Income Statement

Accounting in a “multi-period” world

Cash Invested

0 1 2 3 4 5 6 ......

Cash Returned

• No pre-determined end to a firm's life - going concern

• Cash invested and generated at multiple points in time

 Principles in Preparing Financial Statements: Fiscal Period

• Artificially divide the life of an organization into annual periods for the purpose of
financial reporting.
- Quarterly Reporting.
- Annual Reporting

• Why is there a demand for periodic performance measures?

- Valuation
- Evaluate management performance
oReward management
oDecide whether to continue to trust the firm’s assets with the current
management

• Ideally, all the relevant information with respect to a firm’s performance should
be in the quarterly / annual report on a timely basis. Is that the case?
Financial Accounting Principles: Objectivity and Conservatism

• Objectivity: financial accounting information must be verifiable and reliable.

• Conservatism
- Asymmetry in the treatment of gains and losses
- Greater degree of verification for gains than for losses
- Required by GAAP, but arose voluntarily. Why?
oManagement’s incentive to report good information, hide bad
information
oCredibility of information in valuation

• Conservatism does not suggest that financial statements should arbitrarily

understate assets and overstate liabilities
Income Statement: Results of Operating Performance

• Revenues --Sales or service revenue

• Gains --e.g., selling an equipment for cash greater than its net book
value

• Expenses --Cost of goods sold, operating expenses, etc.

• Losses

• Other revenues and expenses

- Interest revenue, dividend income, interest expense for a
manufacturing or merchandising firm.
 Income Statement: Results of Operating Performance

• The income statement measures firm performance regardless of when cash is exchanged.
Toward this end, two key principles are

• Revenue Recognition:
o Earnings process substantially complete
o Cash collection reasonably assured
- Conservatism principle is applicable

• The Matching Principle for Expenses:

– Match efforts to the benefits generated
– Capitalize expenditures that will benefit future periods, expense as benefits are realized
– Recognize liabilities when efforts benefiting the current period require cash payment in
the future
– Produces a difference between cash flows and earnings
 Matching Example
• In 2012-13, A & Co. Spent Rs. 20 million on
advertisement on the launch of its new shampoo.

• The company estimates the life cycle of the product

is 2 years. Estimated Sales:
Year 1 Year2
50 million units 17 million units

• How much should A & Co. recognize as an expense

each year?
 Matching Example
Estimated Sales:
Year 1 Year2
50 million units 17 million units

• How much should A & Co. recognize as an expense

each year?
50 17
67 67 (50 + 17)
 Matching Example
Estimated Sales:
Year 1 Year2
50 million units 17 million units

• How much should A & Co. recognize as an expense each year?

(in millions)
50 (Rs. 20) 17 (Rs. 20)
67 67

Yearly Expenses:
Rs. 15 Rs. 5
 Matching Example
Year 1 Year 2 Year 3
Estimate 2 50% 25% 25%

Yearly
Expenses Rs. 10 Rs. 5 Rs. 5
(in millions)
 Recording advertising expenses
Cash Asset RE
Cash outlay
for advertisement (20) 20

Sales 50m @ Rs.3 each150 150

End of Y1 (15) (15)

Sale 17m@ Rs.3 each 51 51

End of Y2 (5) (5)

Total Advertising Expense= Rs. 20m

 Recording advertising expenses
Estimate 1 and Estimate2
Cash Asset RE
Cash outlay
for advertisement (20) 20

Sales 50m @ Rs.3 each150 150

End of Y1 (15)(10) (15)(10)

Sale 17m@ Rs.3 each 51 51

End of Y2 (5)(5) (5)(5)

End of Y3 (5) (5)

Total Advertising Expense= Rs. 20m Rs. 20m

 What is Cost of Goods Sold?

• Company A buys Rs.10,000 worth of cereals

from Special Foods for cash.
• Assets = L + OE
• Cash Inventory
• -10,000 +10,000
• Exchange of one asset for another asset
• Cash outflow = Rs. 10,000
 What is Cost of Goods Sold?
• Co. A sold one-half of the cereals for Rs. 8,000
cash
• Assets =L + Owners’ Equity
• Cash Retained Earnings
• +8,000 +8,000

• What is the most significant matching

expense?
 What is Cost of Goods Sold?
• The cost to Co. A of buying the cereal that was sold
for Rs. 8,000

• one-half of Rs.10,000 = Rs. 5,000

= Cost of Goods Sold or Cost of Sales

• Assets = L + Owners’ Equity

• Inventory Retained Earnings
• -5,000 -5,000
 What is Gross Profit or Margin?
• Assets = L + Owners’ Equity
• Cash Inventory Retained Earnings
-10,000 +10,000
+8,000 +8,000
-5,000 -5,000
• Increase in retained earnings +3,000
• Gross Profit or Margin = Sales Revenue (-) Cost of Goods Sold
= Rs. 3,000
• GM rate= Rs. 3,000 / Rs. 8,000 = 37.5%
 Components of Income

• Sales or Service Revenue

• (-) Cost of Goods Sold
• = Gross Profit
• (-) Operating Expenses
• = Operating Profit / EBIT
• (-) Interest
• (-) Extraordinary items
• = Profit Before Tax / EBT
• (-) Income Tax Expense
• = Net Profit / PAT
• Net Income = Revenues -Expenses + Gains -Losses

• End. Ret. Earn. = Beg. Ret. Earn. + NI -Div

• Therefore...

• Revenues and Gains ultimately Increase Ret. Earn.

• Expenses and Losses ultimately Decrease Ret. Earn.
 Summary
• Key principles underlying financial statement preparation
– Objectivity
– Conservatism
– Matching
– Revenue recognition

• Income statement
– Preparing an income statement from transaction history
– Presentation
– Information in components of income
 Cash Flow Versus Accrual Accounting

• Stock Price = Present value of expected future

cash flows.

• Changes in stock prices = f(changes in

expectations about future cash flows).

• Isn’t cash flow more important than earnings?

 Cash Flow Versus Accrual Accounting
• What cash flows are important?
– Future cash flows!

• When compared to current cash flows, current earnings more

highly associated with future cash flows

• When compared to cash flows, earnings have a stronger

association with stock prices.

• Earnings are superior indicators of expected future cash flows.

 Accounting Earnings versus Stock Prices
• Top management’s incentive compensation is usually linked to stock
prices and accounting earnings.

• Why not link it to stock prices alone?

– Stock prices are affected by economic factors that are outside of a

manager’s control (e.g., macroeconomic, political factors).

– Consequently, stock prices may be a poor indicator of managerial

performance.

– Combining both mitigates this problem

 Accounting Earnings versus Stock Prices
• A second reason for using accounting earnings

• Expected versus delivered performance

– Firm X hires manager Y on December 31, 2015.
– Stock price of X jumps by 10%! Why?
– Market’s expectations regarding the company’s future
performance improve.
– Accounting earnings of 2016 increases by 10%!
• Why?
• Manager Y’s actions produce an actual improvement in the financial
performance of X in 2016. Stock prices anticipated this improvement in
2015 at the time of the earnings announcement.
 Accounting Earnings versus Stock Prices

• By combining stock prices and earnings to reward

managers, a firm can reward a manager for his/her
strategic planning and operational execution.

• Of course, stock prices do reflect the delivered

performance of the manager as well.
– But if payment is on the basis of expected performance, then
what do you do if the manager shirks subsequently? (Moral
hazard problem)
– Earnings provide a straightforward measure of delivered
performance.
 Accruals (Accrue Today, Cash Tomorrow)

• Accrued Wages
– Employees of Co. B are paid at the end of each week.
– Payroll per day: Rs. 2,000
– Weekly payroll: Rs.10,000 (five working days)
– B’s year ends on March 31.
– Assume March 31, 2017 falls on a Tuesday

• On March 31, 2017

– Co. B has incurred wage expense for two days
– But will not pay it in cash until Friday, April 3, 2017.
 Accruals (Accrue Today, Cash Tomorrow)

• Periodic adjustment on March 31

• Assets = Liabilities + Owners’ Equity

• Wages Payable Retained Earnings

+4,000 -4,000

• Effect of omitting this adjustment?

• Liabilities are understated by Rs. 4,000

• Retained earnings & Net income overstated by Rs. 4,000

 Accruals (Accrue Today, Cash Tomorrow)
• What would you see on the balance sheet as of 03/31?

• Wages Payable Rs. 4,000 under Liabilities

• What would you see on the income statement for the year ended 03/31?

• Wage Expense of Rs. 520,000

• 52 Weeks x Rs.10,000 per week

• Without the adjustment

• Wage expense would have been Rs. 4,000 less.
• Expense would have been understated
• Net income overstated
 Accruals (Accrue Today, Cash Tomorrow)

• Now, Rs. 10,000 paid on April 3 of 2017.

• Assets = Liabilities + Owners’ Equity

• Cash Wages Payable Retained Earnings

• -10,000 -4,000 -6,000

 Accruals (Accrue Today, Cash Tomorrow)

• Consider the Rs.10,000 paid to the employees.

• Where and How would it show up in the financial statements?

Period 1 Period 2
• Cash Flow Statement
• Operating cash flow -10,000

• Income Statement
• Wage expense (-RE) -4,000 -6,000
 Cost Expirations (Cash Yesterday, Accrual Today)

• Supplies Inventory

• During 2016 D & Co. purchases (for cash) supplies in the form of spare
parts to support the manufacture of farm machinery at a total cost of Rs.
700.

• The company began the year with Rs. 500 in the supplies account.

• Assets = Liabilities + OE

• Cash Supplies

• -700 +700
 Cost Expirations (Cash Yesterday, Accrual Today)

• On December 31, account reveals that supplies in the amount of Rs.300

remain on hand.

• Supplies Used = Beg. Inv. + Purchases -Ending Inventory

= Rs. 500 + Rs.700 - Rs.300

• = Rs.900

• Assets = L + Owners’ Equity

• Supplies Retained Earnings

• -900 -900
 Cost Expirations (Cash Yesterday, Accrual
Today)
• What shows up in the cash flow statement?

• The cash paid during the year for purchase of supplies

• Operating outflow = Rs.700

• What shows up in the income statement?

• The cost of supplies consumed during the year

• Supplies expense = Rs.900

• What shows up in the balance sheet?

• Ending balance in Supplies of Rs.300

 Cost Expirations (Cash Yesterday, Accrual
Today)
• Pre-received revenues

• Unearned revenue

• Fees received in advance

• Customer advances

• Subscription received in advance, etc.

• Times Magazines receives Rs.5,000 during 2016 for magazine

subscriptions to be fulfilled during 2016 and 2017. Assume that as of the
end of 2016 Times had fulfilled 60% of the subscriptions.
 Cost Expirations (Cash Yesterday, Accrual
Today)
• Rs.5,000 received during 2016 (At the time of receiving the payment)

• Assets = Liabilities + OE

• Cash Unearned Revenue

• +5,000 +5,000

• What happens to this liability at the end of 2016?

– Decreases by 60% because Time Warner delivers magazines in 2016.

 Cost Expirations (Cash Yesterday, Accrual
Today)
• Assets = Liabilities + Owners’ Equity
• Unearned Revenue Retained Earnings
• -3,000 +3,000

• Effect of omitting this adjustment?

– Liabilities are overstated by Rs.3,000

– Retained earnings (income) understated by Rs.3,000

 Cost Expirations (Cash Yesterday, Accrual
Today)
• Effect on financial statements?
• 2016 2017

• Operating cash inflow (+) +5,000

• Subscription revenue (+RE) +3,000 +2,000

• What do you see in the balance sheet as of 31/12/2016?

• Liabilities: Unearned Revenue = Rs.2,000

 Cash Collection v. Revenue Recognition
Prior Period Current Period Subsequent Period

Cash received + Cash (A) =

concurrent with + Revenue (SE)
earning revenue
Income Statement

Cash received before + Cash (A) = 0=

earning revenue + Deferred - Deferred Revenue (-L)
Revenue (L) + Revenue (SE)
Income Statement

Cash received after + Accounts Receivable (A) = + Cash (A)

earning revenue + Revenue (SE) -A/R (-A) = 0
Income Statement

Note: Deferred Revenue can also be called Advances from Customers. Both names signify that
cash has been received for a service or product that hasn't been delivered.
 Cash Payment vs. Expense Recognition
Prior Period Current Period Subsequent Period

Cash paid - Cash (- A) =

concurrent with + Expense (- SE)
using resource to
generate revenue Income Statement

Cash paid before - Cash (-A) = -Productive Asset (- A) =

Expenses made + Productive + Expense (-SE)
Asset (A) = 0
Income Statement

Cash paid after 0= - Cash (- A) =

expenses made + Accrued Liability (+L) - Accrued liability(-L)
+ Expense (- SE)
Income Statement

Note: The "Productive Asset" could be Prepaid Insurance etc. The "Accrued Liability" could be
Accounts Payable, Accrued Wage Expense, Interest Payable, etc
 Assignment:
Initial Balance Sheet
Starting a Company

(1) Issues 50,000 shares of Rs.10 par value common stock at par value for
cash.

(2) Acquires land and building costing Rs.225,000 with the payment of
Rs.50,000 cash and the assumption of a 20-year, 8-percent mortgage for
the balance.

(3) Purchases a used crane for Rs.13,200 cash

(4) Acquires raw materials costing Rs.8,600 on account.

 Initial Balance Sheet
Starting a Company
(5) Returns defective raw materials purchased in (4) and costing Rs.900 to the
supplier. The account has not yet been paid.

(6) Pays the supplier in (4) and (5) the amount due, less a 2-percent discount
for prompt payment. The firm treats cash discount as a reduction in the
acquisition cost of raw materials.

(7) Obtains a fire insurance policy providing Rs.500,000 coverage beginning

next month. It pays the 1-year premium of Rs.4,950.
 Initial Balance Sheet
Starting a Company
(8) Issues a cheque for Rs.1,800 for 3 months rent in advance for office space.

(9) Purchases a patent on a machine process for Rs.90,000 cash.

(10) Purchases office equipment for Rs.2,700, making a down payment of

Rs.250 and agreeing to pay the balance in 30 days.

(11) Pays Rs.825 to Express Trucking Company for delivering the equipment
purchased in (3).
 Recording of transactions
Cash + OCA + PP&E + ONCA = CL + NCL + SE
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)