Financial Accounting Lesson 3: The Income Statement Ben Trnka/Boz Bostrom www.benandboz.com

Let’s start with an example! To the right is Amazon’s income statement Is Amazon a profitable company? How much has Amazon grown over the past two years? Is Amazon paying more taxes as it grows?

Overview: Understand cash vs. accrual accounting Understand revenues, expenses, and net income Learn how to prepare journal entries for income statement accounts Learn how to prepare an income statement

The Operating Cycle Companies receive cash payment Companies purchase goods, often on account Companies sell goods, often on account Companies pay for these goods with cash

Accounts receivable/payable can be significant What is Wal-Mart’s revenue? $500B What is Wal-Mart’s accounts receivable? $6B What is Wal-Mart’s accounts payable? $46B What is Exxon Mobil’s revenue? $244B What is Exxon Mobil’s accounts receivable? $21B What is Exxon Mobil’s accounts payable? $22B

Revenues Inflows of assets due to regular/ongoing transactions Usually either cash, or accounts receivable, which when collected becomes cash Recorded when earned Considered earned when goods are delivered or services are provided An inflow of assets due to a peripheral transaction is called a gain

Expenses Ouflows of assets due to regular/ongoing transactions Usually either cash, or a payable/liability, which is ultimately paid in cash Recorded when incurred / matched to revenue Specific requirements Probable Reasonable estimable An outflow of assets due to a peripheral transaction is called a loss

Knowledge Check Order the accounts as they would appear on an income statement Accounts: Cost of sales Gain from sale of assets General and administrative expenses Income tax expense Interest expense Loss on sale of assets Sales revenue Service revenues Sales revenue Service revenues Cost of sales General and administrative expenses Interest expense Gain from sale of assets Loss on sale of assets Income tax expense

Income Statement Subtotals Gross margin Sales – cost of sales Earnings before interest, taxes, depreciation, and amortization (EBITDA) Subtracts selling, general, and administrative expenses Operating income (EBIT) Subtracts depreciation and amortization Income before income taxes Subtracts interest expense, net of interest income Subtracts peripheral losses, net of gains Net income Subtracts income taxes

Why should you care? Investors/creditors generally want cash from their returns In the long-run, net income and cash flows will be fairly similar Increasing revenues often leads to increasing income and cash flows Expenses – are they increasing more or less quickly than revenues? Net income – is it increasing?

Accounting Equation - Expanded Assets = Liabilities + Equity Debit Credit + -   Debit Credit - +   Debit Credit - Dividends and Losses + Income   Revenues Expenses Debit Credit - +   Debit Credit + -  

Revenue Examples A company provides $100 of services for cash Dr. Cash 100 Cr. Service Revenues 100 A company provides $150 of services on account Dr. Accounts Receivable 150 Cr. Service Revenues 150 A company collects $150 for the services provided on account Dr. Cash 150 Cr. Accounts receivable 150

Revenue Examples A company collects $200 cash for services to be provided in the future Dr. Cash 200 Cr. Unearned Revenues 200 A company provides services for the $200 collected in advance Dr. Unearned Revenues 200 Cr. Service Revenues 200

Expense Examples A company pays interest of $100 in cash Dr. Interest expense 100 Cr. Cash 100 A company pays income taxes of $90 in cash Dr. Income Tax Expense 90 Cr. Cash 90 A company incurs wages of $250 but doesn’t yet pay them Dr. Wages expense 250 Cr. Wages payable 250 A company pays the wages Dr. Wages payable 250 Cr. Cash 250

Combined Example A company purchases inventory for $300 on account Dr. Inventory 300 Cr. Accounts payable 300 A company sells the $300 of inventory for $500 cash Dr. Cash 500 Cr. Sales revenues 500 Dr. Cost of goods sold 300 Cr. Inventory 300 A company pays off its $300 on account Dr. Accounts payable 300 Cr. Cash 300

T-Accounts

Prepare the company’s income statement Service revenue 450 Sales revenue 500 Cost of Goods Sold -300 Gross margin 650 Wages expense -250 Operating income 400 Interest expense -100 Income before income taxes 300 Income tax expense -90 Net income 210 If the company has 100 shares outstanding, what is its earnings per share? $210 net income / 100 shares outstanding = $2.10 earnings per share

Thanks for tuning in! Key Takeaways Revenues, Expenses, and Net income Record revenues when earned Record expenses when incurred / match to revenues Know how to record transactions using journal entries Revenues are credits Expenses are debits Cash receipt does not equal revenues Cash payment does not equal expenses Know how to create an income statement Thanks for tuning in!