Chapter 2 income statement

Operating Cycle Operating cycle - the time span during which cash is used to acquire goods and services, which in turn are sold to customers, who in turn pay for their purchases, with

Chapter 2

Income statement

Learning Objectives

After studying this chapter, you should be able to:

 Explain how accountants measure income

 Use the concepts of recognition, matching, and

cost recovery to record revenues and expenses

 Prepare an income statement and show how it is related to a balance sheet

 Calculate operating cash flows and show how cash flow differs from income

because measurement is the same in all

companies

Operating Cycle

 Operating cycle - the time span during which

cash is used to acquire goods and services,

which in turn are sold to customers, who in turn pay for their purchases, with cash

Cash 7,000

Merchandise Inventory 7,000

Accounts Receivable 10,000

Buy Sell

Collect

Revenues and Expenses

 Revenues (sales) - gross increases in

owners’ equity arising from increases in

assets received in exchange for the

delivery of goods or services to customers

 Expenses - decreases in owners’ equity

that arise because goods or services are

delivered to customers

Revenues and Expenses

 Income (profit) - the excess of

revenues over expenses

 Revenues - Expenses = Profit

 Retained income - additional owners’

equity generated by income or profits

 Revenues increase owners’ equity

 Expenses decrease owners’ equity

Accrual and Cash Basis

 The most common ways of measuring income are the accrual basis and the cash basis.

 Accrual basis - recognizes the impact of

transactions for the time periods when revenues and expenses occur even if no cash changes

hands

 Cash basis - recognizes the impact of

transactions only when cash is received or

disbursed

Accrual and Cash Basis

 Under the accrual basis:

 Revenues are recorded when earned

 For example, a sale on account is recorded as revenue when the transaction takes place even though the seller receives no cash at that moment.

 Expenses are recorded when incurred

 For example, a purchase on account is recorded as

an expense when the transaction takes place even though the buyer disburses no cash at that

moment.

Accrual and Cash Basis

 Under the cash basis:

 Revenues are recorded when a sale is

made for cash at the time when the cash

changes hands

 Expenses are recorded when a purchase is

made for cash at the time when the cash

changes hands

Accrual and Cash Basis

 The accrual basis is the current

standard for the measurement of

income.

 Presents a more complete summary of

what happened during the year

 Recognizes revenues when they are

earned and expenses when they are incurred

 Matches expenses to revenues

Recognition of Revenues

 Recognition - a test to determine whether

revenues should be recorded in the financial

statements for a given period

 To be recognized, revenue must be:

 Earned - goods are delivered or a service is

performed

 Realized - cash or a claim to cash (credit) is

received in exchange for goods or services

Matching and Cost Recovery

Two types of expenses:

 Product costs - those linked with

revenue earned in the same period

 Cost of goods sold or sales commissions

 Without sales there is no cost of goods sold or sales commissions.

 Period costs - those linked with the time period itself

 Rent or other administrative expenses

 Rent is paid even if no sales are made.

Matching and Cost Recovery

 Matching - recording of expenses in the same time period as the related revenues are recognized

 Cost recovery - concept by which some purchases of goods or services are

recorded as assets and “expired” later

because the costs are expected to be

recovered in future periods

Matching and Cost Recovery

 Another example of matching and cost

recovery is depreciation

 Depreciation - the systematic allocation of

the acquisition cost of long-lived assets or

fixed assets to the expense accounts of

particular periods that benefit from the use of the assets

Expansion of the

balance sheet equation

Assets = Liabilities + Owners’ Equity

Assets = Liabilities + Paid-in Capital + Retained Income Assets = Liabilities + Paid-in Capital + Revenues - Expenses

The Income Statement

revenues and expenses pertaining to a

specific time period

expenses (including income taxes) have been deducted from revenue

revenues

The Income Statement (IS)

SAIGON MILK COMPANY Income Statement for the Year Ended December 31, 2005

Relationship between IS and BS

snapshot of an entity’s

financial position at an

changes that have taken place

between balance sheet dates.

Cash Flows Statement (CFS)

 Income does not measure an entity’s

performance in generating cash, especially

if the income is measured using the

Cash Flows Statement

 Statement of cash flows - reports the cash receipts and cash payments of an

entity during a particular period

 It summarizes activity over a period of time,

so it must be labeled with the exact period

The Language of Accounting

in the Real Life

 Organizations use different terms to describe the same concept or account.

Net Income Net Earnings

Profit

Retained Income Retained Earnings

Reinvested Earnings Earnings retained for use in the business

Profit employed in the business

References: