
For the first quarter ended March 31, 2015
(in thousands) Debit Credit
Cash 543,000
Short-term investments 347,600
Accounts receivable 21,500
Supplies 385,100
Prepaid expenses 150,000
Land 12,100
Buildings 1,275,300
Equipment 476,300
Accumulated depreciation 613,700
Long-term investments 531,100
Intangible assets 68,400
Accounts payable 76,100
Unearned revenue 38,700
Dividends payable 3,000
Wages payable 0
Utilities payable 49,500
Long-term notes payable 2,000
Other liabilities 285,900
Common stock 500
Additional paid-in capital 293,800
Retained earnings 1,718,800
Restaurant sales revenue 1,071,700
Interest revenue 1,200
Wages expense 177,000
Utilities expense 75,400
Repairs expense 18,700
Training expense 40,800
Loss on disposal of assets 4,200
Income tax expense 28,400
Total 4,154,900 4,154,900
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How Is the Income Statement Prepared and Analyzed?

Classified Income Statement

CHIPOTLE MEXICAN GRILL

Consolidated Statement of Income
UNADJUSTED
For the Quarter ended March 31, 2015
(in thousands of dollars)

Restaurant sales revenue $1,071,700

Restaurant operating expenses:
Wages expense 177,000
Utilities expense 75,400
Repairs expense 18,700
General and administrative expenses:
Training expense 40,800
Loss on disposal of assets 4,200
Total operating expenses 316,100
Income from operations 755,600
Other items:
Interest revenue 1,200
Income before income taxes 756,800
Income tax expense 28,400
Net income $ 728,400

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Net Profit Margin Ratio
KEY RATIO ANALYSIS

$$$
How effective is management in generating
profit on every dollar of sales?

Net Profit = Net Income

Margin Net Sales (or Operating Revenues)

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Operating Activities
FOCUS ON CASH FLOWS

Companies report cash inflows and outflows in their $$$

statement of cash flows.

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