CHAPTER 3
THE INCOME STATEMENT
Student Learning Objectives and Related Assignment Materials
Student Learning
Objectives
Mini–
Exercises
Exercises
Coached
Problems
Problems
(Groups
A & B)
Compre–
hensive
Problem
Skills
Develop-
ment
Cases
Continuing
Case
LO 3-1 Describe
common
operating
transactions and
select appropriate
income statement
account titles.
8, 19,
20, 21
1, 2, 3,
4, 5, 6,
15
1, 3
A1, A3,
B1, B3
1, 2, 3,
4, 5, 6
LO 3-2 Explain and
apply the revenue
and expense
recognition
principles.
1, 2*,
3*, 6, 7,
9, 10,
17, 18
3, 4, 5,
6, 7, 8,
9, 10,
11, 12,
14^, 15,
16
1, 2, 3
A1, A2,
A3, B1,
B2, B3
1
4, 5, 6, 7
1†
LO 3-3 Analyze,
record, and
summarize the
effects of
operating
transactions, using
the accounting
equation, journal
entries, and T-
accounts.
4*, 5*,
6, 7, 11,
12, 13*,
14*, 15,
16, 17,
18
7, 8, 9,
10, 11,
12, 14^,
15, 16,
17, 18,
20, 21
1, 2, 3,
4^
A1, A2,
A3, A4^,
B1, B2,
B3, B4^
1
4, 7
1†
LO 3-4 Prepare an
unadjusted trial
balance.
20, 21
13, 19
3
A3, B3
1
6, 7
LO 3-5 Evaluate net
profit margin, but
beware of income
statement
limitations.
8, 19,
21, 22,
23^
11, 20,
21
3, 4^
A3,A4^,
B3, B4^
1
3, 4, 5
1†
* Animated solution included in the PowerPoint Slides.
^ Particularly challenging; requires students to combine multiple concepts in order to advance to the
next level of accounting knowledge.
† Continuing Case 3-1 builds on the story of Nicole’s Getaway Spa, introduced in earlier chapters. This
case focuses on analyzing transactions and preparing journal entries, calculating the company’s
preliminary net income and net profit margin for the month, and identifying the adjustment(s) that will
have to be made before the income statement is finalized. This case will be extended in future
chapters.
Overview
The entrepreneur from Chapters 1 and 2 opens his doors to customers and completes daily operating
transactions.
Students learn how to analyze and record operating transactions involving revenues and expenses and
distinguish cash basis from accrual basis.
Synopsis of Chapter Revisions
• New contemporary focus company: replaced pizza company with SonicGateway, thereby allowing
revenue recognition to be illustrated when game app icon shows “installation completed”
• New illustrations to compare timing of revenue recognition and cash receipt (Exhibit 3.5)
• New Spotlight on Financial Reporting to illustrate revenue recognition policy of Take-Two
Interactive (software maker of Grand Theft Auto)
• New illustrations to compare timing of expense recognition and cash payment (Exhibit 3.6)
• New transactions to illustrate contemporary technology, such as online Facebook advertising,
automated monthly disbursements, and e-commerce sales with online receipts similar to PayPal
• New format for accounting equation effects to illustrate link between income statement and balance
sheet
• New Spotlight on Financial Reporting to focus on technology companies, including Electronic Arts,
Activision Blizzard, Facebook, and LinkedIn
• Updated demonstration case featuring Carnival Corporation
• Reviewed and updated all end-of-chapter material, including new problem formats that automatically
post journal entries to T-accounts and prepare trial balances
PowerPoint Slides
Student Learning Objective
PowerPoint® Slides
LO 3-1 Describe common operating transactions and select appropriate income
statement account titles.
3-2 through 3-5
LO 3-2 Explain and apply the revenue and expense recognition principles.
3-6 through 3-9
LO 3-3 Analyze, record, and summarize the effects of operating transactions,
using the accounting equation, journal entries, and T-accounts.
3-10 through 3-19
LO 3-4 Prepare an unadjusted trial balance.
3-20 through 3-23
LO 3-5 Evaluate net profit margin, but beware of income statement limitations.
3-24 through 3-26
Animated Builds and Animated Solutions
PowerPoint® Slides
Mini-Exercise 3-2
3-28
Mini-Exercise 3-3
3-29
Mini-Exercise 3-4
3-30
Mini-Exercise 3-5
3-31
Mini-Exercise 3-13
3-32 through 3-33
Mini-Exercise 3-14
3-34 through 3-35
Summary of Related Video Program
Spotlight Video Series
Chapter 3 – Time is Money (approximately 4:00)
This video program covers time period assumption. In 2000 and 2001, Computer Associates violated the
time period assumption to present a picture of smooth steady growth. This video illustrates the effect of
shifting sales from one period to another and asks students to discuss its impact.
Chapter Summary
LO 3-1 Describe common operating transactions and select appropriate income statement account
titles.
• The income statement reports the effects of transactions that affect net income, which includes
Revenues—amounts charged to customers for sales of goods or services provided.
Expenses—costs of business activities undertaken to earn revenues.
• See Exhibit 3.2 for basic income statement format.
LO 3-2 Explain and apply the revenue and expense recognition principles.
• The two key concepts underlying accrual basis accounting and the income statement are
Revenue recognition principle—recognize revenues when they are earned, regardless of
when cash is received.
Expense recognition (“matching”) principle—recognize expenses when they are incurred in
generating revenue, regardless of when cash is paid.
LO 3-3 Analyze, record, and summarize the effects of operating transactions, using the accounting
equation, journal entries, and T-accounts.
• The expanded transaction analysis model includes revenues and expenses as subcategories of
Retained Earnings. Increases, decreases, and normal account balances (dr or cr) are shown below:
ASSETS
=
LIABILITIES
+
STOCKHOLDERS’ EQUITY
+
dr
–
cr
–
dr
+
cr
Common
Stock
Retained Earnings
–
dr
+
cr
–
dr
+
cr
Net
Income
Revenues
(and Gains)
Expenses
(and Losses)
–
dr
+
cr
+
dr
–
cr
Chapter Summary, continued
LO 3-4 Prepare an unadjusted trial balance.
• The unadjusted trial balance is a list of all accounts and their unadjusted balances, and is used to
check on the equality of recorded debits and credits.
LO 3-5 Evaluate net profit margin, but beware of income statement limitations.
• Net profit margin expresses net income as a percentage of total revenues.
• The income statement indicates whether the company is profitable, but this might not explain
whether cash increased or decreased.
• Does not directly measure the change in value of a company during the period.
• Estimation plays a key role when measuring income.
Accounting Decision Tools
Net Profit Margin = Net Income ÷ Total Revenues
• It tells you how much profit is earned from each dollar of revenue.
• A higher ratio means better performance.
Chapter Outline
Teaching Notes
I. Understand the Business
LO 3-1 Describe common operating transactions and select appropriate income statement account
titles.
A. Operating Activities
1. Operating activities—The day-to-day functions involved
in running a business; include:
Illustrated in Exhibit 3.1
a. Buying goods and services from suppliers and
employees.
b. Selling goods and services to customers and collecting
cash from them.
2. Most businesses have the same steps in their operating
cycles; however, the length of time for each step varies
from company to company.
3. Operating activities are the primary source of revenues
and expenses and, thus, can determine whether a
company earns a profit (or incurs a loss).
B. Income Statement Accounts
Examples provided in
1. Revenues––Amounts earned by selling goods or services
to customers; reported first in the income statement.
Exhibit 3.2
2. Expenses––Costs of operating the business that are
incurred to earn revenues; reported after revenues in the
income statement.
3. Net income––The excess of revenues over expenses;
amount by which stockholders’ equity increases as a
result of profitable operations.
Stress that net income is a
total and not an account
C. 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.
The “Stoplight on Ethics”
feature notes that some
managers haven’t learned the
1. Key distinction between the income statement and the
balance sheet:
time period assumption
a. The revenues and expenses on an income statement
report the financial impact of activities in just the
current period.
b. Items on a balance sheet will continue to have a
financial impact beyond the end of the current period.
2. Balance sheet accounts are considered permanent
whereas income statement accounts are considered
temporary.
II. Study the Accounting Methods
A. Cash Basis Accounting
1. Cash basis accounting––Reports revenues when cash is
received and expenses when cash is paid.
2. Doesn’t measure financial performance very well when
transactions are conducted using credit rather than cash.
3. Not likely to correspond to the business activities that
actually occur during a given period; leads to a rather
distorted view of the company’s financial performance.
Chapter Outline
Teaching Notes
B. Accrual Basis Accounting
1. Accrual basis accounting––Reports revenues when they
are earned and expenses when they are incurred,
regardless of the timing of cash receipts or payments.
a. Produces a better measure of the profits arising from
the company’s activities.
b. Only acceptable method for external reporting of
income according to GAAP and IFRS.
c. The cash basis is sometimes used by some small
companies.
LO 3-2 Explain and apply the revenue and expense recognition principles.
2. Revenue Recognition Principle
a. Revenue principle—The requirement under accrual
basis accounting to record revenues when they are
earned, not necessarily when cash is received for
them.
❖ Spotlight Video Series –
Chapter 3
i. Recognized means revenues are measured and
recorded in the accounting system.
ii. Earned means the company has fulfilled its
performance obligation to the customer by doing
what it promised to do.
b. All companies expect to receive cash in exchange for
providing goods and services; timing of cash receipts
does not dictate when revenues are recognized.
Timing of reporting revenue
versus cash receipts
illustrated in Exhibit 3.5
c. Timing of related transactions:
i. Cash before sale/service—Cash received is
reported but company hasn’t provided the
promised goods or services, so no revenue is
recorded yet.
• The obligation to provide the promised goods
or service is a liability called Unearned
Revenue.
• Unearned Revenue––A liability representing
a company’s obligation to provide goods or
services to customers in the future.
• Revenue will be reported later, when the goods
or services are provided.
ii. Cash with sale/service—Cash and revenue are
reported at the same time.
The “Spotlight on Financial
Reporting” feature sets forth
iii. Sale/service before, and cash after—Revenue is
reported since the company has provided the
promised goods or services, but cash hasn’t been
received.
The revenue recognition
policy of Take-Two
Interactive Software, Inc.
• Occurs when a company sells on account.
• The company provides goods or services to a
customer for the right to collect cash in the
future; right is the asset Accounts Receivable.
Chapter Outline
Teaching Notes
3. Expense Recognition Principle
a. Expense recognition principle (“matching”)—The
practice under accrual basis accounting to record
expenses in the same period as the revenues they
generate, not necessarily the period in which cash is
paid for them.
Timing of reporting expenses
versus cash payments
illustrated in Exhibit 3.6
b. If an expense cannot be directly associated with
revenues, it is recorded in the period that the
underlying business activity occurs.
c. Timing of related transactions:
i. Cash before expense—It is common for businesses
to pay for something that provides benefits only in
future periods.
• The company might buy office supplies now
but not use them until next month.
• The expense from using these supplies is
reported next month, when the supplies are
used; this month, the supplies represent an
asset (Supplies).
• Similar situations arise when a company
prepays rent or insurance this month and uses
up these assets in a later month.
ii. Cash with expense—Expenses are sometimes paid
for in the period that they arise.
• The company may arrange to make automatic
payments to a utility company at the end of
each month.
• Because the electricity is used up in the current
month, it is an expense of the current month.
iii. Expense before, and cash after—Many costs are
paid after receiving and using goods or services.
• Because the cost of the goods or services
obtained relates to revenues earned this month,
it represents an expense that will be reported
on this month’s income statement.
• Because the cost has not yet been paid at the
end of the month, the balance sheet reports a
corresponding liability called Accounts
Payable.
• Similar situations arise when employees work
in the current period but are not paid until the
following period; this period’s wages are
reported as Wages Expense on the income
statement and any unpaid wages are reported
as Wages Payable on the balance sheet.
Chapter Outline
Teaching Notes
LO 3-3 Analyze, record, and summarize the effects of operating transactions, using the accounting
equation, journal entries, and T-accounts.
C. The Expanded Accounting Equation
1. Stockholders’ equity includes:
a. Common Stock, given to stockholders when they
contribute capital to the company.
b. Retained earnings, generated by the company itself
through profitable operations.
2. Because revenues and expenses as subcategories within
retained earnings, they are affected by debits and credits
in the same way as all stockholders’ equity accounts:
a. Increases in stockholders’ equity are on the right.
Revenues increase stockholders’ equity, so revenues
are recorded on the right (credit).
Illustrated in Exhibit 3.7
b. Decreases in stockholders’ equity are recorded on the
left. Expenses decrease net income and retained
earnings, so expenses are recorded on the left (debit).
D. Transactions Analysis, Recording, and Summarizing
(a) Provide services for cash—In September, SonicGateway
sold $3,000 of games at its online store; customers paid
when the games were downloaded.
✓ Supplemental Enrichment
Activity (Activity) #1
1. Analyze: Assets = Liabilities + Stockholders’ Equity
Cash (A) +3,000 = Sales Revenue (R, SE) +3,000
2. Record:
Refer to illustrations of
Cash (+A)
3,000
Sales Revenue (+R, +SE)
3,000
transactions in textbook for
Step 3 – Summarize (which
(b) Receive cash for future services – SonicGateway sold
three $100 gift cards at the beginning of September.
includes posting to T–
accounts).
1. Analyze: Assets = Liabilities + Stockholders’ Equity
Cash (A) + 300 = Unearned Revenue (L) + 300
2. Record:
Cash (+A)
300
Unearned Revenue (+L)
300
(c) Sells apps on credit—SonicGateway sold $9,000 of apps
on the App Store and on Google Play; Apple and Google
will release customer payments to SonicGateway later in
the month.
1. Analyze: Assets = Liabilities + Stockholders’ Equity
Accounts Receivable (A) +9,000 = Sales Revenue (R,
SE) +9,000
2. Record:
Accounts Receivable (+A)
9,000
Sales Revenue (+R, +SE)
9,000
Chapter Outline
Teaching Notes
(d) Receive payment on account—SonicGateway received
checks totaling $8,500 from Apple and Google, on
account.
1. Analyze: Assets = Liabilities + Stockholders’ Equity
Cash (A) +8,500 + Accounts Receivable (A) –8,500
= 0
2. Record:
Cash (+A)
8,500
Accounts Receivable (–A)
8,500
(e) Pay cash to employees—SonicGateway wrote checks to
employees, totaling $7,800 for wages related to hours
worked in September.
1. Analyze: Assets = Liabilities + Stockholders’ Equity
Cash (A) –7,800 = Salaries and Wages Expense (E,
SE) –7,800
2. Record:
Salaries and Wages Expense
(+E, –SE)
7,800
Cash (–A)
7,800
(f) Pay cash in advance—On September 1, SonicGateway
paid $7,200 in advance for September, October, and
November rent.
1. Analyze: Assets = Liabilities + Stockholders’ Equity
Cash (A) –7,200 + Prepaid Rent (A) +7,200 = 0
2. Record:
Prepaid Rent (+A)
7,200
Cash (–A)
7,200
(g) Incur cost to be paid later—SonicGateway displayed
Facebook sidebar ads in September, and received a bill
for $500 to be paid in October.
1. Analyze: Assets = Liabilities + Stockholders’ Equity
0 = Accounts Payable (L) +500 + Advertising
Expense (E, SE) –500
2. Record:
dr Advertising Expense (+E, –SE)
500
cr Accounts Payable (+L)
500
(h) Pay cash for expenses—SonicGateway was notified by its
bank that an automatic payment of $600 was transmitted
to its utility company for electricity use in September.
1. Analyze: Assets = Liabilities + Stockholders’ Equity
Cash (A) –600 = Utility Expense (E, SE) –600
2. Record:
Utilities Expense. (+E, –SE)
600
Accounts Payable (+L)
600
Chapter Outline
Teaching Notes
E. Calculating Account Balances
1. After entering (“posting”) the effects of each journal
entry into the T-accounts, the ending balances are
calculated.
2. Ending balance in each account is amount by which the
total of the increase (+) side exceeds the total of the
decrease (–) side.
LO 3-4 Prepare an unadjusted trial balance.
F. Unadjusted Trial Balance
✓ Activity #2
1. After summarizing journal entries in the various accounts
and then calculating ending balances for each account, an
unadjusted trial balance is prepared.
2. Trial balance––An internal report that lists all accounts
and their balances to check on the equality of the total
recorded debits and total recorded credits.
Illustrated in Exhibit 3.9
3. Income statement accounts follow balance sheet
accounts.
4. Ending balances obtained from ledger (T-accounts) are
listed in the appropriate debit or credit column and
columns are totaled.
a. If the trial balance does not balance, look at the
difference between total debits and credits.
b. If the trial balance does balance, it’s still possible that
you’ve made an error. An entry might include the
wrong account or have been posted to the wrong
account in the general ledger.
5. If title says “unadjusted trial balance” then several
adjustments will have to be made at the end of the
accounting period to update the accounts.
The adjustments will be
covered in chapter 4.
G. Review of Revenues and Expenses
1. Remember that revenues are recorded when the business
fulfills its promise to provide goods or services to
customers, which is not necessarily the same time that
cash is received.
2. Under accrual accounting, expenses are recorded when
incurred (by using up the economic benefits of acquired
items). Expenses are not necessarily incurred at the same
time that cash is paid.