The Income Statement: This financial statement is a listing of all Revenues and Expenses of the business earned or incurred during a particular period of time. The Income Statement is usually produced by a company monthly, quarterly, or annually. It is one of the three major statements produced by businesses in the United States, the other two being the Balance Sheet and the Statement of Cash Flows.Let’s examine the transactions that created the Income Statement in Figure 4.1.
Sales In the Revenue section above we looked at the total Revenue (or sales) for the year. Now let’s look at an individual sale during the year, and see what effect it has on the Income Statement. What we have been looking at in Figure 4.1 is the Income Statement at the end of the year. Now let’s go back to the beginning of the year and see how these final figures in Figure 4.1 were arrived at.
Assume that on January 6, the company makes its first sales—two bicycles—for a total of $500. The company originally bought the bikes for $100 each (a total of $200). After this transaction the Income Statement would look like the one in Figure 4.2. (Note that this Income Statement in Figure 4.2 is as of January 6, whereas the one in Figure 4.1, is as of December 31.)
This transaction has caused two changes to the Income Statement. First, it has increased the Revenue account called “Sales” by $500, and second, it has increased an Expense account called “Cost of Goods Sold” by the cost of the two bicycles or $200.
At the same time this transaction has changed the Balance Sheet in several ways.Assuming that these bicycles were sold for cash, the Asset account (cash) on the Balance Sheet would increase by $500. A second Asset account called Inventory, where these bicycles were listed when they were bought, would be decreased by the cost of the two bicycles, $200.
The other change on the Balance Sheet is that the Retained Earnings figure goes up by the difference between the sales price of these two bicycles and the cost. Thus, Retained Earnings increases by $300 ($500–$200), the profit made through the sale of the bicycles.
(Note: Remember that Revenue minus Expenses equals Net Income, and Net Income increases Retained Earnings on the Balance Sheet. Once again, a very important part of this concept is that there is no mention of cash. Whether these bikes were sold for cash or the promise to pay cash in the future, is of no importance to the “bottom line” although it is a very important concern from a cash flow management standpoint.)
Now let’s look at the Accounting Equation, A = L + OE that we learned . One Asset, cash, has increased by the sale price of $500. Another Asset, Inventory, has decreased by the cost of the bicycles that were sold, $200. Retained Earnings, part of Owner’s Equity, has increased by the difference between the sale price and the cost, or $300. Thus the left side of this equation has increased by $300 (one Asset up $500 and the other down by $200), and the right side of the equation, Owner’s Equity, has increased by the same amount, the Net Income of $300.
Using the equation, the transaction would look like this:
Assets = Liabilities + Owner’s Equity
Cash + $500
Inventory – $200 = Net Income + $300
Cost of Goods Sold and Gross Profit
During the complete year of 2006, the cost of the all of the bicycles sold was equal to $14,200. The difference between the sales price of the bicycles ($35,500) and the cost of these bicycles ($14,200) is called the Gross Profit. The word “gross” is used since it represents the profit of the bicycle company before the operating Expenses are subtracted. In the case of the bicycle company, the Gross Profit is equal to $21,300.
Operating Expenses are those costs that are necessary to operate the business on a day-to-day basis. On January 7, Solana Beach Bicycle Company pays the owner her first week’s pay of $100.
Alert : Paying the Owner: Remember that the owner of this company and the Solana Beach Bicycle Company are two separate entities and when the business pays the owner her salary, this constitutes one entity paying another.
After this second transaction, the Income Statement looks like the one in Figure 4.3:
The $100 paid to the owner is an Expense (Salary Expense) and as such it is shown in the Income Statement under Expenses. The Net Income is decreased by the entire $100, as is the Retained Earnings and the cash in the Balance Sheet. Assuming that the salary is paid in cash, the impact on the accounting equation would look like this:
Assets = Liabilities + Owner’s Equity
Cash – $100 = Net Income – $100
Selling Bicycles but Receiving Only Partial Payment
On January 21, the bicycle company sold ten more bicycles for a total of $5,000. The cost of these ten bicycles was $2,000. The buyers of these bicycles paid a total of $3,500 in cash and promised to pay the other $1,500 within sixty days.
After this transaction the Income Statement would look like the one below in Figure 4.4:
Notice that on the Income Statement under the accrual system of accounting, income—like Revenue—is determined when it is earned and has nothing to do with when the cash is received. The entire $5,000 was added to the existing $500 in sales even though only $3,500 cash was received for the ten bicycles. This step is taken because a transaction has occurred in which the buyers have obligated themselves to pay the full $5,000.
The cost of the goods sold (which is an Expense) increased $2,000 because the ten bicycles that were sold had cost the business this amount of money (ten bicycles at $200 each). If we were looking at the Balance Sheet, the Inventory Asset would be decreased by this $2,000, the cost of the Inventory that was sold.
Also, on the Balance Sheet, the Retained Earnings increased $3,000. (Revenue of $5,000 minus Expenses of $2,000.) Now you can see that because of the relationship between Net Income on the Income Statement and Retained Earnings on the Balance Sheet, any time Net Income is changed, Retained Earnings is also changed by the same amount.
So the impact on the accounting equation of A = L + OE would look like this:
Assets = Liabilities + Owner’s Equity
Cash + $3,500
Inventory – $2,000 = Net Income +,$3,000
Accounts Receivable + $1,500
Repairing Bicycles and Receiving Cash
On February 14, five customers pick up bicycles they had brought into the shop for repair. The customers paid a total of $375 for the repair of these five bicycles. The cost of the parts to repair these bicycles was $105.
After this transaction the Income Statement would look like the one in Figure 4.5:
This transaction of repairing the bicycles increased Net Income, cash, and Retained Earnings by $270. Also, the total Assets owned by the company increased by $270.
At this point you should assume that the bicycle parts were bought for cash immediately prior to being used to repair the bicycles. Therefore, there is no Inventory of bicycle parts.
Once again, let’s look at the impact on the Accounting Equation:
Assets = Liabilities + Owner’s Equity
Cash +$375 (from customers) = Net Income +$270
Cash –$105 (to buy parts)
Other Operating Expenses
During the year, Solana Beach Bicycle Company incurred other Expenses that were necessary to operate the business. The business had to pay interest on the mortgage that it held. Since the mortgage is for $20,000, and the interest rate on this loan is 10 percent, the total interest paid during the year is $2,000. In addition to the interest, the company bought some small tools to use on the repairs, which cost a total of $1,625. The company was also charged a service fee of $15 by the bank where it has its account. The total of these operating Expenses increased the Expenses on the Income Statement and reduced cash and Retained Earnings on the Balance Sheet.
At the end of the year, the owner concluded from prior experiences with business receivables that she was not going to be able to collect $175 from one of the customers that had promised to pay. In order to recognize this on the financial statements, she created an Expense category called Bad Debts Expense. This Expense is increased by the amount of the receivable that will not be collected, and a new account is set up, called Allowance for Doubtful Accounts for the other side of the transaction. This allowance account is called a “contra-Asset” account, and is used to reduce Accounts Receivable on the Balance Sheet.
The last Expense that is listed on the Income Statement, Insurance Expense is another Expense that reduces Net Income without using cash at the time the Expense is recognized. Prepaid Insurance is listed on the Balance Sheet as an Asset of $1,500.This came about because the bicycle company bought the insurance in advance of using it. Since this was a three-year policy, by the end of year one, one-third of it had been used by the business. To recognize the “using up” of this Asset (Prepaid Insurance), the Insurance Expense is increased by $500 which corresponds to the Expense of using the insurance for one year. Even though the insurance was paid for last year, it is being used one-third at a time during each of the three years. Each time we use the insurance, it represents an Expense to the company even though the cash was expended (an expenditure) in a prior year. Once again, we see the difference between an expenditure and an Expense. We also see that expenditures eventually become Expenses. In year one when the insurance was purchased, it was an expenditure of cash to the company. It does not become an Expense until the insurance policy is actually used for one year.
The Asset itself is no longer worth the full amount paid, since it now only represents the remaining two years. Therefore, the Asset is reduced by the same one-third (one year of the three years), or by $500.
Looking at the impact this would have on the accounting equation, we note the following:
Assets = Liabilities + Owner’s Equity
Prepaid Insurance – $500 = Net Income (Interest Expense) – $500
In this chapter you learned the components of an Income Statement and how they relate to each other. You also learned that Revenue and Net Income are not the same as cash because accountants usually use the accrual basis of accounting and not the cash basis. Finally, you learned how individual transactions affect and change the Income Statement.
It is important to note that the Solana Beach Bicycle Company did make a profit of $10,385. Many new small businesses do not make a profit for the first three or four years, so that is impressive.
In planning for the year ahead, Sam might decide to put more money into advertising and expand the repair business. Only 10 percent of the company’s Revenue came from repairs, so there could be room for growth in that area of the business.
Other information that would be helpful to look at includes the other financial statements as well as the budgets for the next two years, 2007 and 2008.
Accounts Receivable: This is a term used to describe money that is to be received in the future for current sales of goods or services. Normally, Accounts Receivable appears on the Balance Sheet as a Short-Term Asset since companies generally give credit to customers for thirty to sixty days.
Accrual Basis of Accounting: This accounting method recognizes transactions when Revenue is earned, Expenses are incurred, and purchases take place—whether or not cash changes hands at that moment. This is the method of accounting used by virtue of Generally Accepted Accounting Principle, and most businesses use this rather than the alternative, the cash basis of accounting.
Bad Debt Expense: This Expense appears on the Income Statement and is increased by the amount of the receivables that will not be collected (that is, debts owed to the company that will not be paid). When this Expense is created, a contra-Asset to Accounts receivable is also created called Allowance for Bad Debts. This contra-Asset reduces the Accounts Receivable account on the Balance Sheet and keeps the two sides of the Balance Sheet in balance.
Bottom Line: Another term used for Net Income, it represents all Expenses subtracted from all Revenues. This figure gets it name from the fact that it appears at the bottom of the Income Statement.
Cash Basis of Accounting: This accounting method only recognizes Revenue and Expenses when cash is exchanged. If the sale or Expense takes place in one period without cash changing hands, because of receivables and payables, the Revenue and the Expenses are not recognized until a future period. For this reason, the cash basis of accounting is typically not used for business according to GAAP, but is the method generally used in personal accounting.
Cost of Goods Sold: The cost of all the Inventory that was sold during the period stated in the Income Statement. Cost of goods sold is an Expense and is subtracted from Revenue to arrive at Gross Profit.
Expenditures: The spending of cash. All Expenses are expenditures; however, all expenditures are not Expenses. Only expenditures that immediately generate Revenue are considered Expenses. When expenditures are made for items that have future benefits, they are classified as Assets and converted to Expenses as they are used up.
Expenses: Expenses are expenditures made to generate Revenue. Whether or not cash changes hands, a company incurs an Expense as soon as it makes a commitment to pay for a product or service.
Gross Profit: The difference between Revenue and Cost of Goods Sold before operating Expenses, interest, and taxes are subtracted. A good analysis for the owner of a company is to compare Gross Profit from one year to another and determine whether it is increasing or decreasing and why.
Net Income: The difference between Revenue and Expenses for a designated period of time. In the case of Solana Beach Bicycle Company, we saw three uses of the term Net Income. The first, Net Income from operations, shows all normal Revenue and Expenses that deal with the main operations of this business—selling bicycles. The second usage was Net Income before taxes, where Net Income from operations is increased and reduced by other Revenue and Expenses that are outside the normal operations of this business—like repairing bicycles. The third usage was Net Income. This is what is referred to as the “bottom line” since it appears at the bottom of the Income Statement. It is derived by reducing Net Income before taxes, by the amount of Income Taxes for the year.
Other Revenues and Expenses: Those items that are derived from transactions that are not the main business of the company and that are listed on the Income Statement under “Other Revenues and Expenses.” In the case of Solana Beach, sales of bicycles is the main business; repairs are not the shop’s main business and are listed under “Other Revenues and Expenses.”
Recognize: This term refers to the recording of the Revenues and Expenses in the records of the company. This occurs at the point in time when Revenue and Expenses are shown on the Income Statement. Revenues are recognized when services are performed or when title is transferred on goods sold. Expenses are recognized when they are incurred and become an obligation of the company.
Revenue: The amount earned by a business by selling goods or performing services is termed “Revenue.” In the case of the Solana Beach Bicycle Company, Revenue represents the earnings in from the selling of bicycles as well as the repair of bicycles. Since the main business of the company is to sell bicycles, the Revenue that is earned from the repairs is shown as other income.