Class 5 Chapter 3 The Income StatementPlanIncome MeasurementIncome Statement (Accounting cycle)Income Statement ElementsSlide 6Slide 7Principles Affecting Income DeterminationThe Revenue Recognition PrincipleThe Revenue PrincipleSlide 11Slide 12Slide 13Slide 14The Matching PrincipleSlide 16Slide 17Slide 18Slide 19Slide 20Accrual vs. Cash Basis AccountingSlide 22Slide 23Debit/Credit FrameworkSlide 25Slide 26Expanded Transaction Analysis ModelSlide 28Summary of Debit/Credit FrameworkSlide 30Slide 31Slide 32Slide 33Slide 34Slide 35What did we do?Practice problem 1Practice problem 1Slide 39Slide 40Slide 41Slide 42Slide 43Next Class1Class 5Chapter 3 The Income StatementAccounting 2610Xiumin Martin9/19/20112Plan Business operating objective is to make profits. How do we measure these profits? Income MeasurementOperating cycleIncome statement elementsPrinciplesAccrual versus Cash Basis AccountingDebit/Credit Framework Example3Income MeasurementThe cash-to-cash cycle of a businessLength depends on nature of businessThe Operating Cycle1 2 3 4Purchasemerchandisefrom supplierPay supplier for merchandiseSell merchandiseto customerCollect cash fromcustomertime4Income Statement (Accounting cycle)Income statement provides a measure of company’s performance on a periodic basisRelies on time period assumption that the life of a company can be divided into shorter intervals5Income Statement ElementsRevenues result from selling goods or services as part of company’s normal ongoing operations.There are “revenues” not from operating activitiesGains are a result of peripheral transactions (E.g. Selling of land).Investment income6Income Statement ElementsExpenses are the “use” of assets to generate revenues (different from expenditures)There are expenses not from operating activitiesLosses are a result of peripheral transactionsInterest expense7Income MeasurementTwo critical questions when reporting on a periodic basis1. When should revenue and expenses be recognized? (Recognition)2. What amount should be recorded by the company? (Measurement)8Principles Affecting Income DeterminationRecognitionRevenue Principle: Record revenues when earned and measurableMatching Principle: Record expenses when incurred in earning revenueMeasurementHistorical Cost Principle: Cash equivalent cost given up is the basis for initial recording of financial statement items9The Revenue Recognition PrincipleRecognize Revenue when1. Delivery has occurred or services have been rendered. 2. There is evidence of an arrangement for customer payment. 3. The price is fixed or determinable. 4. Collection is reasonably assured.In general, these conditions are satisfied at the point of delivery of goods or services.10The Revenue PrincipleSometimes services are rendered before cash collection.In these circumstances a revenue will be recorded along with an asset.$ReceivedCash (+A) x,xxx Accounts receivable (-A) x,xxxAccounts receivable (+A) x,xxx revenue (+R) x,xxxCompany Delivers11The Revenue PrincipleCASH TO BE COLLECTED (Owed by customers)and already earned asREVENUE (Earned when goods or services provided)Interest receivable Interest revenueRent receivable Rent revenueRoyalties receivable Royalty revenueOther assets reflecting revenues earned butOther assets reflecting revenues earned butnot yet received in cash includenot yet received in cash include12The Revenue PrincipleSometimes services are rendered AFTER cash collection.In these circumstances a liability will be recorded along with cash collection. The liability will decrease as services are rendered and revenue is recognized.$ReceivedCompany DeliversCash (+A) x,xxx Unearned revenue (+L) x,xxxUnearned Revenue (-L) x,xxx Revenue (+R) x,xxx13The Revenue PrincipleCASH COLLECTED (Goods or services due to customers)over time will becomeREVENUE (Earned when goods or services provided)Rent collected in advance Rent revenueUnearned air traffic revenue Air traffic revenueDeferred subscription revenue Subscription revenueTypical liabilities created upon cash receipt that will Typical liabilities created upon cash receipt that will becomebecomerevenue when earned, includerevenue when earned, includeThe Revenue PrincipleRevenues are accompanied by:Asset increases or liability decreases (both are debits, remember?)Sell product, receive cash ( Assets)Perform service that was paid in advance, reduce liability recorded for unearned revenue ( Liabilities)1415The Matching PrincipleRecognize Expenses whenResources are consumed to generate revenues (regardless of when cash is paid)16The Matching PrincipleOften cash is paid before actual expense is recognized. In this case, an asset will be recorded. This asset will turn into an expense over time. ExpenseIncurredRent expense (+E) x,xxx Prepaid rent expense (-A) x,xxx$PaidPrepaid rent expense (+A) x,xxx Cash (-A) x,xxx17The Matching PrincipleCASH PAID FORas used over time becomesEXPENSESupplies inventory Supplies expensePrepaid insurance Insurance expenseBuildings and equipment Depreciation expenseTypical assets and their relatedTypical assets and their relatedexpense accounts includeexpense accounts include18The Matching PrincipleSometimes expenses are incurred to generate revenue but cash is not paid out yet. In this case, a liability will be recorded. $PaidWages payable (-L) x,xxx Cash (-A) x,xxxWages expense (+E) x,xxx Wages payable (+L) x,xxxExpenseIncurred19The Matching PrincipleCASH TO BE PAIDand already incurred asEXPENSESalaries payable Salaries expenseInterest payable Interest expenseProperty taxes payable Property tax expenseTypical liabilities and their relatedTypical liabilities and their relatedexpense accounts includeexpense accounts includeThe Matching PrincipleExpenses are accompanied by:Asset decreases or liability increases (both are credits, remember?)Employees earn wages Reduce cash ( Assets) orRecord salary payable ( Liabilities)2021Accrual vs. Cash Basis AccountingAccrual BasisRevenue recorded as earned Expenses recorded as incurred Doesn’t necessarily correspond with cash flowsCash Basis Revenues and expenses recorded when cash exchanges hands22Accrual vs. Cash Basis AccountingProblems with
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