Learning MBA Master Degree

TEACHER: Hello, Student. In this Module we will introduce the idea of income as used in financial accounting. We will also describe the income statement; of course, you know what the income statement is, don’t you?

STUDENT: The income statement is the financial statement which reports income and its origins. But I also know that in the previous Module you mentioned ten basic concepts, and you only described six of them: Money measurement, Entity, Going concern, Cost, Dual aspect and Conservatism. You owe me the description of the missing four basic concepts, don’t you?

TEACHER: I certainly have not forgotten and I will pay my debt to you in this Module, and we will discuss the remaining concepts, which are:

7. The realization concept.

8. The matching concept.

9. The consistency concept

10. The materiality concept.

However, allow me to discuss a few other subjects first.

THE NATURE OF INCOME

As I am sure you recall, in Module I we described the balance sheet, which reports the financial condition of an entity as of one moment in time.

Now let’s begin with the description of a second financial statement, the income statement.

The income statement summarizes the results of operations for a period of time. It is therefore a flow report, as contrasted with the balance sheet which is a status report.

We can define a business as an organization that uses inputs to produce outputs. The outputs are the goods and services that the business sells to its customers. The values of these outputs are basically the amounts of money customers pay for them.

STUDENT: Is income the same as "revenue"?

TEACHER: Often in accounting the amounts a firm collects and is owed for the sale of its outputs are called revenues. Obviously to produce outputs a business needs to purchase inputs. In accounting, the cost of the inputs, the resources used in providing goods and services during a period are called expenses. Income is the amount by which the revenues earned during a period exceed the expenses incurred during that period.

STUDENT: Now you truly succeeded in confusing me!

TEACHER: This is because the word "income" is often used with various qualifying adjectives. "Gross income" is the equivalent of revenue, the total proceeds of sales. "Net income" is used to refer to the difference of all the revenues over all the expenses of a period; a positive figure is a profit, a negative figure is a loss.

The Accounting Period

Management and other interested parties in a business need to know at frequent intervals "how things are going." Therefore, accountants choose some convenient segment of time and they measure the net income for that period of time. The time interval chosen is called the accounting period.

For the purpose of reporting to outsiders, one year is the usual accounting period. This is a time honored tradition: Piccolo, the first author of an accounting text, wrote in 1494: "Books should be closed each year, especially in a partnership, because frequent accounting makes for long friendship".

STUDENT: Well, this guy Piccolo might have been a small person, but he was clever nevertheless!

TEACHER: I notice that you are showing off your -probably limited- knowledge of Italian. Yes, I know that "piccolo" means "small" in that language. Anyway, it is a fact that most corporate bylaws require an annual report to the shareholders, and income tax reporting is also on an annual basis.

STUDENT: Why is it then that so many large corporations, especially in the USA, publish income statements every quarter?

TEACHER: This is a requirement for public companies that are listed on stock exchanges, like the NYSE, NASDAQ, etc. Obviously the idea is giving to shareholders and investors relevant information more frequently.

In the majority of businesses, the accounting year, or fiscal year, corresponds to the calendar year, but many businesses use the natural business year instead of the calendar year. For example, nearly all department stores end their fiscal year on January 31. Can you guess why?

STUDENT: I suppose this is in order to reflect the Christmas sales which represent a very high percentage of the total yearly sales.

TEACHER: Correct. But management needs information more often than once a year, and income statements for the use of management are therefore prepared more frequently. The most common period is a month, but the period may be as short as a week.

As mentioned before, the Securities and Exchange Commission requires quarterly income statements from companies over which it has jurisdiction. These reports are called interim reports to distinguish them from the annual reports.

Relation between Income and Owners' Equity

As explained in Module I, the net income of an accounting period affects owners' equity. It increases owners' equity (if positive) or decreases it (if negative).

Revenues and expenses can be defined in terms of their effect on owners' equity: a revenue is an increase in owners' equity resulting from the operation of the entity, and an expense is a decrease.

The basic equation is:

Revenues ("Gross Income") - Expenses = Income (Net)

Please make a note that in accounting "expense" is not the same as "expenditure"; I will explain the difference later on.

This equation clearly indicates that income is a difference. Sometimes the word income is used improperly as a synonym for revenue; you will recall that you felt a bit confused by this semantic problem at the start of this Module.

On an income statement, no misunderstanding is caused by such an error because revenue, however it is labeled, appears at the top and income at the bottom; but in other contexts confusion can be created. For example, if someone says Company X had an income of a million dollars, he gives a completely false impression of the size of the company if he actually meant that Company X had revenues of a million dollars.
Income Not the Same as Cash Receipts

It is extremely important to recognize that income is associated with changes in owners' equity, and that it has no necessary relation to changes in cash. Roughly speaking the bigger the income, the better off are the owners. An increase in cash, however, does not necessarily mean that the owners are any better off -that their equity has increased. The increase in cash may merely be offset by a decrease in some other asset or by an increase in a liability, with no effect on owners' equity at all.

As promised, we will know continue with the description of Basic Concepts.

No. 7 - The realization concept

Revenues result from providing goods and services to customers. In order to measure the revenues in a given accounting period, we need the answers to two questions:

1. When should revenues be recognized? and

2. At what amounts should revenues be recognized?

The answers to these questions, according to the realization concept, are the following:

1. Revenues are generally recognized in the period in which goods are delivered to the customer or the period in which services are rendered. This is the period in which revenue is said to be realized.

2. The amount of revenue is the amount that customers are reasonably certain to pay.

Distinction between Cash Receipt and Revenue

The realization concept refers to the delivery of goods or the rendering of services, and these actions must be clearly distinguished from the receipt of cash. There are, of course, many cases of "cash sales", like in supermarkets and other retail stores. But in most business transactions the cash is received in either an earlier period or a later period than that in which the revenue is realized. Examples of each are given below.

Precollected Revenue. Most newspaper and magazine companies sell subscriptions that the subscriber pays for in advance.. If subscription money is received this year for magazines to be delivered next year, the revenue belongs in next year, not this year.

STUDENT: And how are this transactions recorded?

TEACHER: The amount is recorded, not as revenue for this year, but as a liability on the balance sheet as of the end of this year.

Accounts Receivable. The converse of the above situation is illustrated by sales made on credit. In this case, the revenue is reported in the period in which the sale is made, and an asset, accounts receivable, is shown on the balance sheet as of the end of the current period.

STUDENT: This means then that when the customer pays his or her bill, it is not revenue; it reduces the amount of accounts receivable and increases cash.

TEACHER: Exactly.

Amount of Revenue

You will recall that the realization concept states that the amount that is recognized as revenue is the amount that is "reasonably certain" to be realized.

A typical case is the sale of merchandise on credit. In reporting the revenue for a period, the amount of sales made on credit should be reduced by the estimated amount of credit sales that will never be realized -bad debts.

No. 8 - The Matching Concept

Relation of Cost and Expense

STUDENT: Before we start, can you help me to distinguish between "cost" and "expense" ? Sometimes I get confused about the respective meanings.

TEACHER: Sure. The amounts involved in the acquisition of resources are costs. An expense is an item of cost that is subtracted from revenue in a given accounting period. It is important to distinguish between assets and expenses because if a certain item of cost classified as an asset, income at that time is unaffected; whereas if it is classified as an expense, income is reduced.

STUDENT: An example, please?

TEACHER: Sure. Assume that you manage a retail store.

You purchase 100 gadgets for a total of $1,000; this amount is the cost of the gadgets (resources) you intend to sell later. Until you sell the gadgets, the $1,000 are recorded as an asset (inventory) in the balance sheet and do not appear in the income statement. When you sell them the $1,000 are subtracted from the amount of your inventory; the $1,000 become an expense (cost of goods sold) in the income statement and the amount you sold them for appears as revenue.

STUDENT: You mean that until I sell the gadgets the $1,000 (the cost) are an expenditure and only become an expense when I take them off from inventory and record the amount as cost of goods sold.

TEACHER: Exactly. More on that later.

Nature of the Matching Concept

The matching concept provides guidelines for deciding which items of cost are expenses in a given accounting period. Costs are reported as expenses in the period in which the associated revenue is reported. In the previous example, you should report the $1,000 as an expense in the same period you report the revenue produced by the sale of the gadgets.

STUDENT: I can imagine that sometimes this matching is not possible, right?

TEACHER: Indeed. Some items of expense are reported in a certain accounting period, even though they cannot be traced to any specific revenue transactions occurring in that period. In general, these expenses are the costs of "being in business", and examples are employee training, advertising, legal fees, etc.

Expenses and Expenditures

Let’s go back to the example of yourself as a store manager. An expenditure takes place when an asset or service is acquired; so, when you purchased the gadgets, you incurred in an expenditure of $1,000. The expenditure may be made by cash, by the exchange of another asset, or by incurring in a liability.

If you did not sell the gadgets when issuing your income statement, there was no expense related to your expenditure made when purchasing the gadgets. The amount only becomes an expense reported in the income statement of the accounting period when the gadgets are sold.

STUDENT: I see that just as it is important to distinguish between revenue and cash receipts, it is also important to distinguish between expenses and expenditures.

TEACHER: Very much so. The expenses of "this year" include the cost of the products sold during the year, even though these products were purchased or manufactured (and an expenditure incurred) in a prior year.

No. 9 - The Consistency Concept

The eight concepts that have been described till now are very broad. In practice there are several different ways in which a given event may be recorded in the accounts.

The consistency concept implies that the same criteria be used over time. A company's auditors invariably include in a letter summarizing the results of their annual examination of accounting records the statement that the figures were prepared "in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year"; or if there were changes in practice, these are (or should be!) spelled out in the opinion.

No. 10 - The Materiality Concept

Obviously the accountant does not attempt to record a great many events which are so insignificant that the work of recording them is not justified by the usefulness of the results. But the problem is that there is no agreement as to the exact line separating material events from immaterial events. The decision depends on judgment and common sense; and as we mentioned before, in many cases (Enron, Xerox, etc.) very material events were wrongfully judged to be "immaterial".

The Income Statement

The accounting report that summarizes the revenues and the expenses of an accounting period is called the income statement (or the "profit and loss statement," "statement of earnings," or "statement of operations"). In a technical sense the income statement is subordinate to the balance sheet in that it shows in some detail the items that together account for the change arising from operations during an accounting period in one balance sheet category, owners' equity, and more specifically in one item in that category, retained earnings.

STUDENT: Do you mean the Balance Sheet is more important?

TEACHER: Not exactly. The information on the income statement is usually much more important than information on the balance sheet, because the income statement reports the results of operations and indicates reasons for the business's profitability or lack thereof.

There is in practice considerable variation among companies in the format used for the income statement.

The income statement in the illustration below gives information for the prior year, as well as for the current year, to provide a basis for comparison. The FASB requires such a practice, both for the income statement and for the balance sheet.

Let’s describe the items of the illustrated report.

Revenues - An income statement often shows several separate items in the revenue section, the net of which is the net sales figure. For example:

Gross sales $30,000 . Less: Returns and allowances ($500) . Less: Sales discounts ($3,500) = Net sales $26,000

Gross sales is the total invoice price of the goods shipped (or services rendered) during the period.

Sales returns and allowances represent the sales value of goods that were returned by customers or on which customers were given a discount.

Other revenue is revenue earned from activities not associated with the sale of goods and services. Interest or dividends earned on marketable securities owned by the company is an example. The amount is shown separately from net sales so as to facilitate the calculation of gross margin, as explained below.

Cost of Goods Sold – At the same time that income is increased by the sales value of merchandise sold, it is also decreased by the cost of that merchandise. If a company sells services, rather than goods, or if it sells both goods and services, the item would be labeled cost of sales rather than cost of goods sold. The cost of services are the costs associated with providing the service (labor, material if any, etc.)

Gross Margin - The difference between sales revenue and cost of goods sold is the gross margin or gross profit. On many income statements this amount appears as a separate item and the percentage of total gross margin vs. revenue is a very relevant indicator of the health of a business.

Expenses - The items listed in the illustration are a minimum. In many income statements, especially those prepared for internal use, the "selling, general, and administrative expense" category is broken down so as to show separately the principal items of which it is composed.

Net Income - Net income is colloquially referred to as "the bottom line" for obvious reasons.

In our example, income tax is listed with the other expenses. In many income statements, the item "income before income tax" is given and income tax expense is then subtracted. The term used is "net income," with no qualification or modification. For larger corporations net income is reported not only in total but also per share of stock.

Retained Earnings - Strict1y speaking, the income statement ends with the item "Net Income." In our example the Retained Earnings are also reported.

Relation between Balance Sheet and Income Statement

There is a definite relationship between the balance sheet and the income statement. The amount of net income reported on the income statement, together with the amount of dividends, explains the change in retained earnings between the two balance sheets prepared as of the beginning and the end of the accounting period. This relationship is shown in the illustration below.

Income Tax Accounting

Most business entities must calculate their taxable income and pay taxes based on this income. The amounts of revenue and expense used to determine federal taxable income are usually similar to, but not identical with, amounts measured in accordance with generally accepted accounting principles. Normally special reports are prepared for tax purposes in accordance with tax regulations.

STUDENT: Will you give me the benefit of a summary of this Module?

TEACHER: Gladly.

Revenues are the value of goods sold and services supplied to customers during an accounting period.

Expenses are the cost of the resources used.

Net income is the amount by which revenues exceed expenses.

In measuring revenues, the basic guide is the realization concept, which is that revenues are generally recognized in the period in which they are realized, that is, in the period in which goods are shipped to customers or in which services are rendered. The amount recognized is the amount that customers are reasonably certain to pay.

The consistency concept requires that once a company has decided on a certain method of accounting for a given class of events, it will use the same method in accounting for all subsequent events of the same character unless it has a sound reason to do otherw1se.

The income statement summarizes the revenues and expenses for an accounting period. The "official" accounting period is one year, but interim income statements are usually prepared on a monthly or quarterly basis.

Satisfied, Student?

STUDENT: Yes, thank you, Teacher. Bye now!