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Chapter 3 -- Income Statement:
Reporting the Results of
Operating Activities
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
10th Edition
Clyde P. Stickney and Roman L. Weil
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Learning Objectives
1. Understand the accrual basis of accounting.
2. Understand when firms recognize revenues
and expenses.
3. Build skills in recording transactions.
4. Understand end-of-period adjustments.
5. Develop skills to analyze the income
statement.
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Chapter Outline
1. Accounting periods.
2. Accounting methods: cash and accrual bases.
3. Measurement principles of accrual based
accounting.
4. Overview of accounting procedures.
Chapter Summary
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 Income
1. The Accounting Period
generating activity occurs almost
continuously in modern firms.
 Financial reports are prepared at the end of
time periods of uniform length, for example,
months or quarters or years.
 Uniform time periods facilitate comparisons
and analyses.
 Many companies use the end of the calendar
year as the end of their accounting period.
 Retail stores are an exception so that they may
include the entire Christmas season in one
period.
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2. Accounting Methods for Measuring
Performance
(a) Cash basis of accounting.
 Revenues are recognized when cash is
received and expenses are recognized when
cash is paid.
(b) Accrual basis of accounting.
 Revenues and expenses are recognized on an
economic basis without regard for the actual
flow of cash.
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2.a. Cash Basis of Accounting
 Intuitive
and easy.
 Provides reliable information about cash flows.
 Provides information on the liquidity of a firm.
 Liquidity is the ability of a firm to meet its short
term cash obligations.
 Subject to manipulation, for example, the firm
can delay having to recognize an expense by
postponing cash payment.
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 More
2.b. Accrual Basis of Accounting
difficult conceptually.
 Economically, changes in wealth may occur
without involving cash, for example, a barter
trade or a customer purchasing goods on
account.
 Revenues and expenses are recognized
independent of the timing of the cash flow.
 Provides information on long-term profitability.
 Subject to manipulation by the choice of
recognition rules.
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3. Measurement Principles of Accrual
Accounting
Measurement involves both the amount and the
timing of the recognition for both revenues and
expenses.
(a) Timing of revenue recognition.
(b) Measurement of amount of revenue.
(c) Timing of expense recognition.
(d) Measurement of amount of expenses.
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3.a. Revenues -- Timing
 When
does the accountant recognize revenue?
 When both of the following are met:
1. The firm has performed all or most of the
services or it has delivered the goods, that is,
it has earned the revenue.
2. The firm has received a good, service or
right in exchange and can reasonably
measure the value of the good, service or
right. A promise to pay (such as a
receivable) is a right.
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3.b. Revenues -- Amount
 Revenues
are measured by the cash or
equivalent that it expects to receive.
 Uncollectible Accounts have no value by
definition and are not included in revenue.
 Sales Discounts and Allowances are reductions
in price and not included in revenue.
 Sales Returns are a reversal of the sale and are
not included in revenue.
 Delayed Payments may carry an implied
interest charge.
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3.c. Expenses -- Timing
 Assets
provide future benefits to the firm and
are consumed in the process of generating
revenues.
 As assets are consumed, the value of the
remaining asset is reduced and an expense in
incurred, thus, assets flow out of the firm as
expenses.
Balance Sheet
Assets
(Unexpired Costs)
Income Statement
Expenses (Expired Costs,
which reduce shareholders’
equity on the balance sheet.)
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3.d. Criteria for Expense Recognition
Accountants recognize expenses as follows:
1. If an asset expiration associates directly with a
revenue, that expiration becomes an expense in
the period when the revenue is recognized, that
is, expenses are matched to revenues.
2. If an asset expiration does not clearly associate
with revenues, that expiration becomes an
expense of the period in which the firms
consumes the benefits of that asset.
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Examples of Expense Recognition
 Product
Costs -- the cost of making a product is
not an expense until the product is sold, then it
becomes a cost of goods sold expense. Prior to
this time, the cost is the unexpired asset,
inventory.
 Marketing Costs -- may or may not give rise to
revenue. Most accountants prefer to expense
marketing costs in the period when occurred.
 Administrative Costs -- cannot easily be
matched with revenue, so are considered a
period cost.
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4. Overview of Accounting Procedures
(a) Relation between balance sheet and income
statement.
(b) Purpose and use of individual revenue and
expense accounts.
(c) Debit and credit procedures for revenues,
expenses and dividends.
(d) Adjusting journal entries.
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 The
4.a. Relation between Balance
Sheet and Income Statement.
balance sheet reports assets and financing
of those assets at a point in time.
 The income statement reports revenues and
expenses over a period of time.
 Dividends are a return to the shareholders and
are not an expense.
 Two consecutive balance sheets are connected
by the income statement.
The Basic Accounting Equation with
Revenues, Expenses and Dividends
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Assets
Assets
Assets
Assets
=
Liabilities
+
=
Liabilities
+
Contributed
Capital
+
Contributed
Capital
+
Contributed
Capital
=
=
Liabilities
Liabilities
Shareholders’
Equity
Retained
Earning
+
+
Retained
Earning
Beginning
of Period
+
Retained
Earning
Beginning
of Period
+
+
Net Income
for period
Revenues
for period
-
Dividends
for period
Expenses
- for
period -
Dividends
for period
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4.b. Purpose and Use of Individual Revenue
and Expense Accounts
 Revenue
and expenses could be recorded
directly to the Retained Earnings account.
 It is more informative to collect revenues and
expenses separately during the accounting
period.
 At the end of the accounting period, revenues
and expenses are cleared (reset to zero) for the
new accounting period. Their balances flow
into Retained Earnings. This is called closing
the accounts.
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4.c. Debit and Credit Procedures for
Revenues, Expenses and Dividends
 Revenues,
expenses and dividends are closed to
Retained Earnings.
 Recall that Retained Earnings normally carries
a credit balance since it represents a source of
financing; thus, credits increase R.E. while
debits decrease R.E.
Shareholders’ Equity (or R.E.)
decreases
increases
(debit)
(credit)
Expenses
Revenues
Dividends
Issues of Stock
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 Some
4.d. Adjusting Entries
journal entries are made at the end of
the accounting period just to separate the
effect of an event into its proper periods.
 Examples include:
1. Recognition of accrued revenues and
receivables,
2. Interest calculations,
3. Recognition of accrued expenses and
payables,
4. Allocation of prepaid operating costs, and
5. Recognition of depreciation.
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4.d.1. Recognition of Accrued Revenues
and Receivables
 A firm
earns revenue as it renders services. If
part of the service has been rendered in one
accounting period and the remainder in others,
accrual accounting calls for apportioning the
revenue among the appropriate periods.
 For example, a firm earns rental revenue as the
tenant occupies the property. If the rental
period spans two accounting periods, accrual
accounting calls for splitting the rent revenue
between the two in proportion to the rental
time.
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4.d.1. Recognition of Accrued Revenues and
Receivables (Cont.)
 Notice
in contrast, that cash basis accounting
would recognize revenue as the cash rent
payments were received.
 Other examples include notes receivable
which accrue interest revenue as time passes
without regard for the timing of cash
payments.
 The accrued revenue (a credit) is offset by an
accrued receivable (a debit) until the cash is
paid.
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4.d.2. Interest Calculations
 Interest
revenue is earned and interest expense
is incurred as time passes. Both of these are
accrued in proportion to time.
 If the interest period spans two or more
accounting periods, accrual accounting calls for
recognizing the interest at the end of each
accounting period in proportion to the amount
of time the interest was in effect.
 The offsetting journal entry is to a receivable (if
a revenue) or a payable (if an expense).
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4.d.3. Recognition of Accrued Expenses and
Payables
 As
a firm receives services, it incurs an
obligation to pay for them.
 If the services are received over a time period
spanning two or more accounting periods,
accrual accounting calls for recognizing the
proportion of service received as an expense.
 The offsetting journal entry is to a liability
account, generally a payable.
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4.d.4. Allocation of Prepaid Operating Costs
 Sometimes,
the firm prepays for a service.
Since a prepaid service has future benefit, it is
an asset until the time for the service expires.
 If the time period of service spans two or more
accounting periods, accrual accounting calls
for recognizing the asset when the service
begins and adjusting the asset down at the end
of accounting periods in proportion to the
amount of service used.
 The asset is reduced (credited) and an expense
is recognized (debited).
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4.d.5. Recognition of Depreciation
 Depreciation
is a long-term form of a prepaid
service. An asset may last many years. As the
asset is used, it is expensed.
 One simple form of depreciation is straightline. The original cost of the asset is expensed
over the useful life in equal amounts over
time.
 Because assets may be purchased at any time
during the accounting period, some special
rule must apply to the first year of
depreciation -- some firms just take one half
of a year’s depreciation for the first year.
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

5. Interpreting and Analyzing
the Income Statement
The income statement provides information about the
profitability of the firm over the long term.
Three tools are useful in analysis:
1. Common size statements -- revenues are set to 100% and each
expense item is shown as a percentage of revenue.
2. Time series analysis -- changes from year to year are
calculated in both revenue and expense items. It is hoped
that revenues will grow but that expenses will remain stable
or even reduce in proportion to revenue.
3. Cross-section analysis -- revenues and expenses are compared
to competitors. Some differences are strategic and some may
be driven by different production technologies, but some
differences may be due to inefficiency.
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 The
Chapter Summary
income statement which measures net
income is presented.
 Revenues and expenses are defined and how
they relate to retained earnings is presented.
 Adjusting entries are defined as journal entries
that are made at the end of an accounting
period to recognize revenues or expenses but
they are not initiated by an economic event.
 Further chapters discuss the use and analysis
of the income statement.