AC310

Principles of Accounting
I: Financial Accounting
Session 2:
Measuring and Reporting Financial Performance
The Income Statement
Learning Objectives
After studying this chapter, you should be able to
1. Explain how accountants measure income
2. Determine when a company should record revenue from a sale
3. Use the concept of matching to record the expenses for a period
4. Prepare an income statement and show how it is related to a balance sheet
5. Account for cash dividends and prepare a statement of retained earnings

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Measuring Income
• Up to this point, we have only considered transactions that do not
create “wealth”
• But managers and investors want to know how well the company is
doing economically – accountants try to tell them by measuring
income
• Income is a measure of the increase in the “wealth” of an entity over
a period of time
• Income is generated primarily through the operating cycle

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The Operating Cycle

Starts Accounts
Startswith
with Buys Merchandise
Merchandise
Merchandise Sells Merchandise
Accounts
Cash Inventory Receivable
Receivable
Cash Inventory
$100,000 $100,000 $160,000
$160,000
$100,000 $100,000

Collects Cash

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The Accounting Time Period
• Companies cannot wait the end of every operation cycle and shut down
afterwards, so they measure their performance over discrete time periods
• The calendar year is the most common time period for measuring income or
profits
• About 40% of large companies use a fiscal year that differs from a calendar year
• The fiscal year-end date is often the low point in annual activity when inventories
can be counted more easily
• Companies also prepare financial statements for interim periods (which may be
for a month or a 3-month period)

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Revenues and Expenses
• Revenues and expenses are the key inflows and outflows of assets that occur during a
business’ operating cycle
• Revenues are the amount of assets received in exchange for the delivery of goods or
services to customers, for example:
• Sales of goods and merchandises
• Fees for services
• Subscriptions (e.g. of a club)
• Interest received (e.g. of an investment fund)
• Expenses are measures of the assets that a company gives up or consumes in order to
deliver goods or services to a customer, for example:
• Cost of goods sold (or Cost of sales)
• Salaries and wages
• Rent
• Interest (e.g. for a loan)
• Taxes
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Revenues and Expenses (continued)
• Accounts receivable are the amounts owed by customers as a result
of delivering goods or services on account in the ordinary course of
business
• Cost of goods sold expense is:
• For a merchandising company: the original acquisition cost of the inventory
that a company sold to customers during the reporting period
• For a manufacturing company: the production cost of the goods sold during
the period

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Income
• Income is the excess of revenues over expenses
Income = Revenues – Expenses
• Profits or earnings are common synonyms for income
• Retained earnings is the total cumulative equity generated by income

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EXAMPLE: eWheels
• Recall the transactions so far:
• January 2: Mr. Smith disposes of $500,000 in cash and hast a dept of
$100,000. His capital is $400,000 (see Transactions 1+2).
• The same day: He buys in cash 150 bicycles at $1,000 each (Transaction 3).
• On January 4, he purchases store equipment for $15,000 in cash
(Transaction 4).
• During January: He sells on credit 100 bicycles at a price of 1,600€
each (Transaction 5).

What is Mr. Smith’ profit for the month of January?

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 Expanded Balance Sheet Equation
(Corporation)
(1) Assets = Liabilities + Stockholders’ Equity

(2) Assets = Liabilities + Share Capital + Retained Earnings

(3) Accounts receivable + Inventory = Liabilities + Share Capital + Revenues - Expenses - Dividends

Effect of 160,000 + (-100,000) = 0 + 0 + 160,000 - 100,000

Transaction 5

Increase in assets 60,000 = Increase in retained income 60,000

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The Income Statement
• The income statement collects all the changes in owners’ equity for
the accounting period and combines them in one place
• Revenue and expense accounts are nothing more than subdivisions of
stockholders’ equity – temporary stockholders’ equity accounts
• An income statement is a report of all revenues and expenses
pertaining to a specific time period
• Net income = revenues minus all expenses
• A net loss occurs if expenses exceed revenues

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Relationship Between Income
Statement and Balance Sheet
• A balance sheet shows the financial position of the company at a
discrete point in time
• An income statement explains the changes that take place between
those points in time

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Relationship Between Income
Statement and Balance Sheet
(continued)
Balance Sheet Balance Sheet Balance Sheet Balance Sheet
December 31 January 31 February 28 March 31
20X1 20X2 20X2 20X2

Income Income Income

Statement Statement Statement
For January For February For March

Time Time

Income Statement for Quarter Ended March 31, 20X2

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 Exercises

Please do now Exercises 1 & 2. You’ll find the document Exercises on

Moodle in the section of Session 2.
You can check your answer after having finished the exercises by
referring to the document Solutions.

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Accrual Basis and Cash Basis
• One of the principles of financial reporting today is the use of the
accrual basis for the income statement and the balance sheet
• The accrual basis recognizes the impact of transactions in the
financial statements for the time periods when revenues and
expenses occur
• Accountants record revenue as a company earns it, and they record
expenses as the company incurs them to generate these revenues

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Accrual Basis and Cash Basis
(continued)
• The cash basis recognizes the impact of transactions in the financial
statements only when a company receives or pays cash
• The cash basis is used for the cash flow statement
• The accrual basis is the best basis for measuring economic
performance
• The cash basis is the best basis for measuring the capacity to generate
cash flows

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Recognition of Revenues
• Revenues are recognized when they
• Are earned
• A company earns revenues when it delivers goods or services to customers
• And are realized
• A company realizes revenues when it receives cash or claims (e.g., accounts receivable)
to cash in exchange for goods or services
• If cash is not received directly, the eventual collectibility of cash must be reasonably
assured

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Matching of Expenses to Revenues
• There are two kinds of expenses in every accounting period:
• Product costs are those linked with the revenues earned that period (e.g.,
cost of goods sold)
• Period costs are those linked with the time period itself (e.g., rent expense,
insurance expense, sales personnel salaries)
• Matching occurs when the expenses incurred in a period are matched
to the revenues generated in the same period, for example:
• Cost of goods sold is recorded in the period the goods are sold, not in the
period they are purchased or produced;
• Recording a depreciation expense during every year of the useful lifetime of a
long-lived asset, e.g., a machine

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Applying Matching: General
Procedure
• We can account for the purchases and uses of goods and services in
two basic steps:
• The acquisition of the assets
• The expiration of the assets as expenses
• Expense accounts are deductions from owners’ equity

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Recognition of Expired Assets

Acquisition Expiration

Expenses
Expenses
Assets
Assets (Expired
(Expiredcosts,
costs,
(Unexpired
(Unexpiredcosts,
costs, such
suchas
asCost
CostofofGoods
GoodsSold,
Sold,
such
suchas
asInventory,
Inventory, Instantaneously
Rent,
Rent,Depreciation,
Depreciation,
Prepaid
PrepaidRent,
Rent,Equipment)
Equipment) Or Eventually
Other
OtherExpenses)
Expenses)
Become

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Applying Matching: The Example of
Depreciation
• Depreciation is the systematic allocation of the acquisition cost of
long-lived assets to the periods that benefit from the use of the assets
• Land is not subject to depreciation because it does not deteriorate
over time
• We’ll see in the next session how depreciation can be calculated

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Applying Matching: The Example of
Depreciation at eWheels
Transaction 6: Recognize Depreciation Expense
of $100 for the month of January
Assets = Liabilities + Owners’ Equity

Store Equipment = Retained Earnings

Recognize depreciation
expense -100 = -100
(increase
depreciation
expense)

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Income Statement: EXAMPLE
(continued)
eWheels Company Inc.
Income Statement for January 20X2

Sales January $160,000

Deduct expenses:
Cost of goods sold $100,000
Depreciation 100
Net income 59,900

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 Multiple-Choice Questions

Please do now Multiple-Choice Questions 1-6. You’ll find the document

Exercises on Moodle in the section of Session 2.
You can check your answer after having finished by referring to the
document Solutions.

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Cash Dividends
• Cash dividends
• Are distributions of some of the company’s assets (cash) to stockholders
• Reduce Cash and Retained Earnings
• Are not expenses – they are transactions with stockholders!
• A cash dividend involves three important dates:
• Declaration date—the date on which the board declares the dividend
• Record date—stockholders owning the stock on this date receive the
dividend
• Payment date—the date on which the corporation pays the dividend

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Cash Dividends: EXAMPLE
(continued)
Transaction 7: Cash dividends of $50,000 are disbursed
to stockholders. Suppose that the company has become
a corporation at January 20.
Assets = Liabilities + Stockholders’ Equity

Cash = Retained Earnings

Declaration and
payment of cash
dividends -50,000 = -50,000
(dividends)

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Retained Earnings and Cash
• In order to pay a cash dividend, a corporation needs
• Cash
• Retained Earnings
• Cash and Retained Earnings are two entirely separate accounts,
sharing no necessary relationship
• Retained earnings is a residual claim, not a pot of gold

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Statement of Retained Earnings
• The statement of retained earnings consists of the
Beginning balance
+ Addition of net income
- Deduction of dividends
= Ending balance
• A net loss (negative net income) is subtracted from the beginning
balance of retained earnings
• Negative retained earnings is called an accumulated deficit

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Statement of Retained Earnings:
EXAMPLE (continued)
eWheels Company Inc.
Statement of Retained Earnings for January 20X2

Retained earnings, December 31, 20X1 $ 0

Add: Net income for January 59,900
Total $ 59,900
Less: Dividends declared 50,000
Retained earnings, January 31, 20X2 $ 9,900

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Balance Sheet at January 31:
EXAMPLE (end)
eWheels Company Inc.
Balance Sheet January 31, 20X2

Assets Liabilities and Owners’ Equity

Multiple-Choice Questions
Cash $285,000 Liabilities (note payable) $100,000
Acc. Receivable 160,000 Share capital 400,000
Merch. Inventory 50,000 Retained earnings 9,900

Store equipment 14,900

Total assets $509,900 Total liabilities
and owners’ equity $509,900

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 Multiple-Choice Questions &
Exercises

Please do now Multiple-Choice Questions 7 - 10 and Exercises 3 - 6.

You’ll find the document Exercises on Moodle in the section of Session 2.
You can check your answer after having finished the exercises by
referring to the document Solutions.

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End of Session 2
• To complement this session:
• Read the relevant chapter in the primary reading
• Measuring and reporting financial performance
• Do Online Quiz 1 for Continuous assessment on Moodle, to be done within
one week after the Session 2 (graded)

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Next Session: The Accounting Regulatory
Framework and Measurement Issues
• In Sessions 1&2, we have learnt how to use the balance sheet and the
income statement to measure and report the financial position and
performance of a company. In the next session, we will learn about
the rules that govern these financial reports and the main
measurement issues involved (such as depreciation and inventory
valuation).
• To prepare Session :
• Read the slides
• Read the relevant chapter in the primary reading
• Measuring and reporting financial performance

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