INCOME STATEMENT

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INCOME STATEMENT

• Accounting ASW
• Summer 2006

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Warning!

• Income statement is the hardest concept in
  accounting
• Seems intuitive
• More subtle than it seems
• Takes a while to really understand it
• Litmus test Why would we record
• Rent Expense (I/S-Exp) 100
• Rent Payable (B/S-Liab) 100

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Two ways to think about the income statement

• (1) Intuitively (and loosely)
• Lists revenue firm earned
• Even if not yet received (e.g., credit sales)
• Lists all costs incurred to earn revenues
• Even if not yet paid (e.g., rent on credit)
• Calculate whether you were profitable (net
  income)
• Even if not all cash (accrual accounting)

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Two ways to think about the income statement

• (2) The right (and less intuitive) way
• Income statement is part of the balance sheet
• Assets Liab. Contr. Cap. Retained Earnings
• REYear End 06 REYear End 05 NIIn 06
  Div.In 06 OtherIn 06
• Net IncomeIn 06 RevenuesIn 06 -
  ExpensesIn 06
• Therefore, net income is a function of how you
  measured your balance sheet

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Merchandise Sale Example

• Assume purchase at 80
• Inventory 80
• Cash
  80
• Sell for 100
• Cash 100
• Inventory
  80
• ?
  20
  

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What is the credit?

• Is an asset reduced?
• Is a liability created?
• Did investors contribute more capital?
• Therefore, is it retained earnings--residual of
  residual.

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What are Retained Earnings?

• Retained Earnings is a permanent account
• (balance sheet)
• Measures equity which was created by
• the operations of the firm (not contributed)
• Not an asset (the associated assets are
• separately recognized)

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How does it get to RE?

• Put into temporary accounts (measure only net
• income this period)
• Split into revenue and expense
• Cash
  100
• Sales Revenue (Rev.)-RE
  100
• Cost of Goods Sold (Exp.)-RE 80
• Inventory
  80

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What are revenues expense accounts?

• Temporary accounts
• Part of Retained Earnings
• Used to track net income during the period
• Get folded into RE at the end of the period
• Begin and end with zero balances

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Closing Entry

• Recorded at period end after preparing the income
  statement
• Sales Revenue--RE
  100
• Cost of Goods Sold--RE
  80
• Retained Earnings
  20
• Similar entry for other revenues expenses

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Measurement under Accrual Accounting

• Recognize revenues when earned
• Match expenses to revenues where possible
• Net income is revenue net of any associated
• costs, irrespective of cash flows

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Revenue Recognition

• Have performed all (or a substantial
• portion) of service
• Have received an asset (cash or
• receivable) which can be measured
• Revenue may be adjusted for expected
• bad debts and sales discounts and
• allowances

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Revenue Timing Issues

• Cash Now
• Cash 100
• Sales Revenue
  100
• Cash in future
• Accounts Receivable (Asset) 100
• Sales Revenue
  100
• Cash 100
• Accounts Receivable
  100
• Cash in past
• Cash 100
• Adv. from Cust. (Liab.)
  100
• Advances from Customers 100
• Sales Revenue
  100
• Problem 3.18

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Expense Recognition

• Match to revenue to the extent possible--e.g.,
• product cost
• - Merchandising--cost of acquiring inventory
• - Manufacturing--cost of making product
  (including overhead)
• Otherwise charge to expense as consumed--e.g.,
• - selling general and administrative expense
• - research and development expense
• Measure on same basis as asset being consumed

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Timing of Expenses

• Concurrent with cash flows
• Rent Expense
  100
• Cash
  100
• Prior to cash flow
• Rent Expense
  100
• Rent Payable
  100
• Rent Payable
  100
• Cash
  100
• After cash outflow
• Prepaid Rent
  100
• Cash
  100
• Rent Expense
  100
• Prepaid Rent
  100

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Depreciation

• Special case of prepaid expenses
• Spread cost over period of benefit
• - just like other prepaids
• - typically spread straight-line
• - Depreciation Expense (Cost - Estimated
• Salvage)/Estimated useful Life
• E.g. 1,100 asset, 10-year life, 100 salvage
• Depreciation Expense 100
• Accumulated Depreciation-
• (PPE Contra)
  100
• Problem 3.20

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Types of Entries

• Transactions-based entries
• - know to record them based on a
• transaction
• - e.g., receipt/payment of cash, credit
• sale, receipt of bill, etc.
• - recorded during the period

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• Adjusting entries
• - Cases in which there is no immediate
  notification (transaction)
• - Often necessitated by passage of time
• - Expense examples depreciation, accrual of
  salaries, expiration of prepaid rent
• - Revenue examples advances from customers
  earned, interest earned to be collected
• Technically could be recorded every day, but
  typically wait until end of period (quarter)
• Auditor doesnt care if accounts are right until
  reporting date

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• Closing entries
• - Clear out all revenue and expense accounts to
  retained earnings
• - After completing income statement, before
  balance sheet
• Problems 3-30, 3-32 and 3-33