Chapter #3 The Income Statement

THE EXPANDED ACCOUNTING EQUATION

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Unearned Revenue

A liability representing a company's obligation to provide goods or services to customers in the future. (99) The word unearned in the Unearned Revenue account means the company hasn't done everything it was paid to do. It has a liability to do the work or return the cash.

Accounts Payable

Because the cost has not yet been paid at the end of the month, the balance sheet reports a corresponding liability called Accounts Payable. Similar situations arise when employees work in the current period but are not paid their wages until the following period. This period's wages are reported as Wages Expense on the income statement and any unpaid wages are reported as Wages Payable on the balance sheet.

COACH'S TIP

Promises exchanged for promises are not considered transactions, as you learned in Chapter 2. Here, a service has been received in exchange for a promise (of future payment), so it is considered a transaction.

Cash Basis Accounting

Recording revenues when cash is received and expenses when cash is paid. (97)

Stockholders' equity represents stockholders' claims on the company, which come from...

Stockholders' equity represents stockholders' claims on the company, which come from either (1) Contributed Capital, given to the company by stockholders in exchange for stock, or (2) Retained Earnings, generated by the company itself through profitable operations.

Expense Recognition Principle ("Matching")

The business activities that generate revenues also create expenses. Under accrual basis accounting, expenses are recognized in the same period as the revenues to which they relate, not necessarily the period in which cash is paid for them. This is what accountants call the expense recognition principle (or "matching"): record expenses in the same period as the revenues with which they can be reasonably associated. If an expense cannot be directly associated with revenues, it is recorded in the period that the underlying business activity occurs.

The two basic accounting principles that determine when revenues and expenses are recognized under accrual basis accounting are called...

The two basic accounting principles that determine when revenues and expenses are recognized under accrual basis accounting are called the revenue recognition and expense recognition principles.

Expenses

Expenses are costs of operating the business, incurred to generate revenues in the period covered by the income statement. Expenses are reported when the company uses something, like space in a building, supplies for providing services, or the efforts of employees. Basically, whenever a business uses up its resources to generate revenues during the period, it reports an expense, regardless of whether or not payment for the resources has occurred. Expenses are reported in the body of the income statement after revenues.

Accrual Basis Accounting

Recording revenues when earned and expenses when incurred (EARNED), regardless of the timing of cash receipts or payments. The "rule of accrual" is that the financial effects of business activities are measured and reported when the activities actually occur, not when the cash related to them is received or paid. That is, revenues are recognized when they are earned and expenses when they are incurred. (98)

Trial Balance

The best way to ensure your accounts are "in balance" is to prepare a trial balance. A trial balance is an internal report used to determine whether total debits equal total credits. Typically, a trial balance lists every account name in one column (usually in the order of assets, liabilities, stockholders' equity, revenues, and expenses). The ending balances obtained from the ledgers (T-accounts) are listed in the appropriate debit or credit column. A list of all accounts with their balances to provide a check on the equality of the debits and credits. (108)

INCOME STATEMENT ACCOUNTS

The income statement summarizes the financial impact of operating activities undertaken by the company during the accounting period. It includes three main sections: revenues, expenses, and net income.

operating cycle

The period from buying goods and services through to collecting cash from customers is known as the operating cycle. (Pg. 94, 3.1)

Retained Earnings has 2 subcategories

"Revenues" and "Expenses" are subcategories within retained earnings. (102) They are shown this way because revenues and expenses eventually flow into Retained Earnings, but they aren't initially recorded there. Instead, each revenue and expense is accumulated in a separate account, making it easier to identify the amount to report for each item on the income statement. For now, just focus on learning how revenues and expenses are recorded to indicate increases and decreases in the company's earnings, with corresponding effects recorded in the company's asset and/or liability accounts. Because revenue and expense accounts are subcategories of Retained Earnings, they are affected by debits and credits in the same way as all stockholders' equity accounts.

Revenue Recognition Principle

According to the revenue recognition principle, revenues should be recognized when they are earned. The word recognized means revenues are measured and recorded in the accounting system. The word earned means the company has fulfilled its obligation to the customer by doing what it promised to do. For most businesses, these conditions are met at the point of delivery of goods or services.

Timing of Reporting Revenue versus Cash Receipts

All companies expect to receive cash in exchange for providing goods and services, but the timing of cash receipts does not dictate when revenues are recognized. Instead, the key factor in determining when to recognize revenue is whether the company has provided goods or services to customers during the accounting period. Regardless of the length of the period (month, quarter, or year), cash can be received (1) in the same period the goods or services are provided, (2) in a period before the goods or services are provided, or (3) in a period after the goods or services are provided. (98, 3.5) 1. Cash is received in the same period the goods or services are provided. 2. Cash is received in a period before goods or services are provided. An example is when the company receives cash for gift cards that customers use to pay for goods in the future. This obligation is a liability called "Unearned Revenue", and it is recorded on the balance sheet equal in amount to the cash received for the gift card. 3. Cash is to be received in a period after goods or services are provided. This situation typically arises when a company sells to a customer on account. Selling on account means that the company provides goods or services to a customer not for cash, but instead for the right to collect cash in the future. This right is an asset called Accounts Receivable.

Net Income

Net income is a total that is calculated by subtracting expenses from revenues. Because it is a total, net income summarizes the overall impact of revenues and expenses in a single number. It is called a net loss if expenses are greater than revenues, and net income if revenues are greater than expenses. Net income indicates the amount by which stockholders' equity increases as a result of a company's profitable operations. For this reason, net income (or loss) is a closely watched measure of a company's success.

Timing of Reporting Expenses versus Cash Payments

Notice that it is the timing of the underlying business activities, not the cash payments, that dictates when expenses are recognized. Cash payments may occur (1) at the same time as, (2) before, or (3) after the related expenses are incurred to generate revenue. (100, 3.6) 1. Cash is paid at the same time that the expense is incurred to generate revenue. Although this isn't as common in business as in your personal life, expenses are sometimes paid for in the period that they arise. In other words, the benefits of incurring the cost are entirely used up in the current accounting period. 2. Cash is paid before the expense is incurred to generate revenue. It is common for businesses to pay for something that provides benefits only in future periods. 3. Cash is paid after the cost is incurred to generate revenue. Although rent is paid and supplies are purchased before they are used, many costs are paid after receiving and using goods or services.

Balance Sheet vs Income Statement

Notice that the income statement reports the financial effects of business activities that occurred during just the current period. They relate only to the current period and do not have a lingering financial impact beyond the end of the current period. This is a key distinction between the income statement and the balance sheet. The revenues and expenses on an income statement report the financial impact of activities in just the current period whereas items on a balance sheet will continue to have a financial impact beyond the end of the current period. Balance sheet accounts are considered permanent, whereas income statement accounts are considered temporary. Another way people describe this difference is that the balance sheet takes stock of what exists at a point in time whereas the income statement depicts a flow of what happened over a period of time.

Operating activities

Operating activities are the day-to-day functions involved in running a business. Unlike the investing and financing activities in Chapter 2 that occur infrequently and typically produce long-lasting effects, operating activities occur regularly and often have a shorter duration of effect. Operating activities include buying goods and services from suppliers and employees and selling goods and services to customers and then collecting cash from them. Operating activities are the primary source of revenues and expenses and, thus, can determine whether a company earns a profit (or incurs a loss).

Net Profit Margin

Profit earned from each dollar of revenue. (112) Net Profit Margin = Net Income / Total Revenue Example: Currently, Pizza Aroma's accounting records report revenues of $15,500 and expenses of $8,100, $600, and $400, suggesting a net income of $6,400. This $6,400 of net income is about 41.3% of the $15,500 of revenues ($6,400 ÷ 15,500 = 0.413). This net profit margin, as it is called, implies that Pizza Aroma earned 41.3 cents of net income from each dollar of pizza revenue.

The Expanded Debit/Credit Framework

Revenues are recorded on the right (credit). Here's the logic again: Increases in stockholders' equity are on the right, revenues increase stockholders' equity, so revenues are recorded on the right (credit). Decreases in stockholders' equity are recorded on the left side, so to show that expenses decrease net income and retained earnings, expenses are recorded on the left (debit). (102, 3.7)

Revenues

Revenues are the amounts a business charges its customers when it provides goods or services. The amount of revenue earned during the period is the first thing reported in the body of the income statement.

Accounts Receivable

Selling on account means that the company provides goods or services to a customer not for cash, but instead for the right to collect cash in the future. This right is an asset called Accounts Receivable. (99)

Time Period Assumption

The assumption that allows the long life of a company to be reported in shorter time periods. (96)