Basic Accounting Concepts: The Income Statement 3 Basic Accounting Concepts: The Income Statement

Balance Sheet - Review Status report. Financial position at point in time. Assets = liabilities + shareholders’ equity.

Basic Concepts - Chapter 2 (Last Chapter) Money measurement. Entity. Going concern. Cost. Dual aspect.

Basic Concepts - Chapter 3 (This Chapter) Accounting period. Conservatism. Realization. Matching. Consistency. Materiality.

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.

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).

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).

Interim Reports Reports on periods less than fiscal year. SEC requires quarterly. Management may require monthly (or weekly, or daily).

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.

Terminology Cautions Read  as not necessarily the same as: Income  revenue. Net income  increase in cash. Retained earnings  cash.

Concept #7: Conservatism “… prudent reporting based on healthy skepticism… builds confidence in the results....” Preference for understatement rather than overstatement of assets and earnings (and Owners’ equity). If 2 estimates are equally likely, use the one that results in smaller assets and earnings.

Conservatism More Formally Stated Recognize revenues when reasonably certain. Recognize expenses when reasonably possible. Requires judgment.

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).

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.

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 after recognition  Sale on credit. Accounts receivable (on BS). Accrued revenue  E.g., interest receivable = Accrued interest Earned but not yet received.

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.

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.

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. The customer is very weak financially.

Summary of Determination of Revenue Recognize revenue when: Earned (Conservatism) and Realized or realizable (Realization).

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.

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.

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 (unsalable).

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.

Expenses and 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.

Types of Expenditure & Expense Transactions 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).

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.

Dividends Distribution of earnings to owners, not an expense. Cash dividends reduce cash and Retained earnings by same amount.

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.

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.

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.

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.

Parts of Income Statement Heading: Name of entity. Name of statement Time period covered. Revenues. Cost of Sales. Gross Margin. Expenses. Net Income

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.

Expenses on Income Statement Cost of Sales (or cost of goods sold). Associated with a decrease in the asset inventory. Gross margin = gross profit = Sales - COGS. May or may not be shown. Separate disclosure of: Research & development expenses. Interest expense.

Income Statement Format Operating income may be shown before Other revenues and expenses. Income before taxes = Operating income adjusted for other revenues and expenses. Net income = Income before taxes – Income tax expense.

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.

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.

Concepts of Income (Continued) Income Tax Accounting Similar but not identical to accrual/GAAP. Objectives differ from GAAP. Pro forma earnings 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.

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.

Approaches to Accounting for Price Changes Constant dollar accounting Adjust for general price changes. Restates financial statements to purchasing power equivalent as of a common date. Current cost accounting Costs adjusted to their replacement cost or specific prices.

3 End of Chapter 3