Accounting for Non-Financial Managers
Chapter 3: The Income Statement
Discussion Questions & Problems: Solutions:
Discussion Questions:
3.1
What is the purpose of the income statement?
The income statement summarizes the revenues earned, the expenses
incurred, and the net profit for a period of time, usually one year.
3.2
The income statement provides a link between successive balance sheets: how
does it do this?
Revenues increase and expenses decrease assets and equity, so the net
income shows the total increase (or decrease if it is a loss) of the assets
and the equity for a year, so it explains the change in net assets and equity
on the balance sheet.
3.3
Why is the income statement prepared for a one year period, unlike the balance
sheet, which is prepared at a point in time?
The balance sheet is a list of assets, liabilities and equity at point in time,
the income statement summarizes revenue and expense activity for a year
3.4
Which is more useful to the shareholder: the income statement or the balance
sheet? Which is more useful to the creditor?
Both statements are useful to both parties, but the income statement is
more useful to the investor, as it shows how much his investment has
increased, while the balance sheet is more useful to the creditor as it
shows what assets are available to pay his interest or loan.
3.5
Explain what is meant by revenue matching in the income statement.
The revenue in the income statement is the revenue recognized as earned
in the year, no matter when the cash was received; the direct costs of
earning that revenue are matched to the same time period when the
revenue was recognized.
3.6
Give a practical example of matching expenses against time a period.
If a property is rented for a year at $10,000 per month, then the annual rent
expense will be recognized as $120,000, although the amount paid may be
more (e.g. when paying “first and last” make it a larger payment) or less
(e.g. when the rent is owed at the end of the year).
3.7
In calculating cost of goods sold, explain how the inventory adjustment makes
matching possible.
The inventory adjustment makes matching possible by adjusting the cost
of goods sold: an increase in inventory reduces the cost of goods sold,
while a decrease in inventory increases the cost of goods sold.
3.8
What happens when the historic cost concept is in conflict with the conservatism
concept?
Conservatism would win. Accounting concepts do, occasionally, collide
with one another. While the historic cost concept is a fundamentally sound
way of making a first estimate of value, it would be superseded by a lower
value suggested by the conservatism concept.
3.9
What is the purpose of the allowance for bad and doubtful debts?
The allowance for bad and doubtful debts matches that expense with the
period when the relevant revenue was earned.
3.10
What is the accounting principle that underlies the depreciation calculation, and
how is this achieved by the depreciation expense?
The depreciation principle matches the expense associated with the
gradual consumption of a long-term asset against the period that benefited
from the asset’s use: it does this by reporting a depreciation expense, even
though no transaction has occurred.
Problems
3.1
Thomas Dylan started business on 1st January manufacturing and selling doors
and windows. By 31st December the following events had occurred:
$500,000 of goods had been ordered; of that:
irrelevant (no transaction, no revenue recognition)
$400,000,000 of goods had been delivered and paid for;
recognize $400,000 revenue
Of that $400,000, one customer had complained that the doors were
manufactured to incorrect specifications, and they were returning goods invoiced
at $10,000;
recognize $10,000 sales returns
$30,000 of goods had been delivered, but not paid for;
recognize (sales realization principle)
$20,000 of goods had been manufactured, and were waiting in the loading bay
for shipment;
do not recognize as revenue: these are still inventory
$10,000 of goods were in process of being manufactured;
do not recognize as revenue: these are still inventory
$40,000 of goods were not yet started.
Do not recognize
Required:
a) calculate the sales revenue for the year;
sales revenue: $400,000 - $10,000 + $30,000 = $420,000
b) describe all the accounting principles that apply to this situation.
See above
3.2
Heaney & Co operate a lawn care and snow clearing service for households in
the Georgian Bay area. Describe how each of the following separate events
would be reported as revenue for the year 2002:
a) cash sales received totaled $600,000, credit sales invoiced totaled
$900,000;
Recognize sales revenue of $1,500,000
b) customers paid a total of $500,000 in September for snow clearing
services for the winter 2002/2003. By 31st December no snow had fallen,
but the usual winter weather was expected in early 2003;
Some, or possibly all, of the $500,000 revenue should be treated as
revenue received in advance, and treated as 2003 revenue.
c) due to an error in the book-keeping system, no invoice was sent to
customer 37 by 31st December 2002. His lawn had been mowed for the
entire 2002 summer. It is expected that she will accept a late invoice, to
be issued in January 2003, and that she will pay by February 2003 at the
latest;
Recognize accrued revenue of the whole amount earned
d) cash of $50,000 was received in January 2002, for work done in 2001.
At the start of 2002 an account receivable should have existed in the
amount of $50,000; this extinguishes the account receivable, so no
further action is necessary.
3.3
Marsha operates a retail clothing store. Her pricing policy is to mark up cost by
100% to get selling price. The following data applied to year 2002:
Inventory at cost, 1st January:
Goods purchased:
Inventory at cost, 31st December:
Sales revenue:
$ 50,000
$ 720,000
$ 100,000
$1,300,000
Required:
a) what was the cost of goods sold?
Opening inventory:
Add: goods purchased:
Goods available:
Less closing inventory:
Cost of goods sold:
$ 50,000
720,000
770,000
100,000
$670,000
b) what was the gross margin?
Sales:
Cost of goods sold:
Gross margin:
$1,300,000
670,000
$ 630,000
c) what was the gross margin as % of sales?
Gross margin as % of sales = $630,000/41,300,000 = 48.5%
d) is there a problem?
Yes, there is a problem: the gross margin % should be 50% if she is selling
goods marked up 100% on cost. Either she is not keeping to her markup
policy, or there has been some loss of inventory.
3.4
Shapiro co purchased a one-year business insurance policy on 1st October 2001
at a cost of $10,000. The policy was renewed on 1st October 2002 at a cost of
$12,000.
Required:
a) what was the insurance paid in advance as at 1st January 2002?
9/12 * $10,000 = $7,500
b) what was the insurance paid in advance as at 31st December 2002?
9/12 * $12,000 = $9,000
c) what was the insurance expense for year 2002?
9/12 * $10,000 + 3/12 * $12,000 = $10,500
d) What accounting principle applies:
This is an example of the matching principle
3.5
One 1st January 2002 Janes Inc had an accrual for wages owing to staff of
$300,000. During year 2002 a total of $1,500,000 was paid to employees as
wages. On 31st December 2002 accrued wages totaled $250,000. What was the
wage expense for the year?
Paid:
Add closing accrual:
Wage expense for the year:
$1,500,000
250,000
300,000
$1,450,000
3.6
Janes Inc. bought a new computer system for $200,000 on 1 st January 2002. It
is expected that it will be used for 5 years, and then be replaced. It will have no
terminal value. Janes Inc. uses the straight-line method of depreciation.
Required:
a) calculate the annual depreciation expense:]
Annual depreciation expense: (Cost – residual value)/# years:
$200,000/5 = $40,000
b) show the way the computer system would be shown on the balance sheet
as at:
Date
Cost
Accum. Dep.
Written-down Value
31/12/2002:
$200,000
$ 40,000
$160,000
31/12/2003:
$200,000
$ 80,000
$120,000
31/12/2004:
$200,000
$120,000
$ 80,000
31/12/2005:
$200,000
$160,000
$ 40,000
31/12/2006:
$200,000
$200,000
$
nil
3.7
General Smiles had the following transactions for January 2002:
Sales for cash totaled $50,000;
Sales on credit totaled $40,000;
Cash received for credit sales of earlier months totaled $25,000;
Typically, 4% of credit sales become uncollectible;
Goods purchased for resale totaled $45,000;
Inventory decreased from $10,000 on 1st January, to $8,000 on 31st January;
Wages paid totaled $20,000;
$5,000 of performance related bonuses for January were as yet unpaid by the
end of the month;
A lease was agreed for a new store: $10,000 was paid, as first and last month’s
rent at $5,000 per month;
Store equipment was purchased for $160,000;
The store equipment is to be depreciated over its 12 year life on the straight line
basis, with an expected terminal value of $16,000.
Required:
prepare an income statement (in good form) for January.
General Smiles: Income Statement for January:
Revenue:
$90,000
Cost of goods sold:
Purchases:
$45,000
Add decrease in inventory 2,000
47,000
Gross margin:
43,000
Less expenses:
Wage expense:
$25,000
5,000
Depreciation expense
1,000
Doubtful debts expense
3,600
34,600
Net income:
$ 8,400
($50,000 + $40,000)
($20,000 + $5,000)
(one month’s rent)
($160,000 - 16,000)/12*12
($90,000 * 4%)
3.8
The Warden Co had the following items in its 2002 income statement:
Sales revenues:
Opening inventory:
Goods purchased for resale:
Closing inventory:
Wages expense:
Rent expense:
Utilities expense:
Depreciation expense:
Interest expense:
Income tax expense:
$800,000
$100,000
$450,000
$ 50,000
$ 25,000
$ 20,000
$ 37,000
$ 18,000
$ 10,000
$ 80.000
Required:
a) prepare an income statement in good form;
b) calculate the following ratios:
gross margin as % of sales;
operating income as % of sales;
net income as % of sales.
Warden Co: Income Statement for the year ended 31st December 2002:
% of sales
Sales Revenue:
$800,000
100%
Less: Cost of goods sold:
Opening inventory:
$100,000
Add: Purchases:
450,000
550,000
Less: closing inventory:
50,000
500,000
Gross margin:
$300,000
37.5%
Less operating expenses:
Wages expense:
Rent expense:
Utilities expense:
Depreciation expense:
Operating income:
$ 25,000
20,000
37,000
18,000
Less
Interest expense:
Income tax expense:
Net income:
$ 10,000
80.000
100,000
$200,000
25.0%
90,000
$110,000
13.75%