What is Income Statement
The Income Statement reports the changes in Shareholders’ Equity due to business operations over a period of time.
(Recall that Shareholders’ Equity = Contributed Capital + Prior Retained Earnings + Net Income – Dividend)
The calculation of Net Income is Revenues – Expenses. Note that Net Income is also called Earnings or Net Profit.
Accrual accounting is an approach of recognising revenues and expenses tied to business activities, regardless of whether cash has been exchanged. In other words, accounting for revenues and expenses of businesses is independent of cash flow. This is an important concept to remember.
Revenue Recognition Condition: revenue is only recognised when both
- It is earned (i.e. goods or services are provided to the customer) and
- It is realised (i.e. payment received in cash or something that can be converted to a known amount of cash such as promissory note, purchase order etc.).
Expense Recognition Condition: expenses is recognised immediately when either
- Related revenues are recognised (product costs) or
- Incurred, if difficult to match with revenues (period costs and unusual events).
As you have observed, there are two underlying principles to the recognition conditions. First, the matching principle, which require the revenue and expense to be recognised when the matching goods or services are provided. Revenue and expense must also be recognised within the same business operating period for periodic revenue (such as subscription services) and periodic costs. Second, the conservatism principle, which require anticipated losses to be recognised immediately, but to recognise gains only when realised.
Recall that for an accounting cycle, at the end of each accounting period, Adjusting Entries will be performed. Adjusting entries are internal transactions that update account balances in accordance with accrual accounting. They record deferred revenues and expenses, as well as accrued revenue and expenses.
- Deferred Expenses – assets that have been “consumed” in the period, e.g. expending prepaid rent, prepaid insurance, depreciation and amortisation.
- Deferred Revenues – liabilities that have been fulfilled by delivery of goods or services, e.g. unearned rental revenue, deferred subscription revenue.
- Accrued Expenses – expenses that have been accumulated in the period, e.g. income taxes payable, interest payable, salaries and wages payable.
- Accrued Revenues – revenues accumulated in the period, e.g. interest receivable, rent receivable.
Note: the purpose of Depreciation and Amortisation is to allocate the cost of a long-lived asset (longer than one accounting period) over the entire useful life of the asset. Tangible assets require depreciation. Intangible assets require amortisation.
Here is a cheat sheet showing the relationship between cash transaction and revenue / expense recognition. It all depends on whether the cash transaction happens before or after the associated business activity take place.
Preparation of Financial Statements
Let us appreciate how the financial statements are prepared. The Income Statement will be prepared first. Using the Net Income recorded in the income statement, the Retained Earnings will be updated. Second, the Balance Sheet will be prepared. Lastly, the Statement of Cash Flow and Statement of Stockholders’ Equity will be prepared.
These are some of the example formats provided by the online course:
Income Statement Format
- Revenue (or Sales)
- [less] Cost of Goods Sold (COGS)
- [give] Gross Profit
- [less] Operating (SG&A) Expense
- [give] Operating Income
- [less] Interest, Gains, and Losses
- [give] Pre-tax Income
- [less] Income Tax Expense
- [give] Net Income
Balance Sheet Format: Assets
- Current Assets (benefits to be enjoyed within the next year)
- (ordered by liquidity)
- Accounts Receivable
- Prepaid Assets
- Non-Current Assets
- Tangible Assets
- Intangible Assets
Balance Sheet Format: Liabilities and Stockholders’ Equity
- Current Liabilities (obligations to be fulfilled within next year)
- (Ordered by liquidity)
- Bank Borrowings
- Accounts Payable and Other Payable
- Deferred Revenues and Other Non-Cash
- Non-Current Liabilities
- Bank Borrowings and Bonds
- Other types of Liabilities (deferred taxes, pensions)
- Stockholders’ Equity
- Contributed Capital
- Retained Earnings
(Reference: Coursera Wharton Online Introduction to Financial Accounting)