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Basic Accounting Concepts:

The Income Statement

Basic Concepts
Accounting period.
Conservatism.
Realization.
Matching.
Consistency.
Materiality.

Nature of Income
Summarizes results of operations for a period of
time.
Flow report.
Flows are continuous.
Focuses on earnings activities (or operating
activities).
Reports nature and magnitude.

Elements of Income Statement


Revenues
Inflows or creation of assets that result from
sales of goods or services.
Expenses
Outflows or consumption of resources to
generate revenues.
Revenues - expenses = income = net income (loss)
= earnings = profit = net earnings (loss).

Accounting Period
Net income for life of company:
= Money in - money out.
Accounting period:
Specified arbitrary interval of
time.
Accounting year = fiscal year =
calendar year (if fiscal YE is
12/31).
Natural business year (1/31 for
retailers).
In India FY is from 1st April, 20x1 to
31st March, 20x2.

Terminology Cautions
Read as not necessarily the same as:
Income revenue.
Net income increase in cash.
Retained earnings cash.

Conservatism
prudent reporting based on healthy skepticism builds
confidence in the results....
Preference for understatement rather than overstatement of
assets and earnings (and Owners equity).
If 2 estimates are equally likely, use the one that results
in smaller assets and earnings.
Conservatism More Formally Stated
Recognize revenues when reasonably certain.
Recognize expenses when reasonably possible.
Requires judgment.

Application of Conservatism: Revenue


Recognition
Earning process is complete.
Sale of goods recognized when :
Goods are shipped.
Revenue from services recognized when:
Services are performed.

Cash Receipts and Revenue Recognition


Cash can be collected in the period before, same
as or after revenue is earned.
Pre-collected
Unearned revenue, a liability.
Collected after recognition
Sale on credit.
Accounts receivable (on BS).
Accrued revenue
E.g., interest receivable = Accrued interest
Earned but not yet received.

Revenue Recognition Exercise


For each of the following indicate how much
revenue is earned and the amount of receivable or
liability on the BS.
We sold subscriptions for $1,200. The
magazines will be sent next year.
We shipped goods for which the customer will
pay $1,500 next month.
On 9/30 we loaned $1,000. 8% interest and
principal are to be paid in one year. It is now
12/31.

Realization
Indicates amount of revenue that should be recognized.
Conservatism concept indicates when revenue should be
recognized.
Recognize as revenue:
Amount that is reasonably certain to be realized.
Realized = cash received.
For each of the following, how much revenue should be
recorded:
The list price of the product sold to a customer is
$100,000. Because of the large quantity, we agreed to
a 15% discount off of list.
We are a retail store that sells for cash and on credit.
We sold $400,000 on credit last month. Based on prior
experience, we expect that we will eventually collect
about 97% of our sales.
We sold $10,000 of old product on credit. The customer
is very weak financially.

Matching
Expenses must match their revenues and
benefits.
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.

Terminology Related to Expenses


Cost = a monetary measurement of the 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.
Criteria for Expense Recognition

Direct matching: e.g. COGS.


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).

Expense Recognition Exercise


Classify the following as (1) direct matching, (2)
period costs, or (3) costs not associated with future
benefits and indicate when expensed:
Costs of goods sold.
Controllers salary.
Sales persons commission based on sales.
Inventory that just became obsolete.
Sales persons monthly salary.
Building lost in a fire.

Expenses and Expenditures


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.

Types of Expenditure & Expense


Transactions
Expenditures and expenses of same year.
Expenditures of prior year (assets at beginning of
year) that are expenses of this year.
Expenditures of this year that are expenses of
future years (assets at end of year).
Expenses of this year that will be paid for in
future years (liabilities at end of year).

Exercise
Which type of expenditure are each of the
following?
Presidents salary; rent of sales office.
Inventory purchased last year & sold this.
Building purchased several years ago.
Insurance premium paid last year.
Costs of goods purchased or produced this
year but not yet sold.
Equipment purchases.
December salary of president not yet paid.
Interest expense on loan not yet paid.

Dividends
Distribution of earnings to owners, not an
expense.
Cash dividends reduce cash and Retained
earnings by same amount.

Gains and Losses


Not associated with routine operations.
Cash received (if any) less costs.
Gains increase RE (similar to revenues).
Losses decrease RE (similar to expenses).
In practice, no sharp distinction between gains and
revenues and expenses and losses.

Consistency
Once an accounting method is selected use for all subsequent
events of same character.
Can change if there is sound reason to change.
Must be disclosed to users.
Consistency overtime not over different types of transactions.

Materiality
Insignificant events may be disregarded.
Amounts need not be exact as long as inaccuracy
would not affect decisions of users.
Full disclosure of all important info.
Overriding concern: Would knowledge of event
affect decisions of users?
Application of judgment and common sense.

Income Statement
Also called: Profit & Loss statement = P&L
statement = statement of earnings = statement
of operations
Technically subordinate to BS.
-Shows detail of changes to RE.
Many investors consider IS more important than
BS.
Variations in format.

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