The Income Statement and the Statement of Cash Flows

Income Statement

Revenue is generated when a firm sells a product or provides a service to a client or customer and receives cash, creates an accounts receivable, or satisfies an obligation.

Revenue is generally measured by the amount of cash received or expected to be received from a transaction.

When is revenue realized?

When the product or service has been exchanged for cash, claims to cash, or an asset that is readily convertible to a known amount of cash.

When is revenue earned?

When the firm has completed, or substantially completed, the activities it must perform to be entitled to the revenue benefits.

Should companies disclose unusual revenue recognition methods?

Yes, such as percentage-of-completion or installment methods

Sales Returns

Merchandise returned by the customer

Sales allowances

A reduction in the amount owed by the customer as a result of defective merchandise received

Sales discounts

A reduction in the amount owed by the customer to encourage prompt payment on account

Cost of Goods Sold: Perpetual vs Periodic Inventory Systems

In a perpetual inventory system, cost of goods sold is determined for each sale.

In a periodic inventory system, cost of goods sold is determined at the end of the period.

Recording Cost of Goods Sold Under a Perpetual System

A record is made of every purchase and every sale, and a continuous record of the quantity and cost of each item is maintained. When an item is sold, its cost is transferred from the inventory asset to the cost of goods sold expense.

Gross Profit

The excess of sales over cost of goods sold

Sales Price with Gross Profit Ration Equation

Selling Price = Cost of Product / (1 - Desired gross profit ratio)

Expenses

Outflows or other using up of assets or incurring liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing central operations

Operating Expenses

Usually reported in the following classifications on the income statement:

Selling Expenses

General and administrative expenses

Research and development expenses

Earnings Per Share formula

Net income / average number of shares of common stock outstanding during the year.

Statement of Cash Flows

Provides relevant information about the cash receipts and cash payments of an enterprise during a period.

Shows why cash and cash equivalents changed during the period by reporting net cash provided or used by operating activities, investing activities, and financing activites

Cash Flows from Investing and Financing Activies

1. Investing activities relate primarily to the purchase and sale of noncurrent assets

2. Investments in debt or equity securities of other entities are also shown as investing uses

3. The lending of money and subsequent collection of loans are considered investing activities as well.

Interpreting the Statement of Cash Flows

A business entity should have positive cash flows from operating activities. If operating activities do not generate cash, the entity must look to outside parties for funds to meet its day-to-day activities.