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.

3-2
 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).
3-5
 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.

3-6
 Income Statement:
Basic Elements
• Revenues - Expenses = Income.
• Other names for income:
– Profit.
– Net income.
– Net earnings.
• If expenses exceed revenues,
– Net loss.
3-7
 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.
– SEC requires quarterly.
– Management may require monthly (or
weekly, or daily).

1-9
 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 Plus: Net Income Retained
Earnings Minus: Net Loss Earnings
Jan 1 Minus: Dividends Dec 31
3-10
 Terminology Cautions

Income IS NOT Revenue

Net income IS NOT Increase in Cash

Retained Earnings IS NOT Cash

3-11
 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.

3-12
 Conservatism

• Formally:
– Recognize revenues when reasonably certain.
– Recognize expenses when reasonably possible.
• Informally:
– “anticipate no profits but anticipate all losses.”
– Sometimes requires judgment.

3-13
 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.

3-14
 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).

3-15
 Concept #8:
Realization
• Indicates amount of revenue that should
be recognized.
– Conservatism indicates when.
• Recognize amount that is reasonably
certain to be realized.

3-16
 Realization Concept
Application
• How should each of the following affect
revenue realization?
– Price discounts?
– Uncollectible accounts?
– The financial stability of a credit customer?

3-17
 Summary
Determination of Revenue
• Recognize revenue when:
– Earned (Conservatism) and
– Realized or realizable (Realization).

3-18
 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.

3-19
 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.
3-20
 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., president’s salary.
• Costs not associated with future revenue.
– E.g., inventory determined to be obsolete
(unsalable).
3-21
 Expense Recognition Exercise

• When should each of the following be

expensed and why?
• Shipping costs?
• Controller’s salary?
• Sales person’s commission (based on sales)?
• Sales person’s monthly salary?
• Employee training costs?
• Building lost in a fire?

3-22
 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).

3-23
 Types of Expenditure &
Expense Transactions
Think of an example that fits each scenario
below…
Expenditure Expense
This year This year
Prior year This year
This year Future year
Future year This year
3-24
 Expenditures vs. Expenses
Exercise
For each of the following, when does the
expense occur?
1. President’s salary is paid at the end of each
month.
2. Fire insurance for this year was paid last year.
3. Next year’s 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.

3-25
 Dividends

• Not an expense.
• Distribution of earnings to owners.
• Cash dividends reduce Cash and
Retained earnings by same amount.

3-26
 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.

3-27
 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.

3-28
 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.
3-29
 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.
3-30
 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.
3-31
 Revenues in Income
Statement
Gross sales
- Sales returns and allowances
- Sales (cash) discounts
= Net sales

• May show just Net sales amount or add’l detail.

• Other revenues.
– Not associated with primary operations.
– E.g., interest/dividends earned

3-32
 Revenues in Income
Statement
• Excluded from revenue:
– Sales or excise taxes.
– Postage, freight charge billed to customers.
– Trade discounts are not shown.

3-33
 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. 3-34
 Completing the
Income Statement
Operating income
- Other revenues (expenses)
= Income before taxes
- Income taxes
= Net income

3-35
 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.
– GAAP, 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.
3-37
 Other Concepts of Income

• Income Tax Accounting.

– Similar but not identical to accrual/GAAP.
– Objectives differ from GAAP.
– Tax minimization (legal) vs. tax avoidance (illegal).
• Economic Income.
– Difference in value at end compare to value at beginning.
– Considers cost of using owners’ investment as an expense.
• Pro forma earnings.
– Alternative to GAAP.
– Excludes item(s) management deems to be nonrecurring.

3-38