INCOME STATEMENT

Accounting ASW

Summer 2007

Warning!

• Income statement is the hardest concept in accounting– Seems intuitive– More subtle than it seems– Takes a while to really understand it

• Litmus test: Why would we record:Rent Expense (I/S-Exp) 100

Rent Payable (B/S-Liab) 100

Two ways to think about the income statement

(1) Intuitively (and loosely)– Lists revenue firm earned

• Even if not yet received (e.g., credit sales)

– Lists all costs incurred to earn revenues• Even if not yet paid (e.g., rent on credit)

– Calculate whether you were profitable (net income)

• Even if not all cash (accrual accounting)

Two ways to think about the income statement

(2) The “right” (and less intuitive) way– Income statement is part of the balance sheet

Assets = Liab. + Contr. Cap. + Retained Earnings

REYear End ‘07 = REYear End ‘06 + NIIn ‘07 – Div.In ’07 + OtherIn ’07

Net IncomeIn ‘07 = RevenuesIn ‘07 - ExpensesIn ’07

– Therefore, net income is a function of how you measured your balance sheet

Merchandise Sale Example

Assume purchase at $80

Inventory 80

Cash 80

Sell for $100

Cash 100

Inventory 80

? 20

What is the credit?

Is an asset reduced?

Is a liability created?

Did investors contribute more capital?

Therefore, is it retained earnings--residual of

residual.

What are Retained Earnings?

Retained Earnings is a permanent account (balance sheet)

Measures equity which was created bythe operations of the firm (not contributed)

Not an asset (the associated assets are separately recognized)

How does it get to RE?

Put into “temporary accounts” (measure only net income this period)

Split into revenue and expense

Cash 100 Sales Revenue (Rev.)-RE 100

Cost of Goods Sold (Exp.)-RE 80 Inventory 80

What are revenues & expense accounts?

Temporary accounts

Part of Retained Earnings

Used to track net income during the period

Get folded into RE at the end of the period

Begin and end with zero balances

Closing Entry

Recorded at period end after preparing the income statement

Sales Revenue--RE 100 Cost of Goods Sold--RE 80 Retained Earnings 20

Similar entry for other revenues & expenses

Measurement under Accrual Accounting

Recognize revenues when earned

Match expenses to revenues where possible

Net income is revenue net of any associated costs, irrespective of cash flows

Revenue Recognition

Have performed all (or a substantial portion) of service

Have received an asset (cash or receivable) which can be measured

Revenue may be adjusted for expected bad debts and sales discounts and allowances

Revenue Timing IssuesCash NowCash 100 Sales Revenue 100

Cash in future Accounts Receivable (Asset) 100 Sales Revenue 100

Cash 100 Accounts Receivable 100

Cash in pastCash 100 Adv. from Cust. (Liab.) 100

Advances from Customers 100 Sales Revenue 100

Problem 3.18

Problem 3.18: Neiman Marcus How much revenue is recognized in Feb, March & April for: Collect $800 in March for a suit to be delivered in April Collects $2,160 in March cash sales Collects $39,200 in March for sales in February

Sells $59,400 in March, to be collected in April Collects $18,000 in rent on March 1 for 3/1 – 4/30 Collects $18,000 in rent on April 1 for 3/1 – 4/30

Expense Recognition

Match to revenue to the extent possible--e.g.,product cost- Merchandising--cost of acquiring inventory- Manufacturing--cost of making product

(including overhead)

Otherwise charge to expense as consumed--e.g.,- selling general and administrative expense- research and development expense

Measure on same basis as asset being consumed

Timing of Expenses

Concurrent with cash flowsRent Expense 100 Cash 100

Prior to cash flowRent Expense 100 Rent Payable 100Rent Payable 100 Cash 100

After cash outflowPrepaid Rent 100 Cash 100Rent Expense 100 Prepaid Rent 100

DepreciationSpecial case of prepaid expenses

Spread cost over period of benefit- just like other prepaids- typically spread straight-line- Depreciation Expense = (Cost - Estimated Salvage)/Estimated useful LifeE.g. $1,100 asset, 10-year life, $100 salvage

Depreciation Expense 100 Accumulated Depreciation- (PP&E Contra) 100

Problem 3.20

Problem 3.20: Sun Microsystems How much is recognized in June, July and August: $180K paid on July 1 for one year’s rent. Receives a June utility bill on July 2 for $4.56K, pays in July. Purchases office supplies on account for $12.6K during July. Pays $5.5K in July and $7.1K in August. Supplies on hand were $2.4K on 7/1, $9.2K on 7/31 and $2.9K on 8/31.

Pays $7.2K on July 15 for property taxes for the calendar year. Pays $2K on July 15 for a van to be delivered in September. Advances an employee $4.5K on July 25 from August salary. Pays $6.6K on July 25 for ads that appeared during June.

Types of Entries

Transactions-based entries

- know to record them based on a transaction

- e.g., receipt/payment of cash, credit sale, receipt of bill, etc.

- recorded during the period

Adjusting entries

- Cases in which there is no immediate notification (transaction)

- Often necessitated by passage of time

- Expense examples: depreciation, accrual of salaries, expiration of prepaid rent

- Revenue examples: advances from customers earned, interest earned to be collected

- Technically could be recorded every day, but typically wait until end of period (quarter)

- Auditor doesn’t care if accounts are right until reporting date

Closing entries

- Clear out all revenue and expense accounts to retained earnings

- After completing income statement, before balance sheet

- Problems 3-31 and 3-33

Problem 3.31: Prepare journal entries for transaction and yearend: 12/2/6: Swap a $6K account payable for a note due on 1/30/7 with 10% annual interest 9/1/6: Sell a two-year premium for $18K in advance 10/1/6: Buy a machine for $40K, $4K expected salvage in 4 years

7/1/6: Buy a car for $24K, $3K expected salvage in 3 years 12/2/6: Prepay $12K to rent an office for 3 months starting 12/1 11/1/6: (Start business on 11/1.) Buy supplies of $7K on account. Pay $5K by yearend. Inventory of $1.5K at yearend.

Problem 3.33: Prepare I/S and B/S on 12/31 Purchase inventory on account for $1,100K. Sell on account for $2,000K, cost of goods sold is $1,200K. Collect $1,400K from accounts.

Pay inventory suppliers $950K for payables. Pay employees $625K for services during year. Repaid the note in 2.29 with interest: $80K note, 6% annual interest, signed on 12/31/12, due 6/30/13. Recognize interest on long-term bank note in 2.29: $300K note, 8% ann. interest, signed 12/31/12, first interest to be paid on 1/1/14, principal to be paid in five years.

Recognize expired insurance from 2.29: 1 year prepaid policy, $12K, signed 12/31/12, ending 12/31/13. Recognize depreciation from 2.29. Building cost $450K, expected life 25 years, equip cost $80K, expected life 5 years. Estimate taxes owed at 40% of pretax income.

Pr. 3.33 Cash Accounts Receivable Prepaid Insurance

343.00 0.00 12.00

Inventory Land and Building Equipment

275.00 500.00 80.00

Accumulated Deprec. Accounts Payable Equip. Note Payable

30.00 80.00

Interest Payable Bank Loan Payable Contributed Capital

300.00 800.00

Retained Earnings Sales Revenue Cost of Goods Sold

Salary Expense Interest Expense Depreciation Expense

Income Tax Expense

Problem 2.30: Prepare B/S on 1/31 1. Issue Ps500K of common stock. 2. Purchase patent for Ps20K, Ps4 to register. 3. Order merchandise for Ps200K. 4. Sign a lease for Ps30K/mo starting 2/1,

prepay Ps60K.

5. Receive merchandise in 3, to be paid later. 6. Return Ps8K of defective merchandise in 3. 7. Pay off Ps160K of payable from 3, less 2%. 8. Pay Ps12K for insurance starting 2/1.

Problem 3.34: Prepare I/S and B/S on 2/28/8 2/1: Borrow Ps90K and purchase equipment for Ps90K. Loan is 12%/year, payable on 2/1/7. Purchase Ps217.9K of inventory on account. Sell merchandise costing Ps162.4K for Ps62.9K cash and Ps194.6K on account.

Pay employees Ps32.4K for services during Feb. Pay utilities of Ps2.7K for Feb. services. Collect accounts of Ps84.6K from customers. Pay accounts payable of Ps210K, less 2%, and Ps29K at full amount.

Adjusting entries on 2/28: Owe employees Ps6.7K for February services since last pay check. Owe utilities of Ps0.8K since last payment Equipment purchased on 2/1 has 5 year life and no salvage. Prepaid rent from 2.30 is used up.

Prepaid insurance from 2.30 is used up. Patent in 2.30 is amortized over 60 months. Recognize interest on 2/1 loan. Calculate taxes owed at 30% of pretax income.