Download The Income Statement

Chapter 3
Basic Accounting Concepts:
The Income Statement
1
Balance Sheet - Review
 Status
report.
 Financial position at point in time.
 Assets = liabilities + shareholders’ equity.
2
Basic Concepts - Chapter 2
(Last Chapter)
 Money
measurement.
 Entity.
 Going
concern.
 Cost.
 Dual
aspect.
3
Basic Concepts - Chapter 3
(This Chapter)
 Accounting
period.
 Conservatism.
 Realization.
 Matching.
 Consistency.
 Materiality.
4
Nature of Income
 Summarizes
results of operations for a
period of time.
 Flow report.
 Flows are continuous.
 Focuses on earnings activities (or
operating activities).

Reports nature and magnitude.
5
Elements of Income Statement
 Revenues
•
Inflows or creation of assets that result from
sales of goods or services.
 Expenses
•
Outflows or consumption of resources to
generate revenues.
 Revenues
- expenses = income = net
income (loss) = earnings = profit = net
earnings (loss).
6
Concept #6:
Accounting Period
 Net

income for life of company:
= Money in - money out.
 Accounting

period:
Specified arbitrary interval of time.
 Accounting
year = fiscal year = calendar
year (if fiscal YE is 12/31).
 Natural business year (1/31 for retailers).
7
Interim Reports
 Reports
on less than fiscal year.
 SEC requires quarterly.
 Management may require monthly (or
weekly, or daily).
8
Income and Owners’ Equity
 Owners’ equity
= Stockholders’ equity (for
a corporation) = Paid-in-capital + Retained
earnings.
 RE =  net income -  dividends
 Net income = Revenues - expenses
 Increases RE:

Revenues and net income.
 Decreases

RE:
Expenses and net losses.
9
Terminology Cautions
 Read



 as not necessarily the same as:
Income  revenue.
Net income  increase in cash.
Retained earnings  cash.
10
Concept #7:
Conservatism
 “…
prudent reporting based on healthy
skepticism… builds confidence in the
results....”
 Preference for understatement rather than
overstatement of assets and earnings (i.e.,
Owners’ equity).

If 2 estimates are equally likely, use the one
that results in smaller assets and earnings.
11
Conservatism
More Formally Stated
 Recognize
revenues when reasonably
certain.
 Recognize expenses when reasonably
possible.
 Requires
judgment.
12
Application of Conservatism:
Inventory
 How
much should the following inventory
items be valued at 12/31:


Cost of item A is $500. We could sell item A
for $800.
Cost of item B is also $500. Because of a
new competitor’s product on the market, item
B can be sold for only $400.
 Example
of lower of cost or market (LCM).
13
Application of Conservatism:
Revenue Recognition
 Earning

process is complete.
Sale of goods recognized when :
• Goods are shipped.

Revenue from services recognized when:
• Services are performed.
14
Cash Receipts and
Revenue Recognition
 Cash
can be collected in the period
before, same as or after revenue is
earned.
 Precollected 

Unearned revenue, a liability.
 Collected


Sale on credit.
Accounts receivable (on BS).
 Accrued

after recognition 
revenue 
E.g., interest receivable = Accrued interest 15
Revenue Recognition Exercise
 For
each of the following indicate how
much revenue is earned and the amount
of receivable or liability on the BS.



We sold subscriptions for $1,200. The
magazines will be sent next year.
We shipped goods for which the customer
will pay $1,500 next month.
On 9/30 we loaned $1,000. 8% interest and
principal are to be paid in one year. It is now
12/31.
16
Concept #8:
Realization
 Indicates
amount of revenue that should
be recognized.

Conservatism concept indicates when
revenue should be recognized.
 Recognize

as revenue:
Amount that is reasonably certain to be
realized.
 Realized
= cash received.
17
Realization Concept Exercise
 For
each of the following, how much
revenue should be recorded:



The list price of the product sold to a
customer is $100,000. Because of the
large quantity, we agreed to a 15%
discount off of list.
We are a retail store that sells for cash and
on credit. We sold $400,000 on credit last
month. Based on prior experience, we
expect that we will eventually collect about
97% of our sales.
We sold $10,000 of old product on credit. 18
Summary of
Determination of Revenue
 Recognize


revenue when:
Earned (Conservatism) and
Realized or realizable (Realization).
19
Concept #9:
Matching
 When
an event affects both revenues and
expenses, the effect should be recognized
in the same accounting period.


First determine revenues for period.
Then expense matching items of cost.
20
Terminology Related to
Expenses
 Cost
= a monetary measurement of the
amount of resources used for some
purpose.
 Expenditure = a decrease in an asset or
increase in a liability.
 Expense = an item of cost applicable to
the current accounting period.
 Disbursement = a payment of cash.
21
Criteria for Expense
Recognition
 Direct
matching: e.g., COGS.
 Period costs: items of expense of an
accounting period that cannot be traced to
specific revenue transactions. e.g.,
president’s salary.
 Costs not associated with future revenue:
e.g., inventory determined to be obsolete
(worthless).
22
Expense Recognition Exercise
 Classify
the following as (1) direct
matching, (2) period costs, or (3) costs not
associated with future benefits and
indicate when expensed:
•
•
•
•
•
•
Costs of goods sold.
Controller’s salary.
Sales person’s commission based on sales.
Inventory that just became obsolete.
Sales person’s monthly salary.
Building lost in a fire.
23
Expenses and Expenditures
 Expenditures




Made by paying cash or incurring a liability.
Occur when acquiring goods or services.
Can be assets and/or expenses.
No necessary relationship between amounts
of expenditures and expenses.
• Except over life of entity.
24
Types of Expenditure &
Expense Transactions
1
2
3
4
Expenditures and expenses of same year.
Expenditures of prior year (assets at
beginning of year) that are expenses of
this year).
Expenditures of this year that are
expenses of future years (assets at end of
year).
Expenses of this year that will be paid for
in future years (liabilities at end of year).
25
Exercise
Which type of expenditure are each of the following?
• President’s salary; rent of sales office.
• Inventory purchased last year & sold this.
• Building purchased several years ago.
• Insurance premium paid last year.
• Costs of goods purchased or produced this year
but not yet sold.
• Equipment purchases.
• December salary of president not yet paid.
• Interest expense on loan not yet paid.
26
Dividends
 Distribution
of earnings to owners, not an
expense.
 Cash dividends reduce cash and Retained
earnings by same amount.
27
Gains and Losses
 Not
associated with routine operations.
 Cash received (if any) less costs.
 Gains increase RE (similar to revenues).
 Losses decrease RE (similar to
expenses).
 In practice, no sharp distinction between
gains and revenues and expenses and
losses.
28
Concept #10:
Consistency
 Once
an accounting method is selected
use for all subsequent events of same
character.
 Can change if there is sound reason to
change.

Must be disclosed to users.
 Consistency
overtime not over different
types of transactions.
29
Concept #11:
Materiality
 Insignificant

events may be disregarded.
Amounts need not be exact as long as
inaccuracy would not affect decisions of
users.
 Full
disclosure of all important info.
 Overriding concern: Would knowledge of
event affect decisions of users?
 Application of judgment and common
sense.
30
Income Statement
 Also
called: Profit & Loss statement = P&L
statement = statement of earnings =
statement of operations
 Technically subordinate to BS.

Shows detail of changes to RE.
 Many
investors consider IS more
important than BS.
 Variations in format.
31
Parts of Income Statement

Heading:
1.
2.
3.





Name of entity.
Name of statement
Time period covered.
Revenues.
Cost of Sales.
Gross Margin.
Expenses.
Net Income
32
Revenues in Income Statement
 Several
separate revenue items or net.
 Net sales = gross sales - sales returns and
allowances - sales or cash discounts.



Trade discounts not shown.
Excludes sales or excise taxes collected for
government.
Other revenues (from activities not associated
with sales of entity’s goods/services) may be
included in net sales or shown separately.
33
Expenses on Income Statement

Cost of Sales (or cost of goods sold).


Gross margin = gross profit = Sales - COGS.


Associated with a decrease in the asset inventory.
May or may not be shown.
Separate disclosure of:


Research & development expenses.
Interest expense.
34
Income Statement Format
 Operating
income may be shown before
Other income and expense.
 Net income = Income before taxes –
Income tax expense.
 Income before taxes = Operating income
adjusted for other revenues and expenses.
35
Statement of Retained Earnings
 May
be presented at bottom of Income
Statement.
 Reconciles change in RE from beginning
(i.e., end of last period) to end of this
period.
 Beg. RE + NI - Div = End. RE
 Articulates BS and IS.

NI from IS (less dividends) explains changes
in RE.
36
Concepts of Income
 Accrual
accounting: GAAP, focus of text.
 Cash-basis accounting.

Cash receipts (revenues) - cash payments
(expenses).
 Modified

cash-basis accounting.
E.g., cash basis except for inventory and
long-lived assets.
37
Concepts of Income
(Continued)

Income Tax Accounting



Pro forma earnings


Similar but not identical to accrual/GAAP.
Objectives differ from GAAP.
Alternative to GAAP; excludes item(s) management
deems to be nonrecurring.
Economic Income.


Value at end - value at beginning – return on invested
capital.
Considers cost of using owners’ investment as an
expense.
38
Accounting for Changing Prices

Not required by U.S. GAAP.




Required in some countries with high rates of
inflation.
Used by some multinational companies for internal
performance measurement.
Previously required by U.S. GAAP in supplemental
disclosures.
Ignoring changing prices during periods of
inflation tends to:


Overstate return on investment.
Makes comparisons between companies difficult.
39
Approaches to Accounting for Price
Changes
 Constant


Adjust for general price changes.
Restates financial statements to purchasing
power equivalent as of a common date.
 Current

dollar accounting
cost accounting
Costs adjusted to their replacement cost or
specific prices.
40