Chapter 3: The Income Statement

LO3-1: Describe common operating transactions and select appropriate income statement account titles.
LO3-2: Explain and apply the revenue and expense recognition principles.
LO3-3: Analyze, record, and summarize the effects of operating transactions, using the accounting equation, journal entries, and T-accounts.
LO3-4: Prepare an unadjusted trial balance.
LO3-5: Evaluate net profit margin, but beware of income statement limitations.

Operating Cycle: The period that begins with buying goods and services and continues through to collecting cash from customers.
Operating Activities: Day-to-day functions involved in running a business; the primary source of revenues and expenses.

Purpose: Summarizes the financial impact of operating activities undertaken by the company during the accounting period.
- Main Sections:
- Revenues: Amounts charged to customers for goods/services provided.
- Expenses: Costs incurred to generate revenues for the period, recognized when the item is utilized.
- Net Income/(Loss): Calculated by subtracting expenses from revenues. This total indicates changes in shareholders’ equity due to operations.
Time Period Assumption: Divides the long life of a company into shorter periods (e.g., months, quarters, years).

Example: Prairie Proud Income Statement
- Period: For the Month Ended September 30, 2023
- Revenues:
- Sales Revenue: $11,000 (Amount earned from apparel sales)
- Total Revenues: $11,000
- Expenses:
- Supplies Expense: $4,000 (Cost of supplies)
- Salaries and Wages Expense: $2,000 (Cost of salaries for September)
- Rent Expense: $1,500 (Cost of rent for September)
- Utilities Expense: $600 (Cost of utilities)
- Insurance Expense: $300 (Cost of insurance)
- Advertising Expense: $100 (Cost of advertising)
- Income Tax Expense: $500 (Cost of taxes)
- Total Expenses: $9,000
- Net Income: $2,000 (Difference between total revenues and expenses)

Definition: Income based on changes in the cash balance.
Example Scenarios:
- MONTH 1: No cash is received, expenses of $10,000 paid → Net Income (Loss) = $-10,000
- MONTH 2: Cash received of $15,000, no cash paid → Net Income = $15,000.

Definition: Reports revenues and expenses when services are provided, regardless of cash transactions.
Example Scenarios:
- MONTH 1: Products worth $15,000 provided, expenses of $10,000 → Net Income (Loss) = $5,000
- MONTH 2: No cash received, Net Income = $0 (services provided earlier).

Guideline: Under ASPE and IFRS, accrual basis is mandatory for external reporting; the cash basis is only for internal use in some small companies.
Principles of Accrual Accounting:
- Financial effects of business activities are recognized when transactions occur, not when cash changes hands.

Definition: Revenues recognized when earned.
Conditions for Recognition:
1. Risks and rewards have passed or earnings process is substantially complete.
2. Measurability is reasonably certain.
3. Collectability is reasonably assured.

Definition: Occurs when cash is received before goods/services are provided. It's a liability indicating future service obligations.

Definition: Expenses are recognized in the same period as the revenues they generate.
- If not directly linked to revenues, recorded in the period the underlying activity occurs.

Example Scenarios:
- Case 1: Cash paid before expense incurred → No expense recorded until use.
- Case 2: Cash paid at the same time as expense → Expense reported immediately.
- Case 3: Expense incurred before cash payment → Expense recorded when incurred, even if payment is delayed.

Concept: Explains shareholders’ equity as the sum of contributed capital and net income/loss from the income statement.
Net income is critical as it directly affects both revenues and expenses, being a component of the expanded accounting equation.

Examples of Transactions:
- (a) Provide Apparel for Cash: Sold $15,000 of apparel to customers, treated as cash if paid by card.
- (b) Receive Cash for Future Services: Issued $300 in gift cards, creating deferred revenue liability.
- (c) Provide Apparel on Credit: $500 of apparel to a university organization, billing it on account.
- (d) Receive Payment on Account: Received a $300 cheque as partial payment.
- (e) Pay Cash to Employees: $8,700 e-transferred for salaries.
- (f) Pay Cash in Advance: $7,200 paid for rent covering upcoming months.
- (g) Pay Cash for Supplies: $1,600 for various supplies.
- (h) Incur Cost to Be Paid Later: $400 online ad bill to be paid in October.
- (i) Pay Cash for Expenses: $600 automatic payment for utilities.

Definition: Prepared by listing each account and its T-account ending balance. Total debits must equal total credits.

Focus: The income statement serves as a measure of operating performance for a specific period, critical to analyze net income.
- Positive net income indicates revenues exceed expenses.
- Assessment of whether revenues grow faster than expenses is integral for evaluating performance trends.

Purpose: Evaluate company trends and compare results against industry averages.
Formula: Net Profit Margin = ( \frac{Net Income}{Total Revenue} )
- Interpretation: Indicates profit earned from each dollar of revenue. A higher ratio reflects better performance.

Common Misconceptions:
1. Net income does not equal cash generated during the period (especially under accrual basis accounting).
2. Net income does not accurately represent a company’s value.
3. Income measurement involves estimation, not just counting.

The income statement reports transaction results affecting net income, comprising revenues and expenses.
Key concepts: revenue recognition principle and expense recognition principle.
Transactions are analyzed, recorded, and summarized through the accounting equation, journal entries, and T-accounts.
An unadjusted trial balance is prepared to ensure total debits equal total credits.
While income statements have limitations, net profit margin serves as a useful performance evaluation tool.