Chapter 3 The Income Statement

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Operating Activities

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The day-to-day functions involved in running a business. They occur regularly and often have a short duration of effect than investing and financing operations. These operations include:


* Buying Goods and Services From Suppliers
* Employees
* Selling Goods and Services to Customers
* Collecting Cash From Customers

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Operating Cycle

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The period from buying goods and services through to collecting cash from customers.

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Income Statement Accounts

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The income statement summarizes the financial impact of operating activities undertaken by the company during the accounting period. It includes revenues, expenses, and net income.

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Revenues

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The amounts a business charges its customers when it provides goods or services. This is the first thing reported on an income statement.

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Expenses

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The costs of operating the business, incurred to generate revenues in the period covered by the income statement. Expenses are reported when the company uses something, like space in a building, supplies for providing services, or the efforts of employees. In short, whenever a business uses up its resources to generate revenues during the period, it reports an expense, regardless of whether or not payment for the resources has occurred. This is the second section of an income statement

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Net Income

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The total that is calculated by subtracting expenses from revenues; it is not an account like revenues. Because it is a total, a net income summarizes the overall impact of revenues and expenses in a single number. It is called a net loss if expenses are greater than revenues, and net income if revenues are greater than expenses.

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Time Period Assumption

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The practice of dividing the company's long life into meaningful and shorter chunks of time so that you can measure and evaluate the company's financial performance on a timely basis.

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What Does The Income Statement Report?

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The income statement reports the financial effects of business activities that occur during just the current period. They relate only to the current period and do not have a lingering financial impact beyond the end of the current period. This is a key distinction between the income statement and balance sheet.

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Cash Basis Accounting

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Is measuring financial success by watching only your cash flows. It is a good means of tracking for personal finances but not for running a business. A major reason for this is that when something is bought on credit it is not accounted for in real time.

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Accrual Basis Accounting

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Is when you report revenues and expenses when services are provided, regardless of when cash is received or paid. It is a better measure of business financial activities.

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Rule of Accrual

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That the financial effects of business activities are measured and reported when the activities actually occur, not when the cash related to them is received or paid.

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Revenue Recognition

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According to the revenue recognition principle, revenues should be recognized when they are earned. Recognized means revenues are measured and recorded in the accounting system. Earned means the company has fulfilled its obligation to the customer by doing what it promised to do. The key factor in determining when to recognize revenue is whether the company has provided goods or services to customers during the accounting period. An accounting period can be a month, quarter, or year.

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Revenue Recognition Posting

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1. Cash is received in the same period the goods or services are provided. This is earned revenue.

2. Cash is received in a period before goods or services are provided. This is cash that is reported as unearned revenue. This occurs when something like giftcards are purchased.

3. Cash is to be received in a period after goods or services are provided. This typically happens when a company sells products or services to customers on account. This means that the company provides goods or services to a customer not for cash, but instead for the right to collect cash in the future. This is reported as Accounts Receivable.

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Expense Recognition Principle (Matching)

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The business activities that generate revenues also create expenses. Under accrual basis accounting, expenses are recognized in the same period as the revenues to which they relate, not necessarily the period in which cash was paid for them.

Record expenses in the same period as the revenues with which they can be reasonably associated. If an expense cannot be directly associated with revenues, it is recorded in the period that the underlying business activity occurs. For example advertising is reported in the accounting period in which the ads are run.

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Expense Recognition Principle (Matching) Posting

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1. Cash paid at the same time that the expense is incurred to generate revenue. These would be reported in the income statement. The benefits of incurring the cost are entirely used up in the current accounting period.

2. Cash is paid before the expense is incurred to generate revenue. These would be reported in the future accounting period in which revenue was earned from their use. In this time frame they are considered assets.

3. Cash is paid after the cost is incurred to generate revenue. This would be considered accounts payable.

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Trial Balance

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The best way to ensure that your accounts are "in balance". It is an internal report used to determine whether total debits equal total credits. It basically a trial balance lists every account name in one column (usually in the order of assets, liabilities, stockholders' equity, revenues, and expenses). The ending balances obtained from the ledgers (T-Accounts) are listed in the appropriate debit or credit column.

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Net Profit Margin

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The income statement provides the main measure of a company's operating performance. The key thing to look for is whether net income is positive (more than expenses).

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Income Statement Limitations

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1. Net income does not equal the amount of cash you have generated.

2. Net income does not represent the change in the company's value during the period.

3. The measurement of income does not only involve counting.