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Notes
CHAPTER 4
INCOME STATEMENT: REPORTING THE RESULTS OF OPERATING
ACTIVITIES
I. Learning Objectives
1. Understand the classifications of revenues and expenses on the income
statement and the importance of those classifications.
2. Understand the timing of revenue and expense recognition and their
measurement.
3. Understand the concept of comprehensive income and the relation between
net income and comprehensive income.
4. Develop skills to analyze the relations among revenues, expenses, and net
income, and understand how differences in business models affect those
relations.
II. Organization of Class Sessions
Because of the importance of the material in Chapter 4 to an
understanding of much of accounting, we spend four hours of class time on it.
We spend one hour developing an understanding of the classifications of
revenues and expenses on the income statement and the importance of those
classifications. We then spend two hours of class time on Understand the
timing of revenue and expense recognition, their measurement, and the
concept of comprehensive income and the relation between net income and
comprehensive income. We spend the last hour working Problems 4.34, 4.35, or
4.36. We find that these are excellent devices for testing comprehension of
material in the first four chapters.
III. Lecture Outline
1. Understand the classifications of revenues and expenses on the income
statement and the importance of those classifications.
Begin by illustrating with U.S. GAAP and IFRS which allow significant
latitude with respect to whether and how to aggregate revenues from multiple
business lines (segments) on the income statement. We discuss typical ways
income statements classify and display items. Chapter 2 introduces the income
statement, one of the principal financial statements. The income statement is
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also called the statement of operations or the statement of operating activity,
or the statement of profit and loss.
The income statement begins with revenues followed by a list of expenses.
U.S. GAAP and IFRS requirements for the presentation of income statements
are similar, with some important differences. Then explain the meaning terms,
concepts and why accountants treat interest as an expense in measuring net
income but do not treat dividends on common stock as an expense. And also
why is it important to separate gains from revenues. Other than separating
revenues from expenses, U.S. GAAP provides little guidance about which items
the firm must separately display or their order. IFRS requires, at a
minimum,the separate display of revenues, financing costs (for Example,
interest expense), income tax expense, profit or loss for the period, and certain
other items.
Income statements begin with revenues; for this reason, analysts often
refer to revenue growth as “top–line” growth. In Chapter 2 we define revenues
(or sales, sales revenues, or for some non-U.S. firms, turnover) as the inflow of
net assets (for Example, cash or receivables) received in exchange for providing
goods and services. U.S. GAAP and IFRS allow significant latitude with
respect to whether and how to aggregate revenues from multiple business lines
(segments) on the income statement; there is no requirement that a firm with
multiple segments separately disclose on the income statement the revenues of
each segment.
The word net before the word sales means that sales revenues less
discounts, allowances, and returns; we revisit these topics later in this chapter.
Net income or profit for a period is the difference between revenues from
selling goods and services and the expenses incurred to generate those
revenues, plus some gains or losses of the period. If the expenses plus losses
exceed the revenues plus gains, the result is a net loss. U.S.GAAP and IFRS
require the accrual basis of accounting, which detaches the recognition of
revenue from the receipt of cash.
For each revenue and expense component, have the students discuss
whether the treatment under the cash basis gives a fair measurement of
performance for the period. Their suggestions as to a more desirable treatment
of some items lead directly into the accrual basis of accounting. We find this
initial overview of the two methods a useful introduction. Problems 4.34, and
4.35 relate to the classifications of revenues and expenses on the income
statement.
2. Understand the timing of revenue and expense recognition and their
measurement.
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Notes
Next, consider the recognition of revenue under the accrual basis.
Criteria for Revenue Recognition and its Measurement and Application of
Revenue Recognition Criteria. Chapter 7 introduces criteria for a firm to use
in deciding when to recognize revenue (timing) and how much revenue to
recognize (measurement). Recognizing revenue often triggers the recognition
of expenses associated with those revenues. We therefore discuss the
accounting procedures for recognizing both revenues and expenses. We
describe the concept of comprehensive income and distinguish net income
from comprehensive income.
Revenue recognition refers to the timing and measurement of revenues.
Revenue recognition is among the most complex issues in financial reporting.
The U.S. GAAP contains over 200 pieces of authoritative guidance for
recognizing revenues. The quantity and complexity of this guidance result
from several factors. First, misreporting of revenues (either reporting
revenues before the firm earns them or reporting nonexistent revenues)
Second, firms often bundle products and services and sell them in multiple-
element arrangements, and each element of the arrangement has the
potential to result in revenue recognition. As a general principle, under the
accrual basis of accounting, the firm recognizes revenue when the transaction
meets both of the following conditions: Completion of the earnings process.
and Receipt of assets from the customer.
The seller measures revenue as the amount of cash, or the cash-
equivalent value of other assets, that it receives from customers. As a starting
point, this amount is the exchange price between buyer and seller at the time
of sale. If the firm has not performed all of its obligations, however, it will
need to adjust the exchange price to reflect those unperformed obligations.
Two common examples of adjustments are sales discounts and allowances,
and sales returns.
We emphasize the recognition of revenue at the time firms sell goods or
render services. We use Exercises 4.11 or 4.12 here. These are excellent short
discussion questions that help students identify the appropriate revenue
recognition point in a variety of situations.
Criteria for expense Recognition is whether the consumption of the asset
results from a transaction that leads to the recognition of revenue and the
consumption of the asset results from the passage of time. In case of Expense
measurement, expenses measure the consumption of assets during an
accounting period, so the basis for expense measurement is the same as the
measurement of the consumed asset. If the firm measures an asset at
acquisition cost on the balance sheet, it also measures expenses based on the
acquisition cost of the asset consumed.
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The chapter concludes by describing how to analyze common-size income
statements to understand how a given firm performs over time, to explain
that performance, and to compare performance across firms. Consider the
recognition of expenses and its measurement under the accrual basis. We
emphasize the matching convention as it applies to merchandising and service
firms here, omitting consideration of product costs for a manufacturing firm
for the most part. Exercises 4.13 and 4.14 are excellent short discussion
questions.
3. Understand the concept of comprehensive income and the relation
between net income and comprehensive income.
Demonstrate the relation between the balance sheet and income
statement. Point out that revenues and expenses increase and decrease
retained earnings, respectively. We enter transactions and other events that
affect net income in separate revenue and expense accounts during the period.
After preparing an income statement for the period, we close these
revenue and expense accounts by transferring their balances to the Retained
Earnings account. Net income under U.S. GAAP, or profit under IFRS, reports
increases in net assets from certain transactions with nonowners such as
customers. Net income, or profit, does not include all transactions with
nonowners. Both U.S. GAAP and IFRS define net income, or profit, for the
current period to exclude certain events and transactions with nonowners that
change net assets.
Both U.S. GAAP and IFRS use the term Other Comprehensive Income
(OCI) to refer to changes in net assets that are not transactions with owners
and that do not appear on the income statement. The sum of net income and
other comprehensive income is Comprehensive Income, which includes all
changes in net assets for a period except for changes arising from transactions
with owners.
The students should observe that both U.S. GAAP and IFRS specify the
items that do not appear in the income statement and that are included in
other comprehensive income. Next, we work several problems that require
students to enter transactions and other events in T-accounts. Problems 4.25,
4.26, 4.27, 4.28, 4.29 and 4.30.
Finally, some time is spent at this point in the course integrating the
accrual basis of accounting with cash receipts and disbursements. We find the
following diagram to be helpful in linking the income statement and
statement of cash receipts and disbursements.
Given any three of the four statements, we can derive the fourth one. The
usual accounting problem gives (1), (2), and (3), and asks for (4).
(2) Income Statement (Accrual Concept)
(3) Statement of Cash Receipts
and Disbursements
(1) Balance Sheet
Beginning of the Period
End of the Period
The last few problems provided in the text require a thorough
understanding of the accrual basis of accounting. Because of the complexity
and length of these problems, you might prefer assigning them over two or
three class periods.
We ask students to use the transactions spreadsheet to prepare solutions
to these problems. They should enter the given information and reprogram
the spreadsheet to solve for unknown amounts.
4. Develop skills to analyze the relations among revenues, expenses, and
net income, and understand how differences in business models affect
those relations.
Users of financial statements often analyze the ratio of net income to
revenues, called the profit margin percentage, when evaluating profitability.
Students should consider the following firms and their profit margin
percentages for a recent year:
A. Nordstrom (retail clothing): 7.9%.
B. Scania (engine and truck manufacturing): 8.4%.
C. Colgate Palmolive (consumer and pet products): 11.1%.
D. Polo Ralph Lauren (clothing design and manufacture): 9.3%.
E. McDonald’s (retail food): 16.4%.
F. Boeing (airplane manufacture): 3.6%.
Looking above results we should be in a position to analyze that we can we
conclude that Boeing and McDonald’s have the worst and best profitability,
respectively? Do differences in profit margin percentages signal differences in
operating performance, and do they have economic or strategic explanations?
Answering these questions requires understanding both the income
statement and investments in assets that firms in different industries must
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have in order to generate revenues. In this section, we focus on tools for
understanding the income statement, recognizing that the analysis of
profitability and operating performance also requires consideration of the
assets used to generate profits.
We merely introduce interpretation of the income statement at this point
in the course because we treat it more fully in Chapter 6. Problems 4.31, 4.32,
4.33, 4.34, and 4.35 work well for this purpose.