Chapter 3: The Income Statement

Objective 3.1: Describe common operating transactions and select appropriate income statement account titles.

Operating Activities

• Operating activities occur routinely and are necessary for running a business. They often have a shorter duration of effect.
• Operating activities ^^produce expenses and revenues^^ for a company.
• Examples include:
  • Selling a good or service
  • Buying a good or service
  • Cash payments
  • Receiving cash
• The transactions between a company and a customer when selling goods or services is called the operating cycle.
• ^^The order of the operating cycle is^^:
  • Buying goods and services
  • Paying cash to suppliers and/or employees
  • Selling goods and services
  • Receiving money from customers
• The journal entries for this cycle would be structured like:

1. Buying goods and services

2. Paying suppliers and/or employees

3. Selling goods and services

4. Receiving cash from customers

The Income Statement

• The Income Statement vs the Balance Sheet
  • Income Statements show the activities over a period of time (month ended, year ended)
  • The accounts under an Income Statement are ^^temporary^^.
  • Balance Sheets records assets, liabilities, and stockholders’ equity at specific point in time (like a snapshot)
  • Accounts under the Balance Sheet are ^^permanent^^.
• Under the Income Statement, you will find:
  • Revenues
  • Expenses
  • Net Income or Loss
• Revenues are the amount of ^^money generated^^ from selling goods or services. They are recorded when earned (doing the sale or service). Just because they are reported, does not mean they have gotten paid yet.
• Expenses are ^^costs incurred^^ from business operations. They are reported when resources are used, like supplies, land, buildings, etc.
• Net Income or Loss measures the company’s success
• To have Net Income, revenues must be greater than expenses.
  • Net Income INCREASES stockholders’ equity.
• To get Net Loss, expenses are higher than revenues.
  • Net Loss DECREASES stockholders’ equity.
• @@Equation to calculate net income or loss:@@
  • Revenues - Expenses = Net Income or Loss
• The Income Statement uses the Time Period Assumption - Dividing the company’s long life into shorter chunks of time such as months, quarters, and years.

Cash Basis Accounting

• Cash basis accounting records revenues when cash is received and expenses when cash is paid.
• ^^Cash may not be received when something is paid “on account” or by credit^^.
• When cash is paid but not received, expenses are recorded and it creates an inaccurate representation of the company.
• When cash is received but not paid, revenues are recorded and it looks good for the company.

Objective 3.2: Explain and apply the revenue and expense recognition principles.

Accrual Basis Accounting

• In Accrual Basis Accounting, revenues are recorded when earned and expenses are recorded in the same period as correlated revenues (regardless of cash received or payment)
• Accounting standards:
  • GAAP - Generally Accepted Accounting Principles
  • IFRS - International Financial Reporting Standard
• Both GAAP and IFRS use accrual accounting for external reporting of income.
• The two basic accounting principles associated with accrual accounting are the revenue recognition principle and the expense cognition principle.

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Revenue Recognition Principle

• The Revenue Recognition Principle says that revenues are acknowledged when the good or service is provided to the customer and not when cash is received.

• ^^Three scenarios can apply to revenues^^.

• Scenario 1: Cash is received before a sale or service.

  

• Scenario 2: Cash comes in with the sale or service.

  • The cash and revenue are reported at the same time.
  • ONE journal entry: An asset is debited (cash) and revenue is credited at the same time.

  

• Scenario 3: The sale or service happens first and cash comes after.

  • Sale/service is provided, so an asset is debited (accounts receivable) and revenue is credited.
  • Cash is received, so an asset is debited (cash) and an asset is credited (accounts receivable).

  

• Deferred Revenue is a liability on the Balance Sheet. It means you ^^promise to provide a sale or service^^.

• The term “on account” means you bought a good or service without cash and ^^will owe cash to the company in the future^^.

• Accounts Receivable is the right to collect cash from a customer who paid “on account”. It is an asset on the Balance Sheet.

Expense Recognition Principle

• The Expense Recognition Principle (aka “matching”) means expenses are recorded in the same period as revenues.
• An expense is recorded when an asset is used.
• ^^Three scenarios can apply to expenses^^.
  • When paying for supplies, an asset is debited and an asset is credited.
  • When the supplies are used up, an expense is credited and an asset is credited.
  • This can apply to supplies, equipment, prepaid rent, etc.

Scenario 1: Cash is paid before the expense

Scenario 1: Cash is paid and expense is reported in the same period

• ^^Only one journal entry^^: An expense is debited and an asset is credited.
• 

Scenario 3: Cash comes after the expense is reported

• When services are used up, an expense is debited and a liability is credited (Accounts Payable).
• When you pay cash for the service used up, the liability is debited (Accounts Payable) and the asset is credited (cash)
• 
• Accounts Payable - A promise to pay in the future.

Objective 3.3: Analyze, record, and summarize the effects of operating transactions using the accounting equation, journal entries, and T-accounts.

The Expanded Accounting Equation

• Basic accounting equation: Assets = Liabilities + Stockholders’ Equity.
• The Expanded Accounting Equation breaks down the contents of Stockholders’ Equity.
• Stockholders’ Equity consists of Common Stock and Retained Earnings.
• ^^Retained Earnings has two subcategories^^:
  • Revenues
  • They have a normal credit balance (right side of T-account).
  • Increases Net Income.
  • Increases Retained Earnings.
  • Expenses
  • Expenses have a normal debit balance (left side of T-account).
  • Decreases Net Income.
  • Decreases Retained Earnings.

Totaling T-Accounts

• Each individual T-account must have an ending balance.

• T-accounts for assets, liabilities, and stockholders’ equity are totaled.

  

Objective 3.4: Prepare an unadjusted trial balance.

Unadjusted Trial Balance

• An adjusted trial balance makes sure debits equal credits after finding the ending balances for each account. Adjustments are made if needed.
• The totals for accounts with normal debit balances are found in the left column and the totals for accounts with a normal credit balance are found in the right column.

Objective 3.5: Evaluate net profit margin, but beware of Income Statement limitations.

Net Profit Margin

• The Net Profit Margin is the profit made from revenues.

• @@Equation to calculate net profit:@@

  

Income Statement Limitations

• ^^Three misconceptions about the Income Statement^^:
  • Net Income is NOT the cash generated by the business.
  • Net Income does NOT report the change in the company’s value during the period. When assets increase and decrease during a period of time, this is not reflected in Net Income.
  • Net Income is NOT exact, it is an estimate.

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