Chapter 4: Highlights
- The income statement provides a measure of the operating performance of a firm for a particular period of time. Net income occurs when revenues exceed expenses. A loss results when expenses exceed revenues.
- Revenues measure the net assets (assets less liabilities) that flow into a firm when a firm sells goods or renders services.
- Expenses measure the net assets that a firm consumes in the process of generating revenues.
4. The income statement shows the flows of net assets that occurred during the period while the balance sheet shows the level of assets, liabilities, and shareholders’ equity at a point in time.
5. The equation linking the Balance Sheet and the Income Statement is:
Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings
or
Beginning Retained Earnings – Ending Retained Earnings = Net Income – Dividends
or
The Change in Retained Earnings = Net Income – Dividends
6. The format of the Income Statement is:
a. Revenues
b. less: Cost of Goods Sold (an expense)
c. = Gross Profit (Gross Margin or Gross Income)
d. less: Operating Expenses
e. = Operating Income (Profit)
f. +/- Nonoperating Revenues and Expenses
g. = Income before Taxes
h. less: Income Taxes
i. = Income from Continuing Operations
j. =/- Income/Loss from Discontinued Operations
k. = Net Income
7. Revenue recognition refers to when to recognize revenue and measuring the amount of revenue to be recognized. Revenue should be recognized when: (a) the earnings process is completed and (b) assets are received from the customer.
8. The amount of revenue recognized equals the cash or cash-equivalent value of other assets received from customers. The gross revenue for some companies requires adjustment for amounts estimated to be uncollectible, discounts for early payment, and sales returns and allowances.
9. Expenses measure the assets consumed in generating revenue. Assets are unexpired costs. Expenses are expired costs. The amount of an expense equals the cost of the asset consumed.
10. Asset expirations associated directly with revenues are expenses in the period when a firm recognizes revenues. This treatment is called the matching principle.
11. Asset expirations not clearly associated with revenues become expenses of the period when a firm consumes the benefits of the asset in operations. These expenses are called period expenses. Most selling and administrative costs receive this treatment.
12. The cost of merchandise sold is generally the easiest to associate directly with revenue. For a merchandising firm, such as a department store, the acquisition cost of inventory is an asset until it is sold, at which time it becomes an expense. A manufacturing firm incurs costs (product costs) of direct materials, direct labor, and manufacturing overhead in producing its product. Manufacturing overhead is a mixture of indirect costs, which provides the capacity to produce the product. Manufacturing overhead often includes items such as plant utilities, property taxes and insurance on the factory, and depreciation on the factory plant and equipment. In both merchandising and manufacturing, firms expense product costs when the firms generate revenues from the sale of the product.
13. Net Income, or earnings, for a period measures the excess of revenues (net asset inflows) over expenses (net asset outflows) from selling goods and providing services to nonowners (such as customers).
14. Dividends measure the net assets distributed to shareholders. Dividends are not expenses and do not appear in the income statement.
15. The Retained Earnings account on the balance sheet measures the cumulative excess of earnings over dividends since the firm began operations.
16. Other Comprehensive Income refers to changes in net assets that are not transactions with owners and do not appear on the Income Statement.
Comprehensive Income = Net Income + Other Comprehensive Income
17. The income statement provides information for assessing the operating profitability of a firm. Common-size income statements express each expense and net income as a percentage of revenues and permit an analysis of changes or differences in the relations between revenues, expenses, and net income.
18. Financial statement users can employ common-size income statements in time series analysis and cross section analysis.
19. Time series analysis compares common-size income statements for two or more periods. Such comparisons may reveal trends that would help the statement reader interpret and analyze the firm’s operations.
20. Cross section analysis involves using common-size income statements to compare two or more firms. Such analysis provides information about the different strategies that firms follow.