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Income Statement

What is an 'Income Statement'


An income statement is one of the three important financial statements used for reporting a
company's financial performance over a specific accounting period, with the other two key
statements being the balance sheet and the statement of cash flows. Also known as
the profit and loss statement or the statement of revenue and expense, the income
statement primarily focuses on company’s revenues and expenses during a particular
period.

The business entity concept


October 12, 2017
The business entity concept states that the transactions associated with a business must be separately recorded
from those of its owners or other businesses. Doing so requires the use of separate accounting records for the
organization that completely exclude the assets and liabilities of any other entity or the owner. Wit hout this
concept, the records of multiple entities would be intermingled, making it quite difficult to discern the
financial or taxable results of a single business. Here are several examples of the business entity concept:

 A business issues a $1,000 distribution to its sole shareholder. This is a reduction in equity in the records of the
business, and $1,000 of taxable income to the shareholder.
 The owner of a company personally acquires an office building, and rents space in it to his company at $5,000
per month. This rent expenditure is a valid expense to the company, and is taxable income to the owner.
 The owner of a business loans $100,000 to his company. This is recorded by the company as a liability, and by
the owner as a loan receivable.

There are many types of business entities, such as sole proprietorships, partnerships, corporations, and
government entities.

There are a number of reasons for the business entity concept, including:

 Each business entity is taxed separately


 It is needed to calculate the financial performance and financial position of an entity
 It is needed when an organization is liquidated, to determine the amounts of payouts to the various owners
 It is needed from a liability perspective, to ascertain the assets available in the event of a legal judgment against
a business entity
 It is not possible to audit the records of a business if the records have been combined with those of other entities
and/or individuals

The money measurement concept


March 08, 2018
The money measurement concept states that a business should only record an accounting transaction if it can
be expressed in terms of money. This means that the focus of accounting transactions is on quantitative
information, rather than on qualitative information. Thus, a large number of items are never reflected in a
company's accounting records, which means that they never appear in its financial statements. Examples of
items that cannot be recorded as accounting transactions because they cannot be expressed in terms of money
include:

 Employee skill level


 Employee working conditions
 Expected resale value of a patent
 Value of an in-house brand
 Product durability
 The quality of customer support or field service
 The efficiency of administrative processes

All of the preceding factors are indirectly reflected in the financial results of a business, because they have an
impact on either revenues, expenses, assets, or liabilities. For example, a high level of customer support will
likely lead to increased customer retention and a higher propensity to buy from the company again, which
therefore impacts revenues. Or, if employee working conditions are poor, this leads to greater employee
turnover, which increases labor-related expenses.
The key flaw in the money measurement concept is that many factors can lead to long-term changes in the
financial results or financial position of a business (as just noted), but the concept does not allow them to be
stated in the financial statements. The only exception would be a discussion of pertinent items that
management includes in the disclosures that accompany the financial statements. Thus, it is entirely possible
that key underlying advantages of a business are not disclosed, which tends to under represent the long-term
ability of a business to generate profits. The reverse is typically not the case, since management is
encouraged by the accounting standards to disclose all current or potential liabilities of a business in the notes
accompanying the financial statements. In short, the money measurement concept can lead to the issuance of
financial statements that may not adequately represent the future upside of a business. However, if this
concept were not in place, managers could flagrantly add intangible assets to the financial statements that
have little supportable basis.

Going Concern Concept

Going concern concept is a simple but very important


financial accounting principle which stipulates the basis on
which financial statements are prepared depending on the
likelihood of the company continuing its normal course of
business.

General purpose financial statements are prepared assuming


that the company can and will continue its business in the
foreseeable future. If the company is not expected to continue
operations i.e. it is required (or reasonably expected) to wind up,
its financial statements are prepared using break-up basis.
Foreseeable future normally means at least one year.

The assumption that a business is expected to continue in


future affects the timing, nature and amount on which accounting
transactions are recorded. For example, one criteria for
classification of assets and liabilities into current and non-current
is whether they are realized/settled within normal course of
business. In a non-going concern basis, income, expenses,
assets, liabilities and equity are recorded at values that reflect
the winding up of business, i.e. assets are recognized at values
they are expected to fetch if sold right away, etc.

Management is required to assess at the date of financial


statements whether a business is a going concern. Some
accounting frameworks require management to disclose their
assessment of going concern. Indicators that jeopardize the going
concern status of a business include: (a) situation where liabilities
exceed assets, (b) default of a loan(s), (c) tax penalties, heavy
fines, etc., (d) very adverse regulations, (e) negative cash flows,
(f) extremely adverse legal claims, etc.

Consistency Concept

The concept of consistency means that accounting methods


once adopted must be applied consistently in future. Also same
methods and techniques must be used for similar situations.

It implies that a business must refrain from changing its


accounting policy unless on reasonable grounds. If for any valid
reasons the accounting policy is changed, a business must
disclose the nature of change, the reasons for the change and its
effects on the items of financial statements.

Consistency concept is important because of the need


for comparability, that is, it enables investors and other users
of financial statements to easily and correctly compare the
financial statements of a company.
Materiality Concept
Home » Accounting Principles » Materiality Concept

The materiality concept, also called the materiality constraint, states that
financial information is material to the financial statements if it would change the
opinion or view of a reasonable person. In other words, all important financial
information that would sway the opinion of a financial statement user should be
included in the financial statements.

The concept of materiality is relative in size and importance. Some financial


information might be material to one company but might be immaterial to another.
This is somewhat obvious when you think about a small company verses a large
company. A large and material expense to a small company might be small an
immaterial to a large company because of their size and revenue. The main
question that the materiality concept addresses is does the financial information
make a difference to financial statement users. If not, the company doesn’t have to
worry about including it in their financial statements because it is immaterial.

Most of the time financial information materiality is judged on qualitative and


quantitative characteristics. Professionals are often left up to their experience and
good judgment to understand what is material and what isn’t.

Relevance and Reliability

Relevance and reliability are two of the four key qualitative


characteristics of financial accounting information. The others being
understandability and comparability.

Relevance requires that the financial accounting information should be


such that the users need it and it is expected to affect their decisions.
Reliability requires that the information should be accurate and true and fair.

Relevance and reliability are both critical for the quality of the financial
information, but both are related such that an emphasis on one will hurt the
other and vice versa. Hence, we have to trade-off between them. Accounting
information is relevant when it is provided in time, but at early stages
information is uncertain and hence less reliable. But if we wait to gain while
the information gains reliability, its relevance is lost.
Accrual concept of accounting
Posted in: Accounting principles and concepts (explanations)
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Explanation:
The accrual accounting is a system used by companies to record their financial transaction at the
point when they occur regardless of whether a cash transfer has been made. It is unlike cash
accounting in which transaction is deemed as valid for recording when cash is actually received or
paid. Accrual concept of accounting requires that financial statements reflect transactions at the
time when they actually occur, not necessarily when cash changes the hands. This basis of
accounting is generally used in preparing financial statements except for cash flow statement.
Revenue is recorded when it is earned regardless of when it is received and expenses are recorded
when they are incurred, regardless of when they are paid.
Dual aspect concept
May 06, 2018
The dual aspect concept states that every business transaction requires recordation in two different accounts.
This concept is the basis of double entry accounting, which is required by all accounting frameworks in order
to produce reliable financial statements. The concept is derived from the accounting equation, which states
that:

Assets = Liabilities + Equity

The accounting equation is made visible in the balance sheet, where the total amount of assets listed must
equal the total of all liabilities and equity. One part of most business transactions will have an impact in some
way on the balance sheet, so at least one part of every transaction will involve either assets, liabilities, or
equity.
Historical Cost
What is a 'Historical Cost'
A historical cost is a measure of value used in accounting in which the price of an asset on
the balance sheet is based on its nominal or original cost when acquired by the company.
The historical-cost method is used for assets in the United States under generally accepted
accounting principles (GAAP).

What are Retained Earnings?


Retained Earnings (RE) are the portion of a business’s profits that are not distributed as dividends to
shareholders but instead are reserved for reinvestment back into the business. Normally, these funds
are used for working capital and fixed asset purchases, or allotted for paying off debt obligations.

Retained Earnings are reported on the balance sheet under the shareholder’s equity section at the
end of each accounting period. To calculate RE, the beginning RE balance is added to the net income
or loss and then dividend payouts are subtracted. A summary report called a statement of retained
earnings is also maintained, outlining the changes in RE for a specific period.

A:
Cash Dividends
Cash dividends offer a typical way for companies to return capital to their shareholders.
The cash dividend affects the cash and shareholders' equity accounts primarily. There is no
separate balance sheet account for dividends after they are paid. However, after the dividend
declaration and before the actual payment, the company records a liability to its shareholders in
the dividend payable account.

After the dividends are paid, the dividend payable is reversed and is no longer present on the
liability side of the balance sheet. When the dividends are paid, the effect on the balance sheet
is a decrease in the company's retained earnings and its cash balance. As a result, the balance
sheet size is reduced. Retained earnings are listed in the shareholders' equity section of the
balance sheet
Operating Expense
What is 'Operating Expense'
An operating expense is an expense a business incurs through its normal business
operations. Often abbreviated as OPEX, operating expenses include rent, equipment,
inventory costs, marketing, payroll, insurance, and funds allocated for research and
development. One of the typical responsibilities that management must contend with is
determining how to reduce operating expenses without significantly affecting a firm's ability
to compete with its competitors.

Inventory
What is 'Inventory'
Inventory is the term for the goods available for sale and raw materials used to produce
goods available for sale. Inventory represents one of the most important assets of a
business because the turnover of inventory represents one of the primary sources of
revenue generation and subsequent earnings for the company's shareholders.

Raw materials inventory


December 28, 2017
Raw materials inventory is the total cost of all component parts currently in stock that have not yet been used
in work-in-process or finished goods production.

There are two subcategories of raw materials, which are:

 Direct materials. These are materials incorporated into the final product. For example, this is the wood used to
manufacture a cabinet.
 Indirect materials. These are materials not incorporated into the final product, but which are consumed during
the production process. For example, this is the lubricant, oils, rags, light bulbs, and so forth consumed in a
typical manufacturing facility.
Work-in-process inventory
October 04, 2017
Work-in-process inventory is materials that have been partially converted through the production
process. These items are typically located in the production area. The valuation of this inventory may be
stored in a separate work-in-process account in the general ledger.
The cost of work-in-process typically includes all of the raw material cost related to the final
product, since raw materials are usually added at the beginning of the conversion process. Also, a
portion of the direct labor cost and factory overhead will also be assigned to work-in-process; more of
these costs will be added as part of the remaining manufacturing process.
It is time-consuming to calculate the amount of work-in-process inventory, determine the
percentage of completion, and assign a cost to it, so it is standard practice in many companies to
minimize the amount of work-in-process inventory just prior to the end of a reporting period.

Raw materials inventory

Raw materials include assets in the same form suppliers provide them. For an oil production
company, raw materials include natural crude oil. For a metal stamping company that produces
automobile parts, raw materials include unworked sheet metal as acquired from the supplier.
Works In Progress Inventory

Work in progress includes goods that have been worked or partially assembled, but which are
not yet finished goods. For an automobile manufacturer, vehicles halfway through the assembly
line are work in progress inventory.
Finished Goods Inventory

Finished goods include goods the company produced from raw materials, now ready to sell
and ship. For the automobile company, finished vehicles not yet sold or sent to dealers are
finished goods stock.

Note that one firm's finished goods can be another firm's raw materials. Flat sheets of steel may
be finished goods for the steel company, but raw materials for the metal stamping company.

What is the cost of goods sold?


The cost of goods sold is the cost of the merchandise that a retailer, distributor, or manufacturer
has sold.
The cost of goods sold is reported on the income statement and can be considered as
an expense of the accounting period. By matching the cost of the goods sold with
the revenues from the goods sold, the matching principle of accounting is achieved.
The sales revenues minus the cost of goods sold is gross profit.

LIFE AND FIFO

The two common ways of valuing this inventory, LIFO and FIFO, can give significantly
different results.

Last-In, First-Out (LIFO)

LIFO assumes that the last items put on the shelf are the first items sold. Last-in, first-out is
a good system to use when your products are not perishable or at risk of quickly becoming
obsolete. Under LIFO, if the last units of inventory bought were purchased at higher prices,
the higher-priced units are sold first, with the lower-priced, older units remaining in
inventory. This increases a company's cost of goods sold and lowers its net income, both of
which reduce the company's tax liability.

This makes LIFO more desirable when corporate tax rates are higher.

This inventory accounting method seldom gives a good representation of the replacement
cost for the inventory units, which is one of its drawbacks. In addition, it may not correspond
to the actual physical flow of the goods.

First-In, First-Out (FIFO)

FIFO, on the other hand, assumes that the first items put on the shelf are the first items
sold, so your oldest goods are sold first. This system is generally used by companies whose
inventory is perishable or subject to quick obsolescence.

FIFO is the preferred accounting method in an environment of rising prices. If the inventory
market prices go up, FIFO will give you a lower cost of goods sold because you are
recording the cost of your older, cheaper goods first. Your bottom line will look better to your
banker and investors, but your tax liability will be higher because, due to the lower costs,
your company has a higher profit. Because FIFO represents the cost of recent purchases, it
usually more accurately reflects inventory replacement costs.

What Is Inventory Turnover and How Is It Interpreted?


Inventory turnover is the number of times a company sells and replaces its stock of goods
during a period. Inventory turnover provides insight as to how the company managing costs and
how effective their sales efforts have been.
 The higher the inventory turnover, the better since a high inventory turnover typically
means a company is selling goods very quickly and that there’s demand for their
product.
 Low inventory turnover, on the other hand, would likely indicate weaker sales and
declining demand for a company’s products.
 Inventory turnover provides insight as to whether a company is managing its
stock properly. The company may have overestimated demand for their products and
purchased too many goods as shown by low turnover. Conversely, if inventory turnover
is very high, they might not be buying enough inventory and may be missing out on
sales opportunities.
 Inventory turnover also shows whether a company’s sales and purchasing
departments are in sync. Ideally, inventory should match sales. It can be quite costly
for companies to hold onto inventory that isn’t selling. This is why inventory turnover can
be an important indicator of sales effectiveness but also for managing operating costs.
 Alternatively, for a given amount of sales, using less inventory to do so will improve
inventory turnover.

Calculating Inventory Turnover


Like a typical turnover ratio, inventory turnover details how much inventory is sold over a period
of time. To calculate the inventory turnover ratio, cost of goods sold is divided by the average
inventory for the same period.

Cost of Goods Sold ÷ Average Inventory or Sales ÷ Inventory