Chapter 3: The Income Statement - Fundamentals of Financial Accounting

Vocabulary and key concepts from Chapter 3 of Fundamentals of Financial Accounting regarding the Income Statement, accrual accounting principles, and financial ratios.

Operating cycle

The period that begins with buying goods and services and continues through to collecting cash from customers.

Revenues

The amounts a business charges its customers when it provides goods or services.

Expenses

Costs of operating the business, incurred to generate revenues in the period covered by the income statement, which are reported when the company uses something.

Net Income/(Loss)

The total calculated by subtracting expenses from revenues; it indicates the amount by which shareholders’ equity increases or decreases from operations.

Cash basis accounting

A method of reporting income based on changes in a bank balance, measuring performance by when cash is received or paid.

Accrual basis accounting

A method of reporting revenues and expenses when services are provided or activities occur, regardless of when cash is received or paid; mandated by ASPE and IFRS for external reporting.

Rule of accrual

The requirement that the financial effects of business activities are measured and reported when the activities actually occur, not when cash is received or paid.

Revenue recognition principle

The principle stating that revenues should be recognized when they are earned, meaning the company has fulfilled its obligation to the customer.

Conditions for revenue recognition

1. Risks and rewards have passed or the earnings process is substantially complete; 2. Measurability is reasonably certain; 3. Collectability is reasonably assured.

Expense recognition principle

Also known as the matching principle, it states that expenses are recognized in the same period as the revenues to which they relate.

Revenue (Expanded Equation Logic)

Revenues increase Net Income and Retained Earnings, and are therefore recorded with credits.

Expenses (Expanded Equation Logic)

Expenses decrease Net Income and Retained Earnings, and are therefore recorded with debits.

Unadjusted trial balance

A report prepared by listing and summing the T-account balances before any end-of-period adjustments.

Net Profit Margin

A measure indicating how much profit is earned from each dollar of revenue, calculated as $\frac{\text{Net Income}}{\text{Total Revenue}}$.

Income Statement Limitations

Misconceptions include the beliefs that net income equals cash generated, that net income represents the company’s total change in value, and that measurement involves only counting rather than estimation.