OCW041: Understanding the Income Statement

Revenue

Revenue refers to the mechanism by which income enters a company.

Learning Objectives

Explain how a company generates and records revenue

Key Takeaways

Key Points

  • Expenses should be matched with revenue. The expense is recorded in the time period in which it is incurred, which is the time period that the expense is used to generate revenue.
  • Revenue accounts indicate revenue generated by the normal operations of a business. Fees Earned and Sales are both examples of Revenue accounts.
  • Revenue accounts have a normal credit balance.

Key Terms

  • Revenue Recognition: Revenue should not be recorded until the earnings process is nearly complete and there is little uncertainty as to whether or not collection of payment will occur.
  • revenue recognition principle: income is recognized when it is realised or realisable, and is earned (usually when goods are transferred or services rendered), no matter when cash is received
  • revenue expenditures: an ongoing cost for running a product, business, or system
  • income: In U.S. business and financial accounting, the term “income” is also synonymous with revenue; however, many people use it as shorthand for net income, which is the amount of money that a company earns after covering all of its costs.

Revenue

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A simple cash register: Cash registers are a point at which companies capture revenue.

Revenue refers to the receipt of monetary value from the sale of goods or services and other income generating activities. Revenue is recorded for accounting purposes when it is earned by an entity, which usually involves an exchange of value among two or more parties in an arm’s length transaction.

In U.S. business and financial accounting, the term “income” is also synonymous with revenue; however, many people use it as shorthand for net income, which is the amount of money that a company earns after covering all of its costs (which is not the same as revenue).

Revenue Accounts

Revenue accounts indicate revenue generated by the normal operations of a business. Fees Earned and Sales are both examples of Revenue accounts. Revenue accounts have a normal credit balance. Common income accounts are operating revenue, dividends, interest, and gains.

Revenue Recognition Principle

Revenue should not be recorded until the earnings process is nearly complete and there is little uncertainty as to whether or not collection of payment will occur. This means that revenue is recorded when it is earned, or when the job is complete.

Matching Principle

Expenses should be matched with revenue. The expense is recorded in the time period in which it is incurred, which is the time period that the expense is used to generate revenue. This means that you can pay for an expense months before it is actually recorded, as the expense is matched to the period the revenue is made.

It is important to realize that revenue and expenses are not always the same as cash inflows and outflows. For a given cash outflow, an expense can be recognized in a period prior to payment, the same period or a later period. The same idea holds for revenue and incoming cash flows. This is what accounting makes very flexible and at the same time exposes to potential manipulation of net income. Accounting principles provide guidance and rules on when to recognize revenue and expenses.

Cost of Goods Sold and Gross Profit

Gross profit or sales profit is the difference between revenue and the cost of making a product or providing a service.

Learning Objectives

Explain the difference between cost of goods sold and gross profit

Key Takeaways

Key Points

  • When the goods are bought or produced, the costs associated with such goods are capitalized as part of inventory (or stock) of goods. These costs are treated as an expense during the period in which the business recognizes income from sale of the goods.
  • Costs include all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead.
  • The costs of those goods not yet sold are deferred as costs of inventory until the inventory is sold or written down in value.

Key Terms

  • net income: Gross profit minus operating expenses and taxes.
  • gross profit: the difference between revenue and the cost of making a product or providing a service before deducting overhead, payroll, taxation, and interest payments
  • Cost of Goods Sold: refers to the inventory costs of the goods a business has sold during a particular period (sometimes abbreviated as COGS).

Cost of Goods Sold & Gross Profit

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Cost of Good Sold & Gross Profit: Gross profit = Net sales – Cost of goods sold

In accounting, gross profit or sales profit is the difference between revenue and the cost of making a product or providing a service before deducting overhead, payroll, taxation, and interest payments. Note that this is different from operating profit (earnings before interest and taxes).

The various deductions leading from net sales to net income are as follows:

Net sales = Gross sales – (Customer Discounts, Returns, Allowances)

Gross profit = Net sales – Cost of goods sold

Operating profit = Gross profit – Total operating expenses

Net income (or Net profit) = Operating profit – taxes – interest

Cost of goods sold refers to the inventory costs of the goods a business has sold during a particular period. Costs are associated with particular goods by using one of several formulas, including specific identification, first-in-first-out (FIFO), or average cost. Costs include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead. The costs of those goods not yet sold are deferred as costs of inventory until the inventory is sold or written down in value.

Many businesses sell goods that they have bought or produced. When the goods are bought or produced, the costs associated with such goods are capitalized as part of inventory (or stock) of goods. These costs are treated as an expense during the period in which the business recognizes income from sale of the goods.

Operating Expenses, Non-Operating Expenses, and Net Income

Operating expenses and non operating expenses are deducted from revenue to yield net income.

Learning Objectives

Explain the difference between operating expenses and non-operating expenses

Key Takeaways

Key Points

  • Operating expenses are day-to-day expenses such as sales and administration; the money the business spends in order to turn inventory into throughput.
  • A capital expenditure, or non operating expense, is the cost of developing or providing non-consumable parts for the product or system.
  • The income statement is used to assess profitability by deducting expenses from revenue. When net income is positive, it is called profit. When negative, it is a loss.

Key Terms

  • Operating Expense: Any expense incurred in running a business, such as sales and administration, as opposed to production.
  • capital expenditure: Funds spent by a company to acquire or upgrade a long – term asset
  • net income: Gross profit minus operating expenses and taxes.
  • net loss: when revenue is less than expenses

Operating Expenses and Non Operating Expenses

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Income Statement: Operating expenses, non operating expenses and net income are three key areas of the income statement.

An operating expense is the ongoing cost of running a product, business, or system. Its counterpart, a capital expenditure, or non operating expense, is the cost of developing or providing non-consumable parts for the product or system.

For example, the purchase of a photocopier is a capital expenditure. Paper, toner, power, and maintenance costs represent operating expenses. In business, operating expenses are day-to-day expenses such as sales and administration. In short, this is the money the business spends in order to turn inventory into throughput. For larger businesses, operations may also include the cost of workers and facility expenses such as rent and utilities.

On an income statement, operating expenses include:

  • accounting expenses
  • license fees
  • maintenance and repairs, such as snow removal, trash removal, janitorial service, pest control, and lawn care
  • advertising
  • office expenses and supplies
  • attorney legal fees
  • utilities
  • insurance
  • property taxes
  • travel and vehicle expenses
  • leasing commissions
  • salary and wages
  • raw materials

Everything else is a fixed cost, including labor. In real estate, operating expenses comprise costs associated with the operation and maintenance of an income-producing property, including property management fees, real estate taxes, insurance, and utilities. Non operating expenses include loan payments, depreciation, and income taxes.

Net Income

The income statement is used to assess profitability by deducting expenses from revenue. When net income is positive, it is called profit. When negative, it is a loss. Net income increases when assets increase relative to liabilities. At the same time, other assets may decline in value and liabilities may increase.

Income Statement Formats

Income statements are commonly prepared in two formats: multiple-step and single-step.

Learning Objectives

Summarize the difference between a single-step and multiple-step income statement

Key Takeaways

Key Points

  • The income statement describes a company’s revenue and expenses along with the resulting net income or loss over a period of time due to earning activities.
  • In the multiple-step format revenues are often presented in great detail, cost of goods sold is subtracted to show gross profit, operating expenses are separated from other expenses, and operating income is separated from other income.
  • In the single-step format, all expenses are combined in a single section including cost of goods sold.

Key Terms

  • Multiple-Step: Revenues are detailed, cost of goods sold is subtracted to show gross profit, operating expenses are separated from other expenses, and operating income is separated from other income.
  • Single-Step: All expenses are combined in a single section including cost of goods sold.

Income Statement

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Income Statement: Income Statements commonly come in two formats

An income statements may also be referred to as a profit and loss statement (P&L), revenue statement, statement of financial performance, earnings statement, operating statement or statement of operations. A company’s financial statement indicates how the revenue, money received from the sale of products and services before expenses are taken out, is transformed into the net income, the result after all revenues and expenses have been accounted for, also known as Net Profit. It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

Income statements are commonly prepared in two formats: multiple-step and single-step. In the multiple-step format revenues are often presented in great detail, cost of goods sold is subtracted to show gross profit, operating expenses are separated from other expenses, and operating income is separated from other income. In the single-step format, all expenses are combined in a single section including cost of goods sold.

The income statement is used to assess profitability, as the expenses for the period are deducted from the revenues. When net income is positive, it is a called profit. When negative, it is a loss. Net income increases when assets increase relative to liabilities. At the same time, other assets may decline in value and liabilities may increase. Thus, the balance sheet has a direct relation with the income statement.

However, information of an income statement has several limitations: items that might be relevant but cannot be reliably measured are often not reported. Some numbers depend on accounting methods used. While other numbers depend on judgments and estimates.


Source: Accounting