Chapter 3 -- Income Statement: Reporting the Results of Operating Activities FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition Clyde P. Stickney and Roman L. Weil

Learning Objectives 1. Understand the accrual basis of accounting. 2. Understand when firms recognize revenues and expenses. 3. Build skills in recording transactions. 4. Understand end-of-period adjustments. 5. Develop skills to analyze the income statement.

Chapter Outline 1. Accounting periods. 2. Accounting methods: cash and accrual bases. 3. Measurement principles of accrual based accounting. 4. Overview of accounting procedures. Chapter Summary

1. The Accounting Period Income generating activity occurs almost continuously in modern firms. Financial reports are prepared at the end of time periods of uniform length, for example, months or quarters or years. Uniform time periods facilitate comparisons and analyses. Many companies use the end of the calendar year as the end of their accounting period. Retail stores are an exception so that they may include the entire Christmas season in one period.

2. Accounting Methods for Measuring Performance (a) Cash basis of accounting. Revenues are recognized when cash is received and expenses are recognized when cash is paid. (b) Accrual basis of accounting. Revenues and expenses are recognized on an economic basis without regard for the actual flow of cash.

2.a. Cash Basis of Accounting Intuitive and easy. Provides reliable information about cash flows. Provides information on the liquidity of a firm. Liquidity is the ability of a firm to meet its short term cash obligations. Subject to manipulation, for example, the firm can delay having to recognize an expense by postponing cash payment.

2.b. Accrual Basis of Accounting More difficult conceptually. Economically, changes in wealth may occur without involving cash, for example, a barter trade or a customer purchasing goods on account. Revenues and expenses are recognized independent of the timing of the cash flow. Provides information on long-term profitability. Subject to manipulation by the choice of recognition rules.

3. Measurement Principles of Accrual Accounting Measurement involves both the amount and the timing of the recognition for both revenues and expenses. (a) Timing of revenue recognition. (b) Measurement of amount of revenue. (c) Timing of expense recognition. (d) Measurement of amount of expenses.

3.a. Revenues -- Timing When does the accountant recognize revenue? When both of the following are met: 1. The firm has performed all or most of the services or it has delivered the goods, that is, it has earned the revenue. 2. The firm has received a good, service or right in exchange and can reasonably measure the value of the good, service or right. A promise to pay (such as a receivable) is a right.

3.b. Revenues -- Amount Revenues are measured by the cash or equivalent that it expects to receive. Uncollectible Accounts have no value by definition and are not included in revenue. Sales Discounts and Allowances are reductions in price and not included in revenue. Sales Returns are a reversal of the sale and are not included in revenue. Delayed Payments may carry an implied interest charge.

3.c. Expenses -- Timing Assets provide future benefits to the firm and are consumed in the process of generating revenues. As assets are consumed, the value of the remaining asset is reduced and an expense in incurred, thus, assets flow out of the firm as expenses. Balance Sheet Income Statement Assets Expenses (Expired Costs, (Unexpired Costs) which reduce shareholders’ equity on the balance sheet.)

3.d. Criteria for Expense Recognition Accountants recognize expenses as follows: 1. If an asset expiration associates directly with a revenue, that expiration becomes an expense in the period when the revenue is recognized, that is, expenses are matched to revenues. 2. If an asset expiration does not clearly associate with revenues, that expiration becomes an expense of the period in which the firms consumes the benefits of that asset.

Examples of Expense Recognition Product Costs -- the cost of making a product is not an expense until the product is sold, then it becomes a cost of goods sold expense. Prior to this time, the cost is the unexpired asset, inventory. Marketing Costs -- may or may not give rise to revenue. Most accountants prefer to expense marketing costs in the period when occurred. Administrative Costs -- cannot easily be matched with revenue, so are considered a period cost.

4. Overview of Accounting Procedures (a) Relation between balance sheet and income statement. (b) Purpose and use of individual revenue and expense accounts. (c) Debit and credit procedures for revenues, expenses and dividends. (d) Adjusting journal entries.

4.a. Relation between Balance Sheet and Income Statement. The balance sheet reports assets and financing of those assets at a point in time. The income statement reports revenues and expenses over a period of time. Dividends are a return to the shareholders and are not an expense. Two consecutive balance sheets are connected by the income statement.

The Basic Accounting Equation with Revenues, Expenses and Dividends Assets Liab- ilities Shareholders’ Equity = + Contri- buted Capital Retained Earning Assets Liab- ilities = + + Contri- buted Capital Retained Earning Beginning of Period Assets Liab- ilities Net Income for period - Dividends for period = + + + Contri- buted Capital Retained Earning Beginning of Period Assets Liab- ilities Revenues for period - Expenses for period - Dividends for period = + + +

4.b. Purpose and Use of Individual Revenue and Expense Accounts Revenue and expenses could be recorded directly to the Retained Earnings account. It is more informative to collect revenues and expenses separately during the accounting period. At the end of the accounting period, revenues and expenses are cleared (reset to zero) for the new accounting period. Their balances flow into Retained Earnings. This is called closing the accounts.

4.c. Debit and Credit Procedures for Revenues, Expenses and Dividends Revenues, expenses and dividends are closed to Retained Earnings. Recall that Retained Earnings normally carries a credit balance since it represents a source of financing; thus, credits increase R.E. while debits decrease R.E. Shareholders’ Equity (or R.E.) decreases increases (debit) (credit) Expenses Revenues Dividends Issues of Stock

4.d. Adjusting Entries Some journal entries are made at the end of the accounting period just to separate the effect of an event into its proper periods. Examples include: 1. Recognition of accrued revenues and receivables, 2. Interest calculations, 3. Recognition of accrued expenses and payables, 4. Allocation of prepaid operating costs, and 5. Recognition of depreciation.

4.d.1. Recognition of Accrued Revenues and Receivables A firm earns revenue as it renders services. If part of the service has been rendered in one accounting period and the remainder in others, accrual accounting calls for apportioning the revenue among the appropriate periods. For example, a firm earns rental revenue as the tenant occupies the property. If the rental period spans two accounting periods, accrual accounting calls for splitting the rent revenue between the two in proportion to the rental time.

4.d.1. Recognition of Accrued Revenues and Receivables (Cont.) Notice in contrast, that cash basis accounting would recognize revenue as the cash rent payments were received. Other examples include notes receivable which accrue interest revenue as time passes without regard for the timing of cash payments. The accrued revenue (a credit) is offset by an accrued receivable (a debit) until the cash is paid.

4.d.2. Interest Calculations Interest revenue is earned and interest expense is incurred as time passes. Both of these are accrued in proportion to time. If the interest period spans two or more accounting periods, accrual accounting calls for recognizing the interest at the end of each accounting period in proportion to the amount of time the interest was in effect. The offsetting journal entry is to a receivable (if a revenue) or a payable (if an expense).

4.d.3. Recognition of Accrued Expenses and Payables As a firm receives services, it incurs an obligation to pay for them. If the services are received over a time period spanning two or more accounting periods, accrual accounting calls for recognizing the proportion of service received as an expense. The offsetting journal entry is to a liability account, generally a payable.

4.d.4. Allocation of Prepaid Operating Costs Sometimes, the firm prepays for a service. Since a prepaid service has future benefit, it is an asset until the time for the service expires. If the time period of service spans two or more accounting periods, accrual accounting calls for recognizing the asset when the service begins and adjusting the asset down at the end of accounting periods in proportion to the amount of service used. The asset is reduced (credited) and an expense is recognized (debited).

4.d.5. Recognition of Depreciation Depreciation is a long-term form of a prepaid service. An asset may last many years. As the asset is used, it is expensed. One simple form of depreciation is straight-line. The original cost of the asset is expensed over the useful life in equal amounts over time. Because assets may be purchased at any time during the accounting period, some special rule must apply to the first year of depreciation -- some firms just take one half of a year’s depreciation for the first year.

5. Interpreting and Analyzing the Income Statement The income statement provides information about the profitability of the firm over the long term. Three tools are useful in analysis: 1. Common size statements -- revenues are set to 100% and each expense item is shown as a percentage of revenue. 2. Time series analysis -- changes from year to year are calculated in both revenue and expense items. It is hoped that revenues will grow but that expenses will remain stable or even reduce in proportion to revenue. 3. Cross-section analysis -- revenues and expenses are compared to competitors. Some differences are strategic and some may be driven by different production technologies, but some differences may be due to inefficiency.

Chapter Summary The income statement which measures net income is presented. Revenues and expenses are defined and how they relate to retained earnings is presented. Adjusting entries are defined as journal entries that are made at the end of an accounting period to recognize revenues or expenses but they are not initiated by an economic event. Further chapters discuss the use and analysis of the income statement.