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.

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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).
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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.

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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.
Management may require monthly (or
weekly, or daily).

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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
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Terminology Cautions
Income

IS NOT

Net income

Revenue

IS NOT

Retained Earnings

Increase in Cash
IS NOT

Cash

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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.
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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.

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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).

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

Recognize amount that is reasonably

certain to be realized.

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

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

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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.

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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).
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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?
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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).
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Types of Expenditure &

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

Expense

This year
Prior year
This year
Future year

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

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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.

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

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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.
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.
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