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Chapter 3
The Income Statement
ANSWERS TO QUESTIONS
1. Net Income = Revenues - Expenses.
Each element is defined as follows:
Revenues – the amounts a business earns by selling goods or services to its
customers.
Expenses – any costs of operating the business, incurred to generate revenues
in the period covered by the income statement.
Net Income = A total that is calculated by subtracting expenses from revenues.
2. The time period assumption assumes that the long life of a company can be
divided into shorter time periods, such as months, quarters, and years. This
assumption allows management to evaluate a company’s financial performance
on a timely basis.
3. Accrual basis accounting requires recording revenues when earned and
expenses when incurred, regardless of the timing of cash receipts or payments.
Cash basis accounting records revenues when cash is received and expenses
when cash is paid.
4. Using cash basis accounting for your personal finances is acceptable because
your cash inflows and outflows tend to occur close in time to the activities that
cause those cash flows. Cash basis accounting does not work as well for
businesses because most of them use credit for their transactions, and recording
the transactions on a cash basis would not describe the financial results of the
business’s activities as well as accrual basis accounting.
5. To “recognize” an accounting transaction means to measure and record the
transaction in the accounting system. Revenues are recognized when they are
earned, and expenses are recognized when they are incurred to generate
revenues.
6. Under accrual basis accounting, revenues are recognized when they are earned.
In general, revenues are earned when the company has done what it has
promised to do, regardless of when the cash is received.
Fundamentals of Financial Accounting, 4/e 3- 1
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
7. The expense recognition (“matching”) principle requires that expenses be
recorded when incurred in earning revenue. For example, the cost of employee
wages is recorded in the same period that the employees work to generate
revenues for the company; this may differ from the period when the employees
are actually paid.
8. Revenues increase net income, which increases retained earnings—a
stockholders’ equity account. Expenses decrease net income, causing a
decrease in retained earnings—a stockholders’ equity account.
9. Revenues increase stockholders’ equity and expenses decrease it.
Stockholders’ equity accounts are increased with credits and decreased with
debits. Thus, revenues are recorded as credits and expenses as debits.
10. Item Increase Decrease
Revenues Credit Debit
Expenses Debit Credit
11. Item Debit Credit
Revenues Decrease Increase
Expenses Increase Decrease
12. Items on the income statement relate only to the current period and do not have
a lingering financial impact beyond the current period. Balance sheet items, on
the other hand, will continue to have a financial impact beyond the end of the
current period. In other words, the income statement depicts a flow of what
happened over a period of time, whereas a balance sheet captures what exists at
a point in time.
13. The statement of retained earnings indicates that it is appropriate to consider
revenues and expenses as subcategories of retained earnings. This statement
includes net income, which is shown on the income statement to equal revenues
minus expenses.
14. Revenue is the amount earned during a period by providing goods or services to
customers. Accounts Receivable is the amount of revenue that has not yet been
collected in cash at a point in time. Revenue is reported on the income
statement and Accounts Receivable is reported on the balance sheet.
15. Advertising Expense is an expense account that records the cost of
advertisements incurred during the period. It is reported on the income
statement. Accounts Payable for advertising is a liability account that represents
the cost of advertising that has been incurred but not yet paid. It is reported on
the balance sheet.
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16.
Situation Explanation
a. This is an accounting error. When cash is received from a
customer on account, Cash should be debited (not credited) and
Accounts Receivable should be credited (not debited). A trial
balance would not detect this error because total debits would still
equal total credits across all accounts.
b. This is an accounting error. A gift card represents a promise by
the company to deliver goods or services in the future when the
card is redeemed. Because the company has yet to deliver any
goods or services, the proper transaction is to debit Cash and
credit Unearned Revenue. When the card is used to purchase
goods or services, Unearned Revenue will be debited and
Revenue will be credited. A trial balance would not detect this
error because both Revenue and Unearned Revenue hold credit
balances.
c. This is an accounting error because assets (reported on the
balance sheet) differ from expenses (reported on the income
statement). Because both assets and expenses typically hold
debit balances, this error would not be detected on a trial balance.
d. This is an accounting error. In every accounting transaction,
debits must equal credits. Because only a debit was entered in
this transaction, the error would be detected in the trial balance.
e. This is not an accounting error. Under the Separate Entity
Assumption, transactions of the owners (shareholders) of a
business are kept separate from those of the business itself. The
trial balance would not indicate an error.
17. One limitation of the income statement is that people mistakenly believe that net
income equals the amount of cash generated by the business during the period.
A second limitation is that net income does not measure the change in value of a
company during the period. Finally, net income is influenced by estimates, so it
is not always a precise measure.
Fundamentals of Financial Accounting, 4/e 3- 3
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Authors' Recommended Solution Time
(Time in minutes)
Mini-exercises Exercises Problems
Skills
Development
Cases*
Continuing Case
No. Time No. Time No. Time No. Time No. Time
1 5 1 10 CP3-1 20 1 20 1 15
2 5 2 20 CP3-2 30 2 30
3 5 3 20 CP3-3 40 3 30
4 5 4 20 CP3-4 40 4 30
5 6 5 20 PA3-1 20 5 30
6 6 6 20 PA3-2 30 6 25
7 6 7 20 PA3-3 40 7 45
8 6 8 20 PA3-4 40
9 5 9 20 PB3-1 20
10 5 10 20 PB3-2 30
11 5 11 30 PB3-3 40
12 5 12 10 PB3-4 35
13 5 13 20 C3-1 45
14 5 14 10
15 5 15 10
16 5 16 15
17 5 17 15
18 5 18 15
19 10 19 30
20 15 20 15
21 10 21 30
* Due to the nature of cases, it is very difficult to estimate the amount of time students
will need to complete them. As with any open-ended project, it is possible for students
to devote a large amount of time to these assignments. While students often benefit
from the extra effort, we find that some become frustrated by the perceived difficulty of
the task. You can reduce student frustration and anxiety by making your expectations
clear, and by offering suggestions (about how to research topics or what companies to
select). The skills developed by these cases are indicated below.
Case Financial
Analysis Research Ethical
Reasoning
Critical
Thinking Technology Writing Teamwork
1 x
2 x
3 x x x x x
4 x x x x
5 x x x x
6 x x x
7 x x
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ANSWERS TO MINI-EXERCISES
M3-1
MOSTERT MUSIC COMPANY
Cash Basis Income Statement
For the Month Ended March 31
MOSTERT MUSIC COMPANY
Accrual Basis Income Statement
For the Month Ended March 31
Revenues:
Sales
Customer Deposits
Total Revenues
$6,000
1,000
7,000
Revenues:
Sales
$ 10,000
Expenses:
Wages Paid
600
Expenses:
Salaries/Wages Exp.
Utilities Expense
Total Expenses
600
200
800
Cash Income $6,400 Net Income $ 9,200
M3-2
Amount of Revenue Earned in July
a. $12,000
b. $250
c. No revenue earned in July; the revenues will be earned when fall bowling
service is provided (i.e., when games are played). Until then, the amount
received will be reported as Unearned Revenue (a liability).
d. No revenue earned in July; cash collections in July related to revenue
earned in June. The revenue would have been reported in June when
earned.
M3-3
Amount of Expense Incurred in July
e. $1,500
f. $2,500 incurred in July; the $2,000 was an expense
in June even though paid in July.
g. $5,475
Fundamentals of Financial Accounting, 4/e 3- 5
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M3-4
a. dr Cash (+A)......................................................................... 12,000
cr Service Revenue (+R, +SE)........................................ 12,000
b. dr Accounts Receivable (+A)................................................ 250
cr Service Revenue (+R, +SE)........................................ 250
c. dr Cash (+A)......................................................................... 1,500
cr Unearned Revenue (+L)............................................. 1,500
d. dr Cash (+A)......................................................................... 1,000
cr Accounts Receivable (A)........................................... 1,000
M3-5
e. dr Repairs and Maintenance Expense (+E, SE)................ 1,500
cr Cash (A).................................................................... 1,500
f. dr Accounts Payable (–L)..................................................... 2,000
cr Cash (A).................................................................... 2,000
dr Utilities Expense (+E, SE).............................................. 2,500
cr Accounts Payable (+L)................................................ 2,500
g. dr Salaries and Wages Expense (+E, SE)......................... 5,475
cr Cash (A).................................................................... 5,475
M3-6
Assets Liabilities Stockholders’ Equity
a. +12,000 NE Service Revenue (+R) +12,000
b. +250 NE Service Revenue (+R) +250
c. +1,500 +1,500 NE
d. +/–1,000 NE NE
Transaction (d) results in an increase in an asset (Cash) and a decrease in an asset
(Accounts Receivable). Therefore, there is no net effect on total assets.
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M3-7
Assets Liabilities Stockholders’ Equity
e. –1,500 NE Repairs and Maintenance Expense (+E) –1,500
f. –2,000 –2,000 and +2,500 * Utilities Expense (+E) –2,500
g. –5,475 NE Wages Expense (+E) –5,475
* Transaction f. affects liabilities in two ways. Liabilities (Accounts Payable) decreases for the
June bill paid, and liabilities (Accounts Payable) increases for the July bill to be paid in August.
The net effect on total liabilities is an increase of $500.
M3-8
BILL’S EXTREME BOWLING, INC.
Income Statement
For the Month Ended July 31, 2013
Revenues:
Service Revenue $12,250
Total Revenues 12,250
Expenses:
Wages Expense 5,475
Utilities Expense 2,500
Repairs and Maintenance Expense 1,500
Total Expenses 9,475
Net Income $ 2,775
M3-9
Amount of Revenue Earned in February
a. $15,000
b. No revenue earned in February; gift card
recorded as unearned revenue until used
by customer.
c. No revenue earned in February; cash
collections in February related to revenues
earned in January.
d. No revenue earned in February; the
revenues will be earned, when the services
are provided. Record as unearned
revenue.
e. $125
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
M3-10
Amount of Expense Incurred in February
f. $4,750
g. Not an expense incurred in February; cash
payments in February relate to expenses
that were incurred in January.
h. $800
M3-11
a. dr Cash (+A)......................................................................... 15,000
cr Service Revenue (+R, +SE)........................................ 15,000
b. dr Cash (+A)......................................................................... 150
cr Unearned Revenue (+L)............................................. 150
c. dr Cash (+A)......................................................................... 4,000
cr Accounts Receivable (A)........................................... 4,000
d. dr Cash (+A)......................................................................... 2,250
cr Unearned Revenue (+L)............................................. 2,250
e. dr Accounts Receivable (+A)................................................ 125
cr Service Revenue (+R, +SE)........................................ 125
M3-12
f. dr Wages Expense (+E, SE)............................................... 4,750
cr Cash (A).................................................................... 4,750
g. dr Accounts Payable (–L)..................................................... 1,750
cr Cash (A).................................................................... 1,750
h. dr Utilities Expense (+E, –SE).............................................. 800
cr Accounts Payable (+L)................................................ 800
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
M3-13
a.
dr Cash (+A) 25,000
cr Contributed Capital (+SE) 25,000
b.
dr Utilities Expense (+E, -SE) 600
cr Accounts Payable (+L) 600
c.
dr Salaries and Wages Expense (+E, -SE) 2,000
cr Cash (-A) 2,000
d.
dr Accounts Receivable (+A) 2,800
cr Service Revenue (+R, +SE) 2,800
e.
dr Repairs and Maintenance Expense (+E, -SE) 150
cr Cash (-A) 150
Preliminary net income is $50 ($2,800 – 2,000 – 600 – 150).
M3-14
a.
dr Accounts Receivable (+A) 200
cr Service Revenue (+R, +SE) 200
b.
dr Advertising Expense (+E, -SE) 50
cr Cash (-A) 50
c.
dr Cash (+A) 200
cr Membership Revenue (+R, +SE) 200
d.
dr Utilities Expense (+E, -SE) 85
cr Accounts Payable (+L) 85
e.
dr Accounts Receivable (+A) 180
cr Service Revenue (+R, +SE) 180
Preliminary net income is $445 ($200 + 200 + 180 – 50 – 85).
Fundamentals of Financial Accounting, 4/e 3- 9
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
M3-15
a.
dr Cash (+A) 4,000
cr Donations Revenue (+R, +SE) 4,000
b.
dr Salaries and Wages Expense (+E, -SE) 2,000
cr Cash (-A) 2,000
c.
dr Note Payable (short-term) (-L) 1,000
cr Cash (-A) 1,000
d.
dr Supplies (+A) 3,000
cr Cash (-A) 1,000
cr Note Payable (short-term) (+L) 2,000
e.
dr Supplies (+A) 2,500
cr Donations Revenue (+R, +SE) 2,500
Preliminary net income is $4,500 ($4,000 + 2,500 – 2,000).
M3-16
a.
dr Cash (+A) 150,000
cr Note Payable (long-term) (+L) 150,000
b.
dr Accounts Receivable (+A) 2,000
cr Service Revenue (+R, +SE) 2,000
c.
dr Rent Expense (+E, -SE) 600
cr Cash (-A) 600
d.
dr Cash (+A) 450
cr Service Revenue (+R, +SE) 450
e.
dr Advertising Expense (+E, -SE) 400
cr Accounts Payable (+L) 400
Preliminary net income is $1,450 ($2,000 + 450 – 600 – 400).
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M3-17
Assets Liabilities Stockholders’ Equity
a. +15,000 NE Service Revenue (+R) +15,000
b. +150 +150 NE
c. +/–4000 * NE NE
d. +2,250 +2,250 NE
e. +125 NE Service Revenue (+R) +125
* Transaction c. results in an increase in an asset (Cash) and a decrease in an asset
(Accounts Receivable). Therefore, there is no net effect on total assets.
M3-18
Assets Liabilities Stockholders’ Equity
f. –4,750 NE Wages Expense (+E) –4,750
g. –1,750 –1,750 NE
h. NE +800 Utilities Expense (+E) –800
M3-19
SWING HARD INCORPORATED
Income Statement
For the Month Ended February 28, 2013
Revenues:
Service Revenue $ 15,125
Total Revenues 15,125
Expenses:
Wages Expense 4,750
Utilities Expense 800
Total Expenses 5,550
Net Income $ 9,575
Fundamentals of Financial Accounting, 4/e 3- 11
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
M3-20
EQUILIBRIUM RIDING, INC.
Income Statement
For the Year Ended December 31, 2013
Revenues:
Therapy Revenue $ 25,200
Lesson Revenue 10,500
Total Revenues 35,700
Expenses:
Salaries and Wages Expense 3,900
Repairs and Maintenance Expense 410
Other Expenses 270
