Income Statement and GAAP
Income Statement and GAAP
Dr. Rachappa Shette
Session 3: Topics
1. Link between Balance Shee and Income Statement
2. Accounting Period Principle
3. Accounting Methods to measure the performance
4. Measurement Principles of Accrual Accounting
5. Principle of Consistency
6. Principle of Materiality
Link between Balance Sheet and Income Statement
Assets
=
Liab-
ilities
+
Contri-
buted
Capital
+
Retained
Earning
Beginning
of Period
+
Revenues
for period
-
Expenses
for period
-
Dividends
for period
Assets
=
Liab-
ilities
+
Contri-
buted
Capital
+
Retained
Earning
Assets
=
Liab-
ilities
+
Shareholders
Equity
Assets
=
Liab-
ilities
+
Contri-
buted
Capital
+
Retained
Earning
Beginning
of Period
+
Net Income
for period
-
Dividends
for period
2. Accounting Period
Financial reports are prepared at the end of time periods of
uniform length, for example, months or quarters or years.
Uniform time periods facilitate comparisons and analyses.
Many companies use the end of the financial year as the end of
their accounting period.
3. Accounting Methods for Measuring Performance
a) Cash basis of accounting.
Revenues are recognized when cash is received and expenses are
recognized when cash is paid.
(b) Accrual basis of accounting.
Revenues and expenses are recognized on an economic basis
without regard for the actual flow of cash.
3.a. Cash Basis of Accounting
Easy.
Provides reliable information about cash flows and liquidity of
a firm.
Subject to manipulation, for example, the firm can delay having
to recognize an expense by postponing cash payment.
3.b. Accrual Basis of Accounting
More difficult conceptually.
Revenues and expenses are recognized independent of the timing
of the cash flow.
Subject to manipulation by the choice of recognition rules.
4. Measurement Principles of Accrual Accounting
Measurement involves both the amount and the timing of the
recognition for both revenues and expenses.
(a) Timing of revenue recognition.
(b) Measurement of amount of revenue.
(c) Timing of expense recognition.
(d) Measurement of amount of expenses.
4.a & b. Revenues Timing and Amount
When does the accountant recognize revenue?
When both of the following are met:
1. The firm has performed all or most of the services or it has
delivered the goods, that is, it has earned the revenue.
2. The firm has received a good, service or right in exchange
and can reasonably measure the value of the good, service or right.
A promise to pay (such as a receivable) is a right.
Accounting Principles:
Conservatism
Realisation
4.a & b. Revenues Timing and Amount
In March 2007, Mr.X agreed to purchase 100 units of output from
Reddy Lab. Ltd. in the month of April 2008.
Can it be treated as revenue in the hand of Reddy for the
financial year 2006-07?
For each of the following indicate how much revenue is earned
and the amount of receivable or liability on the BS.
We sold subscriptions for $1,200. The magazines will be sent
next year.
We shipped goods for which the customer will pay $1,500 next
year.
On 9/30 we loaned $1,000. 8% interest and principal are to be
paid in one year. It is now 12/31.
4.a & b. Revenues Timing and Amount
For each of the following, how much revenue should be
recorded:
The list price of the product sold to a customer is $100,000.
Because of the large quantity, we agreed to a 15% discount off of
list.
We are a retail store that sells for cash and on credit. We sold
$400,000 on credit last month. Based on prior experience, we expect
that we will eventually collect about 97% of our sales.
We sold $10,000 of old product on credit. The customer is very
weak financially.
4.a & b. Revenues Timing and Amount
TransactionAmountLast YearCurrent YearNext YearCash (Receipts)Sales
RevenueCash (Receipts)Sales RevenueCash (Receipts)Sales Revenue1.
Cash sales made in this yearRs 1102. Credit sales made in this
year; cash received in next yearRs 2203. Credit sales made in last
year; cash received in this yearRs 2304. Cash received in this
year; product delivered in next yearRs 2405. Cash received last
year; product delivered in this yearRs 250
4.a & b. Revenues Timing and Amount
TransactionAmountLast YearCurrent YearNext YearCash (Receipts)Sales
RevenueCash (Receipts)Sales RevenueCash (Receipts)Sales Revenue1.
Cash sales made in this yearRs 1101101102. Credit sales made in
this year; cash received in next yearRs 220022022003. Credit sales
made in last year; cash received in this yearRs 230023023004. Cash
received in this year; product delivered in next yearRs
240240002405. Cash received last year; product delivered in this
yearRs 25025000250
4.C & d.Expenses Timing and Amount
Timing of Expenses
First determine revenues for a particular period of time and
then recognize the expenses related to that revenue and period.
Amount of Expenses:
Direct matching
Period cost (Indirect cost)
Costs not associated with future revenues
Principle of Matching
When an event affects both revenues and expenses, both the
effects should be recognized in the same accounting period.
4.C & d.Expenses Timing and Amount
Classify the following as (1) direct matching, (2) period costs
(indirect), or (3) costs not associated with future benefits and
indicate when expensed:
Costs of goods sold.
Controllers salary.
Sales persons commission based on sales.
Inventory that just became obsolete.
Sales persons monthly salary.
Building lost in a fire.
4. Summary of expenses measurement
Assets on balance sheet as on April 1, 2013
Cost incurred during
2013-14
1. Was there a direct association with the revenue of the
period?
2. Was there an association with activities of the period?
3. Can the item be associate with benefits of the future
periods?
Assets on balance sheet as on April 1, 2013
Yes
Yes
No
No
No
Yes
Expense of 2013-14
Ex: Cost of goods sold
Expense of 2013-14
Ex: Administration expenses
Expense of 2013-14
Ex: Obsolete inventory
5. Principle of Consistency
Once an accounting method is selected, use the same method of
accounting for all financial statements in current accounting
period as well as in subsequent accounting periods.
Can change if there is sound reason to change.
Must be disclosed to users.
6. Principle of Materiality
Insignificant events may be disregarded.
Amounts need not be exact as long as inaccuracy would not affect
decisions of users.
Full disclosure of all important info.
Application of judgment and common sense.
Summary
Income statement is part of balance sheet
Cash Accounting Versus Accrual Accounting
Revenue recognition and measurement
Expense recognition and measurement
Accounting principles
Period principle
Conservatism principle
Realization principle
Matching principle
Consistency principle
Materiality principle
Reading
Chapter 3 of the prescribed text book
Solve the problems from 3.1 to 3.8 from chapter 3 of prescribed
text.
