INCOME STATEMENT Accounting ASW Summer 2007

Warning! Income statement is the hardest concept in accounting –Seems intuitive –More subtle than it seems –Takes a while to really understand it Litmus test: Why would we record: Rent Expense (I/S-Exp)100 Rent Payable (B/S-Liab)100

Two ways to think about the income statement (1) Intuitively (and loosely) –Lists revenue firm earned Even if not yet received (e.g., credit sales) –Lists all costs incurred to earn revenues Even if not yet paid (e.g., rent on credit) –Calculate whether you were profitable (net income) Even if not all cash (accrual accounting)

Two ways to think about the income statement (2) The “right” (and less intuitive) way –Income statement is part of the balance sheet Assets = Liab. + Contr. Cap. + Retained Earnings RE Year End ‘07 = RE Year End ‘06 + NI In ‘07 – Div. In ’07 + Other In ’07 Net Income In ‘07 = Revenues In ‘07 - Expenses In ’07 –Therefore, net income is a function of how you measured your balance sheet

Merchandise Sale Example Assume purchase at $80 Inventory 80 Cash 80 Sell for $100 Cash 100 Inventory 80 ? 20

What is the credit? Is an asset reduced? Is a liability created? Did investors contribute more capital? Therefore, is it retained earnings--residual of residual.

What are Retained Earnings? Retained Earnings is a permanent account (balance sheet) Measures equity which was created by the operations of the firm (not contributed) Not an asset (the associated assets are separately recognized)

How does it get to RE? Put into “temporary accounts” (measure only net income this period) Split into revenue and expense Cash 100 Sales Revenue (Rev.)-RE 100 Cost of Goods Sold (Exp.)-RE 80 Inventory 80

What are revenues & expense accounts? Temporary accounts Part of Retained Earnings Used to track net income during the period Get folded into RE at the end of the period Begin and end with zero balances

Closing Entry Recorded at period end after preparing the income statement Sales Revenue--RE 100 Cost of Goods Sold--RE 80 Retained Earnings 20 Similar entry for other revenues & expenses

Measurement under Accrual Accounting Recognize revenues when earned Match expenses to revenues where possible Net income is revenue net of any associated costs, irrespective of cash flows

Revenue Recognition Have performed all (or a substantial portion) of service Have received an asset (cash or receivable) which can be measured Revenue may be adjusted for expected bad debts and sales discounts and allowances

Revenue Timing Issues Cash Now Cash 100 Sales Revenue 100 Cash in future Accounts Receivable (Asset) 100 Sales Revenue 100 Cash 100 Accounts Receivable 100 Cash in past Cash 100 Adv. from Cust. (Liab.) 100 Advances from Customers 100 Sales Revenue 100 Problem 3.18

Expense Recognition Match to revenue to the extent possible--e.g., product cost - Merchandising--cost of acquiring inventory - Manufacturing--cost of making product (including overhead) Otherwise charge to expense as consumed--e.g., - selling general and administrative expense - research and development expense Measure on same basis as asset being consumed

Timing of Expenses Concurrent with cash flows Rent Expense 100 Cash 100 Prior to cash flow Rent Expense 100 Rent Payable 100 Cash 100 After cash outflow Prepaid Rent 100 Cash 100 Rent Expense 100 Prepaid Rent 100

Depreciation Special case of prepaid expenses Spread cost over period of benefit - just like other prepaids - typically spread straight-line - Depreciation Expense = (Cost - Estimated Salvage)/Estimated useful Life E.g. $1,100 asset, 10-year life, $100 salvage Depreciation Expense 100 Accumulated Depreciation- (PP&E Contra) 100 Problem 3.20

Types of Entries Transactions-based entries - know to record them based on a transaction - e.g., receipt/payment of cash, credit sale, receipt of bill, etc. - recorded during the period

Adjusting entries -Cases in which there is no immediate notification (transaction) -Often necessitated by passage of time -Expense examples: depreciation, accrual of salaries, expiration of prepaid rent -Revenue examples: advances from customers earned, interest earned to be collected -Technically could be recorded every day, but typically wait until end of period (quarter) -Auditor doesn’t care if accounts are right until reporting date

Closing entries -Clear out all revenue and expense accounts to retained earnings -After completing income statement, before balance sheet -Problems 3-31 and 3-33