INCOME STATEMENT

Accounting ASW

Summer 2006

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

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)

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

Merchandise Sale Example

Assume purchase at $80

Inventory 80

Cash 80

Sell for $100

Cash 100

Inventory 80

? 20

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.

What are Retained Earnings?

Retained Earnings is a permanent account (balance sheet)

Measures equity which was created bythe operations of the firm (not contributed)

Not an asset (the associated assets are separately recognized)

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

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

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

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

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

Revenue Timing IssuesCash NowCash 100 Sales Revenue 100

Cash in future Accounts Receivable (Asset) 100 Sales Revenue 100

Cash 100 Accounts Receivable 100

Cash in pastCash 100 Adv. from Cust. (Liab.) 100

Advances from Customers 100 Sales Revenue 100

Problem 3.18

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

Timing of Expenses

Concurrent with cash flowsRent Expense 100 Cash 100

Prior to cash flowRent Expense 100 Rent Payable 100Rent Payable 100 Cash 100

After cash outflowPrepaid Rent 100 Cash 100Rent Expense 100 Prepaid Rent 100

DepreciationSpecial 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 LifeE.g. $1,100 asset, 10-year life, $100 salvage

Depreciation Expense 100 Accumulated Depreciation- (PP&E Contra) 100

Problem 3.20

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

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 doesn’t care if accounts are right until reporting date

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