FINANCIAL ACCOUNTING

BASICS

Part Three

J. Income Statement

K. Income Statement Presentation

L. Retained Earnings Statement

M. Journal and Ledger

J. INCOME STATEMENT

1. In Part Two we saw that transactions that increase income are reflected on the balance sheet in Retained Earnings.

2. During the month of January, Retained Earnings for ABC Company increased by $1,500.

3. Income earned during the month of January was $1,500.

4. Income was generated as follows:

January 9 January 12 Total

Revenues $2,500 $5,000 $7,500 Expenses 2,000 4,000 6,000 Income $ 500 $1,000 $1,500

ABC Company Income Statement

For the period January 1-31, Year 1

Revenues $7,500 Expenses 6,000 Income $1,500

J. INCOME STATEMENT (cont)

5. Rather than recording revenues and expenses directly into the Retained Earnings account, separate Revenue and Expense accounts are used.

6. Accounting Conventions• Retained earnings are increased through credits• Revenues increase Retained earnings, so

Revenues are:• increased by making credits

• Retained earnings are decreased through debits• Expenses decrease Retained Earnings, so

Expenses are: • increased by making debits

J. INCOME STATEMENT (cont)

Retained Earnings

- + Expenses Revenues + +

7. Illustration

Transaction 4: On January 9, ABC Company sells inventory that cost $2,000 for $2,500 in cash.

Transaction 6: On January 12, ABC Company sells inventory that cost $4,000 for $5,000, on account.

Revenues increaseretained earnings,

so revenues are credited

Expenses decreaseretained earnings,

so expenses are debited

J. INCOME STATEMENT (cont)

Cash Retained Earnings

Expenses Revenues Inventory

Accounts Receivable

2,500

2,500Begin 8,000 2,000 2,000

4,000

5,000

5,0004,000

End 2,000

6,000

6,0006,000 7,500

7,500

7,500

0 0

Transaction 4: On January 9, ABC Company sells inventory that cost $2,000 for $2,500 in cash.

Transaction 6: On January 12, ABC Company sells inventory that cost $4,000 for $5,000, on account.

1,500

K. INCOME STATEMENT PRESENTATION

TYPICAL COMPANY Income Statement

For the year ended December 31, Year 1 (in thousands)

Sales $ 423,496 Cost of goods sold (216,657) Gross profit 206,839 Selling, general and administrative expenses (112,895) Operating income 93,944 Interest expense (5,327) Other income (expense), net (6,843) Income before taxes 81,774 Provision for income taxes (30,100) Net income $ 51,674

Note that the income statement presents several measures of profit/income:(1) gross profit, (2) operating income, (3) income before taxes, and (4) net income.

The next slide describes the classification of expenses.

K. INCOME STATEMENT PRESENTATION (cont)

1. Expenses normally are classified as: operating and nonoperating.

2. Operating expenses – include: Cost of goods sold Selling expenses General and administrative expenses Research and development expenses

3. Nonoperating expenses – include: Interest expense – this is a financing expense Other (miscellaneous) expenses

includes losses on sales of assets

4. Income tax expense (Provision for income taxes) is also an operating expense. It is always shown separate from other

operating expenses, after the calculation of Income before Taxes.

L. RETAINED EARNINGS STATEMENT

1. The Retained Earnings Statement summarizes the changes in Retained earnings that occurred during the accounting period.

2. Net income increases Retained earnings.

3. Dividends decrease (are paid out) of Retained earnings.

ABC Company Retained Earnings Statement

For the period January 1-31, Year 1

Retained earnings, January 1 $ 0 Income, January 1,500 Dividends, January 0 Retained earnings, January 31 $1,500

4. Many companies prepare a Statement of Changes in Stockholders’ Equity that summarizes the changes in all Stockholders’ equity accounts, including Retained earnings, during the accounting period.

M. JOURNAL AND LEDGER

1. Accountants record transactions in “books” – the primary books used are the Journal and the Ledger.

2. Journal – transactions are first entered into a journal (the journal is the company’s diary) – an explanation of each transaction is provided.

3. Ledger – journal entries are then posted to the ledger (each account has a separate page in the ledger) – easier to determine balance in accounts.

The next slide shows ABC Company’s Journal for the month of January, Year 1. Each transaction 1 – 7 has been recorded in a debit/credit journal entry. Remember that debits increase assets and decrease liabilities and stockholders’ equity; credits decrease assets and increase liabilities and stockholders’ equity.

M. JOURNAL AND LEDGER (cont)Journal

Date Accounts Debit (Dr.) Credit (Cr.)

Jan. 2 Cash Paid-in Capital

10,00010,000

3 Cash Notes Payable

5,0005,000

4 Inventory Accounts Payable

8,0008,000

9 Cash Revenues

2,5002,500

Expenses Inventory

2,0002,000

10 Accounts Payable Cash

8,0008,000

12 Accounts Receivable Revenues

5,0005,000

Expenses Inventory

4,0004,000

31 Cash Accounts Receivable

5,0005,000

M. JOURNAL AND LEDGER (cont)

The next slide shows the pages in the ledger for Cash (Acct. No. 101) and Paid-in Capital (Acct. No. 301).

From the Ledger, it is possible to determine the balance in each account at any point in time. For example, we can see that Cash had a balance of

$17,500 on January 9.

It is more difficult to determine the balance in an account from the Journal.

M. JOURNAL AND LEDGER (cont)

Date Explanation Debit Credit Balance

Jan. 2 Investment by owners 10,000 10,000

3 Borrowing from bank 5,000 15,000

9 Sale of goods 2,500 17,500

10 Payment of suppliers 8,000 9,500

31 Collection from customers 5,000 14,500

Ledger

Account Title Cash Account Number 101

Date Explanation Debit Credit Balance

Jan. 2 Investment by owners 10,000 10,000

Account Title Paid-in Capital Account Number 301

M. JOURNAL AND LEDGER (cont)

4. Most companies have a computerized accounting system, in which:

a. The accountant analyzes transaction to determine which accounts are affected and whether each account is increased or decreased (debit or credit).

b. The accountant then inputs data (DATE, ACCOUNTS, DEBIT/CREDIT) into the system, and the journal entry is prepared and automatically posted to ledger.

End of Part Three