Chapter 2 income statement

OPEN UNIVERSITY HCMC
MBA PREPARATORY COURSE

Principles of Financial
Accounting

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Chapter 2

Income statement

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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.
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Introduction to Income
Measurement


Income is a measurement of evaluating
performance.




All income should be measured in the same
way following a common set of rules.
Using a common set of rules allows decision

makers to compare the performance of one
company with that of other companies
because measurement is the same in all
companies.

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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
Buy
Cash
7,000

Merchandise
Inventory
7,000

Sell

Accounts

Receivable
10,000

Collect

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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
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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.

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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

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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.

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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.

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Accrual and Cash Basis


The accrual basis is the current
standard for the measurement of
income.






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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
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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

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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


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Rent is paid even if no sales are made.
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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


An example is rent for one year paid in
advance.

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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.

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Expansion of the
balance sheet equation
Assets = Liabilities + Owners’ Equity
Assets = Liabilities + Paid-in Capital + Retained Income
Assets = Liabilities + Paid-in Capital + Revenues - Expenses

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The Income Statement


Income Statement - a report of all
revenues and expenses pertaining to a
specific time period



Net income - the remainder after all
expenses (including income taxes) have
been deducted from revenue




Often seen as the “bottom line”

Net loss - the excess of expenses over
revenues

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The Income Statement (IS)
SAIGON MILK COMPANY
Income Statement
for the Year Ended December 31, 2005
(in millions VND)
Sales
Expenses:
Wages expense
Rent expense
Utilities expense
Depreciation expense
Total expenses
Net Income

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10,000
1,800
3,500
1,500
400
7,200
2,800

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Relationship between IS and BS


The balance sheet provides a
snapshot of an entity’s
financial
position at
an instant in time.



The income statement provides a
moving picture of events over a
span of time and explains the
changes that have taken place
between balance sheet dates.

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Cash Flows Statement (CFS)


Income does not measure an entity’s
performance in generating cash, especially
if the income is measured using the
accrual basis.



In a way, accountants use both the accrual
and cash bases.




The accrual basis is used in the income
statement.
The cash basis is used in the cash flows
statement.

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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
covered.
• It details the changes in the cash
account, much like the income
statement which shows changes in
retained earnings.

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The Language of Accounting
in the Real Life


Organizations use different terms to describe
the same concept or account.
Net Income
Retained Income

Net Earnings
Profit

Retained Earnings
Reinvested Earnings
Earnings retained for use in the
business
Profit employed in the business

References:

Horngren, Introduction to financial accounting

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