AC221 – Financial Accounting
Session 3:
Income Statement

Review: Typical Accounting Titles
• The balance sheet
Assets
Cash
Short-Term Investment
Accounts Receivable
Notes Receivable
Inventory (to be sold)
Supplies
Prepaid Expenses
Long-Term Investments
Equipment
Buildings
Land
Intangibles

Liabilities
Accounts Payable
Interest Payable
Taxes Payable
Unearned Revenue
Notes Payable
Bonds Payable

Stockholders’ Equity
Contributed Capital
Retained Earnings

Quiz Time… What type of Account?
•
•
•
•
•
•
•
•
•
•

Accounts payable
Warranty payable
Accumulated depreciation
Accounts receivable
Buildings
Sales Revenue
Short-term investments
Dividends payable
Prepaid expenses
Additional PIC

Income Statement
•

Reports operating performance for a specific time period.

•

Provides information about what happened between balance sheet periods (did our business activities generate more resources than they used this year?).

•

Remember, the balance sheet and the income statement are linked:

Assets=Liabilities + Equity
= Liabilities + Contributed Capital + Earned Capital
=Liabilities + Contributed Capital + Retained Earnings
=Liabilities + Contributed Capital + Beginning RE + NI -Dividends
=Liabilities + Contributed Capital + Beginning RE + Revenues-Expenses-Dividends
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Walmart 2013 10-K I/S
Operating
Activities

Peripheral
Activities

Walmart 2013 10-K B/S
• Asset

Cash is not the same as net income Net Income
• Net Income (or Earnings) = Revenues – Expenses.
• Academic research shows that CEOs & CFOs view earnings to be the most important measure of firm performance reported to outsiders (Graham, Harvey, and Rajgopal 2005).

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Income Statement
• Measure of profitability from an accountant’s perspective • Components taken from Retained Earnings
1.
2.
3.
4.
5.

Revenue (Sales Revenue or Service Revenue)
COGS
Expenses (Wage expense, interest expense)
Gains (Gain on disposition of assets)
Losses (Loss on disposition of assets)

• NOT a measure of cash collected or paid

Components of Net Income: Revenue
• Measure of economic benefit generated by sale of products or providing of services
– What if a customer pays you in advance? Is that revenue? • Comprised of transactions involving both cash and credit
• Typically shown net of an estimated allowance for returns and non-collectible accounts

Components of Net Income: Expenses
• Measure of economic sacrifices incurred to earned revenues • Expenses measure the assets consumed in generating revenue. • Assets are unexpired costs, and expenses are expired costs of “gone assets.”
• Cost of Goods Sold (COGS) => Cost of product being sold
• Selling, General, and Administrative Expenses (SG&A) =>
Advertising and overhead expenses

Other Income/Expenses
• Magnitude usually small
• Not central to operating activities
• Examples include: interest expense or income,
Gains or losses on asset sales

How should we measure performance? • Net Income = Revenues – Expenses
• 2 Bases of Accounting:
1. Cash-based accounting
•

Recognizes revenue when cash is received from customers and expenses when cash is paid for resources

2. Accrual accounting
•
•

Recognizes revenue when it is earned and expenses when they are incurred
Accrual accounting can produce large discrepancies between the firm’s reported income and the amount of cash generated by operation

Cash Accounting
• Reliable
– Cash by any other name is still cash

• Convenient
– Our bank statement reflects cash inflows and outflows • What is the problem with cash?

Example: Cash Basis
•

Year 1: Buy inventory for $10,000 cash. No sales made.
Assets

=

Liabilities

+

Equity

•

Year 2: Sell $5,000 worth of inventories for $8,000 in cash, the rest of inventory for
$10,000 on credit.
Assets
=
Liabilities
+
Equity

•

Year 3: Receive cash from