Financial Accounting Basics:The Income Statement

Developed and narrated by: C. A. Galeener, PhD

This module is provided by the Texas Public Health Training Center in part through a grant supplied by the Public Health

Training Center Program, Health Resources and Services Administration, U.S. DHHS.

Objectives…

Accounting concepts and principles

Definition of financial statements

Governing institutions

Income statement

History and purpose of accounting

Accounting and social development

• Ancient record keeping

• Modern accounting requires: (A. C. Littleton)

– Private Property – Capital – Money – Commerce – Credit – Writing

– Arithmetic

Modern accounting origins…

• 14th C. Italy: “Double entry” bookkeeping emerges with Luca Paciolo’s Summa

• Initially a trade secret

• Many of Paciolo’s concepts persist today: memorandum, journal, ledger with debits and credits.

Financial statements ….

• Key components of financial statements

– income statement

– balance sheet

– statement of cash flows

• Information system for many interests

Reliable accounts are critical to modern business - ask anyone who used to work

for Enron…

Who uses financial statements?

• Public vs. closely-held corporations

• Shareholders (investors) and other stakeholders (creditors, suppliers, directors, etc.)

• Potential investors or their reps

• Donors and potential donors/ funders

• Government – reporting and tax filing– Transparent business; non-profits reporting– Financial reports vs. tax books

A common “language” is needed

• Generally Accepted Accounting Principles (GAAP): common definitions, reporting conventions, and principles.

• The SEC has statutory authority re financial statements – but farms out rule-setting to the Financial Accounting Standards Board (FASB) for private business reporting.

• FASB tends to move very deliberately.

FASB guidance framework …

• Statements of financial accounting concepts (7 since 1978, last in 2000)

• Statements of financial accounting standards (more detailed -- 154 to date)

• Interpretations and technical bulletins – many more

FASB sets general rules …

• Issues broad statements or opinions

• Many issues are industry-specific, e.g.:– oil and gas accounting– retail – health care

Others involved in “how to’s” …

• The American Institute of Certified Public Accountants (AICPA) industry committees -- detailed guidance on preparing/ auditing financial statements.

• Other groups (e.g., Healthcare Financial Management Assoc.) have less heft.

Public Accountancy…a profession

• Specialized knowledge and continuing education

• Ethical standards

• Many people get accounting degrees but never become licensed as a CPA.– Internal vs. public accounting– Each state establishes: licensure rules;

exams; required experience; what public services require a license.

Public Accountancy Functions…

• Accounting: keeping the books

• Audit: giving an opinion on financial reports

• Other attest: examining processes, analyses, etc.

Accounting principles, terminology and concepts…

The next several slides introduce terms and concepts key to financial accounting.

Accounting entity…

Separates the business from investors

When are accounts “consolidated?”

Establishes what is “in/out” of statements

Accounting period…

“Going concern” assumption…

• Most firms use months/ quarters/ years

• “Fiscal years” may start any month

• Financial statements not unduly influenced by short-term effects

Federal Fiscal Year Budgets

Source: http://www.rules.house.gov/archives/98-325.pdf

If alternative accounting interpretations yield different results pick the one that is less likely to overstate the entity’s financial status.

Counterexample: Enron’s accounting for deals.

The Three “C’s”… Conservatism

Apply the same guidelines over time; disclose any change.

Example: avoid changing inventory basis; declare when you do so.

The Three “C’s” … Consistency

Apply definitions and approaches common to the sector.

Example: hospitals use terminology and definitions related to hospitals, not those appropriate to extractive industries

The Three “C’s”… Comparability

Some key accounting concepts…

• Objectivity: documentation of events

• Reliability: correct representation – users can depend on it; reproducible

• Full disclosure: no hiding of assets or events

• Materiality: what is material to Dr. Jones’ solo practice is likely not material to General Motors

Match revenues to expenses…

• Matching principle: report revenues with their accompanying expenses

• Rule holds even if expenses must be estimated (as in capitation)

• Expenses vs. expenditures

Cash vs. accrual accounting…• Cash accounting: revenues and

expenses apply to the period in which the cash comes in/ goes out.

• Small, non-reporting entities often use cash accounting.

• Accrual accounting:– revenue is recognized when customers

incur a payment obligation;– an expense is recognized when a good or

service is sold and the economic costs to produce that item “expire.”

Not all receipt of money is a revenue…

Revenues are not generated when:– Receivables are collected– Initial investors contribute assets– Shares are newly placed in the market– Stockholder shares gain value in the

market– Held assets gain market value

Cash-basis accounting…

• Small entities usually choose cash-basis:– Financial events are recorded when cash

changes hands.– Revenue recognized when cash received (cash

receipts)– Expense recognized when cash paid (cash

payments)

• Strict vs. modified cash-basis• Cash-basis accounting does not meet GAAP

Accrual-basis accounting…

Shortcut way of looking at it:

Events are recognized on a change in amounts you owe or that are owed to you.

Accrual accounting – when is a a liability recognized?

• Example:

A company pays employees on the last business day of each week. The end of the month occurs on a Wednesday … the company accrues the liability it has for three days wages in a “Wages Payable” account, even though cash payment has not yet been made.

Accrual accounting -- when is a revenue recognized?

Revenues are generated by the delivery of goods/ services thus creating a customer obligation to pay.

Revenue is not recognized when a customer simply places an order.

Revenues are what generate “profit.”

Depreciation…

• Fixed assets decay in value over time (i.e. they depreciate) to an estimated salvage value.

• Depreciation expense represents the financial assessment of that loss.

• The matching principle requires that depreciation be recognized as a cost.

• Depreciation is a non-cash expense on the income statement.

Depreciation methods…

• Straight line: equal amounts over the expected life of the asset – analysis

• Modified accelerated (MACRS): formula-based method that yields a rapid declining rate of depreciation each year – taxes

• Sum of the years’ digits: declining balance between straight line and MACRS

• Activity-based/ other methods: based on intensity of use over time

What happens when you sell an asset for more than its depreciated amount?

Accounts and transactions…

• Accounts are info units used in tracking accounting events, e.g. A/R.

• All of the accounts used in the business make up the general ledger.

• The chart of accounts lists all accounts used in the general ledger identified by reference numbers.

• A journal is a record of a transaction with related debits/ credits to accounts.

Accounting is a process…

The next several slides address accounting as

a process.

The basic accounting equation…

Assets = Liabilities + Equity (uses) (sources)

Everything of value that an organization owns (assets) is the result of borrowing (liability) or investment of already owned wealth (equity).

This is an identity -- must balance.

Mortgage example:

Assets = Liabilities + Equity (uses) (sources)

• You own your house – your asset (uses).• How did you get the funding (sources)…

– Mortgage (liability)– Equity (down payment)

Debits and credits…

• Accounting data is compiled in accounts through double entry into a journal

• “Debit” and “credit” are conventions meaning “left” and “right” in the T-accounts that represent the transaction.

Every accounting transaction affects at least two accounts – with balancing debits and credits. That’s why it is

termed “double entry.”

Reference chart…

Assets Liability + Owners’ Equity=

Cash

DR CR+

_

A/P

DR CR_

+

Retained Earnings

DR CR_

+

Expense RevenueDR CR DR CR

+_

+_

Balancing the books…

• For every debit there must be equal credits – keeps the books balanced.

• Income statement accounts are revenues and expenses

• Balance sheet accounts are: assets, liabilities, and equities.

Handy crib sheet…

Source: www.ivey.uwo.ca

Income statement defined…• The income statement (or “P/L”) answers

the question: how much profit was made in a given time period?

• Profit or “net income” is:

Net income = revenue – expenses

• Prepared after all adjusting entries made and the accounts balance

Income is a “flow;” and Balance Sheet accounts, a “stock.”

Basic Income Statement Accounts…

EXPENSE

DR CR

REVENUE

DR CR

+ +- -

Net Income = Revenue - Expense

Income statement: NI = R - E …

Revenues ($k)

Net sales_____$4,400

Rent revenue_____30

Interest revenue__ 15

Total revenue__$4,445

($K)

Income before taxes ___ $500 (i.e. BFIT)Income taxes _________ 150Net income____________ 350 (i.e. AFIT)

Expenses ($k)

Total expense_ $3,945

COGS ___ $3,000 Selling _____ 550 Admin ______350 Interest _____ 45

Income for the period Sept. 1 – 30, 200x

Intergalactic Medical Devices, Inc.

Non-profits and income…

• Even non-profits have “profits” in the income statement sense!

• What would happen if a NFP has no or negative income?

• “No margin; no mission”

• NFP income statement: statement of activities

Non-profits and income accounts …

• “Fund accounting”• Expenses segregated by:

– Program services– Fundraising– Operations

• Revenues segregated by:– Public support– Exempt purpose activities– UBI

Net income vs. cash flow…

• Net income is nice, but “cash is king.”

• Approximate cash flow:

~ cash flow = net income + non-cash expense

What is usually the largest non-cash expense?

Test yourself on the material…

Select the best answer by clicking on the box. You will then find out if you were correct – and the reasoning behind the correct answer. The notes indicated by the light bulbs are further insights or examples illustrating a point.

It is illegal under federal law to keep separate sets of books for different purposes.

True

False

It is illegal under federal law to keep separate sets of books for different purposes.

True

False

Books for tax purposes often legitimately differ from books used in financial reporting. E.g., the tax code often allows more rapid depreciation that is permitted under SEC rules. Further, management reports and analysis may differ from either set.

What is not permitted is hiding or falsifying transactions, or keeping secret bank accounts or other ways of misleading stakeholders, or even committing fraud.

Which of these represents the best estimate of cash flow?

net income

net income + non-cash expenses

net income + depreciation

Which of these represents the best estimate of cash flow?

net income

net income + non-cash expenses

net income + depreciation

Although net income + depreciation is a good answer, net income + non-cash expenses is better since it also includes expense accruals and provisions that will be paid in the future.

Entities that are required to report their financial results publicly must use:

Cash accounting

Cash flow accounting

Accrual accounting

Entities that are required to report their financial results publicly must use:

Cash accounting

Cash flow accounting

Accrual accounting

Accrual accounting must be used since cash accounting is not GAAP compliant – e.g. it does not use the matching principle.

A debit results in a deduction to an account, while a credit results in an account addition.

True

False

A debit results in a deduction to an account, while a credit results in an account addition.

True

False

Recall that debit only means left in a T-account and credit only means right. Whether this results in an addition or a deduction depends on whether the account is an asset, liability, or equity account.

Which statement defines the GAAP conservatism principle?

Revenues and their related expenses must be reported at the same time.

Use the same reporting methods over time.

If there are alternative accounting interpretations, use the one that is least likely to overstate results.

Which statement defines the GAAP conservatism principle?

Revenues and their related expenses must be reported at the same time.

Use the same reporting methods over time.

If there are alternative accounting interpretations, use the one that is least likely to overstate results.

The correct answer is the third. The first choice is a statement of the matching principle. The second is a statement of the consistency principle.

Thank you.