Chapter 3

Basic
Accounting
Concepts: The
Income
Statement
McGraw-Hill/Irwin

Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.

Basic Concepts
(From Last Chapter)
Money measurement.
Entity.
Going concern.
Cost.
Dual aspect.

3-2

Basic Concepts
(This Chapter)
Accounting period.
Conservatism.
Realization.
Matching.
Consistency.
Materiality.
3-3

Balance Sheet:
Chapter 2 Review
Status report.
Financial position at point in time.
Assets = Liabilities +
Shareholders equity.

3-4

Income Statement
Flow report.
Summarizes results of operations for
a period of time.
Focuses on earnings activities (i.e.,
operating activities).
Reports on both what caused the
activity (i.e., nature) and how large
the effect (i.e., magnitude).
3-5

Income Statement:
Basic Elements
Revenues:
Inflows or creation of assets that
result from sales of goods or
services.

Expenses:
Outflows or consumption of
resources to generate revenues.
3-6

Income Statement:
Basic Elements
Revenues - Expenses = Income.
Other names for income:
Profit.
Net income.
Net earnings.

If expenses exceed revenues,

Net loss.
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Concept #6:
Accounting Period
Measurement of activities for a
specified arbitrary interval of time.
A one-year timeframe is commonly
used:
Fiscal year,
Natural business year (e.g., 1/31 for
retailers).
May or may not coincide with calendar
year.
3-8

Accounting Period
Interim Reports.
Reports on periods less than fiscal
year.
SEC requires quarterly.
Management may require monthly
(or weekly, or daily).

1-9

Relationship Between
Income and Owners
Equity

Stockholders equity:

Paid-in-capital + Retained earnings.

Retained Earnings:
Sum of all net income (loss) to date
minus all dividends paid out to date.
Accounting Period
Retained
Earnings
Jan 1

Plus: Net Income

Minus: Net Loss
Minus: Dividends

Retained
Earnings
Dec 31
3-10

Terminology Cautions
Income

IS
NOT

Net income

Revenue
IS
NOT

Increase in Cash

Retained Earnings

Cash
IS
NOT

3-11

Concept #7:
Conservatism
prudent reporting based on healthy
skepticism
builds confidence in the results....
Preference for understatement rather
than overstatement of assets and
earnings.
If two estimates are equally likely, use
the one that results in smaller assets and
earnings.
3-12

Conservatism
Formally:
Recognize revenues when reasonably
certain.
Recognize expenses when reasonably
possible.

Informally:
anticipate no profits but anticipate all
losses.
Sometimes requires judgment.
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Application of
Conservatism:
Revenue Recognition
Recognize revenue when
earnings process is complete.
Sale of goods recognized when:
Goods are shipped.

Revenue from services recognized

when:
Services are performed.
3-14

Application of
Conservatism:
Revenue Recognition
When cash is collected does not
affect revenue recognition.
Recognize later, collect now.
Precollected (Unearned) revenue.
E.g., magazine subscriptions.

Recognize now, collect later.

Sales on credit (i.e., accounts receivable).
Interest on a loan (i.e., interest receivable).

3-15

Concept #8:
Realization
Indicates amount of revenue that
should be recognized.
Conservatism indicates when.

Recognize amount that is

reasonably certain to be realized.

3-16

Realization Concept
Application
How should each of the following
affect revenue realization?
Price discounts?
Uncollectible accounts?
The financial stability of a credit
customer?

3-17

Summary
Determination of
Revenue
Recognize revenue when:
Earned (Conservatism) and
Realized or realizable (Realization).

3-18

Concept #9:
Matching
When an event affects both
revenues and expenses, the
effect should be recognized in
the same accounting period.
First determine revenues for period.
Then expense matching items of
cost.
3-19

Terminology Related
to Expenses
Cost.
amount of resources used for some purpose.

Expenditure.
a decrease in an asset or increase in a liability.

Expense.
an item of cost applicable to the current
accounting period.

Disbursement .
a payment of cash.
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Criteria for Expense

Recognition
Direct matching.
E.g., Cost of goods sold.

Period costs.
Items of expense of an accounting period
that cannot be traced to specific revenue
transactions.
E.g., presidents salary.

Costs not associated with future revenue.

E.g., inventory determined to be obsolete
(unsalable).
3-21

Expense Recognition
Exercise
When should each of the following be
expensed and why?
Shipping costs?
Controllers salary?
Sales persons commission (based on
sales)?
Sales persons monthly salary?
Employee training costs?
Building lost in a fire?
3-22

Expenditures vs.
Expenses
Expenditures:
Made by paying cash or incurring a
liability.
Occur when acquiring goods or services.
Can be assets and/or expenses.
No necessary relationship between
amounts of expenditures and expenses
(except over life of entity).
3-23

Types of Expenditure
& Expense
Transactions
Think of an example that fits each scenario below

Expenditur
e

Expense

This year
Prior year
This year
Future year

This year
This year
Future year
This year

3-24

Expenditures vs.
Expenses
Exercise
For each of the following, when does
the expense occur?
1. Presidents salary is paid at the end of
each month.
2. Fire insurance for this year was paid last
year.
3. Next years rent on a storage
warehouse was paid this year.
4. Interest expense on a loan due next in 2
years will be paid at maturity.
3-25

Dividends
Not an expense.
Distribution of earnings to
owners.
Cash dividends reduce Cash and
Retained earnings by same
amount.
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Gains and Losses

Not associated with routine
operations.
Cash received (if any) less book
value.
Gains increase Retained earnings.
Similar to revenues.

Losses decrease Retained earnings.

Similar to expenses.
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Concept #10:
Consistency
Once an accounting method is
selected, use for all subsequent
events of same character.
Can change if there is sound reason
to change.
But must be disclosed to users.
Consistency over time, not for
different types of transactions.
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Concept #11:
Materiality
Full disclosure of all important
information.
But, insignificant events may be
disregarded.
Overriding concern: Would knowledge
of event affect decisions of users?
Application of judgment and common
sense.
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Income Statement
Also called:
Profit & Loss statement (i.e., P&L statement).
Statement of earnings.
Statement of operations.

Technically subordinate to Balance Sheet.

Why? Shows detail of changes to Retained
Earnings.

Many consider Income Statement more

important than Balance Sheet.
Variations in format.
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Parts of Income
Statement
Heading:
1. Name of entity.
2. Name of statement.
3. Time period covered.

Revenues.
Cost of Sales.
Gross Margin.
Expenses.
Net Income.
3-31

Revenues in Income
Statement
Gross sales
- Sales returns and allowances
- Sales (cash) discounts
= Net sales
May show just Net sales amount or addl
detail.
Other revenues.
Not associated with primary operations.
E.g., interest/dividends earned
3-32

Revenues in Income
Statement
Excluded from revenue:
Sales or excise taxes.
Postage, freight charge billed to
customers.
Trade discounts are not shown.

3-33

Expenses on Income
Statement
Cost of goods sold (aka, Cost of sales).
Associated with a decrease in Inventory (asset).

Net sales
- Cost of goods sold
= Gross Margin
Selling , general, and administrative expenses.
Separate disclosure of:
Research & development expenses.
Interest expense.

3-34

Completing the
Income Statement
Operating income
- Other revenues (expenses)
= Income before taxes
- Income taxes
= Net income

3-35

Statement of
Retained Earnings
Reconciles change in Retained
earnings:
Retained earnings (beginning)
+ Net income (loss)
- Dividends
= Retained earnings (ending)
Articulates (connects) Balance Sheet
and Income Statement.
3-36

Other Concepts of
Income
Accrual accounting.
GAAP, focus of text.

Cash-basis accounting.
Focuses strictly on cash inflows and outflows.
Cash receipts (revenues) - cash payments
(expenses).

Modified cash-basis accounting.

E.g., cash basis except for inventory and
long-lived assets.
3-37

Other Concepts of
Income
Income Tax Accounting.

Similar but not identical to accrual/GAAP.

Objectives differ from GAAP.
Tax minimization (legal) vs. tax avoidance (illegal).

Economic Income.

Difference in value at end compare to value at

beginning.
Considers cost of using owners investment as an
expense.

Pro forma earnings.

Alternative to GAAP.
Excludes item(s) management deems to be
nonrecurring.
3-38