Chapter 3: Highlights

1. The income statement provides a measure of the operating performance of a firm for a particular period of time. Net income occurs when revenues exceed expenses. A loss results when expenses exceed revenues.

2. Revenues measure the net assets (assets less liabilities) that flow into a firm when a firm sells goods or renders services.

3. Expenses measure the net assets that a firm consumes in the process of generating revenues.

4. Most companies use the calendar year as the time span for preparing financial statements for distribution to shareholders and potential investors.

5. Other companies use a natural business year or fiscal period for their accounting period. A natural business year ends when the firm has concluded most of its operating activities for the period.

6. Interim reports are reports of performance for periods shorter than a year. These reports do not eliminate the need to prepare annual reports but are prepared as indicators of progress during the year.

7. The cash basis and the accrual basis are two approaches for measuring operating performance.

8. A company applying the cash basis recognizes revenues when it receives cash from customers and recognizes expenses when it disburses cash for merchandise, salaries, insurance, taxes, and similar items. The cash basis of accounting is subject to three important criticisms. First, the costs of the efforts required to generate revenues are not adequately matched with those revenues. Second, the cash basis postpones unnecessarily the time when firms recognize revenue. Third, the cash basis provides an opportunity for firms to distort the measurement of operating performance by timing their cash expenditures.

9. Some companies use a modified cash basis, which is the same as a cash basis except that long-lived assets (buildings, equipment, etc.) are treated as assets (not expenses) when purchased. Companies recognize a portion of the asset's acquisition cost as an expense over several accounting periods as they consume the asset's services.

10. The accrual basis of accounting typically recognizes revenues when a firm sells goods or renders services. It reports costs as expenses in the period when the firm recognizes the revenues that they help produce. Thus accrual accounting attempts to match expenses with associated revenues.

11. Costs that firms cannot closely identify with specific revenues are treated as expenses of the period in which the firms consume benefits of the asset. 12. Accrual accounting focuses on the inflows of net assets from operations, and the use of net assets in operations regardless of whether those inflows and outflows currently produce or use cash.

13. The accrual basis provides a superior measure of operating performance compared to the cash basis because (a) revenues more accurately reflect the results of sales activity, and (b) expenses are associated more closely with reported revenues.

14. Under the accrual basis, firms recognize revenue when they meet the following two criteria: (a) a firm has performed all, or a substantial portion, of the services it expects to provide, and (b) the firm has received either cash, a receivable, or some other asset whose cash-equivalent value can be measured with reasonable precision. Most companies recognize revenues at the point of sale.

15. The amount of revenue recognized equals the cash or cash-equivalent value of other assets received from customers. The gross revenue for some companies requires adjustment for amounts estimated to be uncollectible, discounts for early payment, and sales returns and allowances.

16. Expenses measure the assets consumed in generating revenue. Assets are unexpired costs. Expenses are expired costs. The amount of an expense equals the cost of the asset consumed.

17. Asset expirations associated directly with revenues are expenses in the period when a firm recognizes revenues. This treatment is called the matching principle.

18. Asset expirations not clearly associated with revenues become expenses of the period when a firm consumes the benefits of the asset in operations. These expenses are called period expenses. Most selling and administrative costs receive this treatment.

19. The cost of merchandise sold is generally the easiest to associate directly with revenue. For a merchandising firm, such as a department store, the acquisition cost of inventory is an asset until it is sold, at which time it becomes an expense. A manufacturing firm incurs costs (product costs) of direct materials, direct labor, and manufacturing overhead in producing its product. Manufacturing overhead is a mixture of indirect costs, which provides the capacity to produce the product. Manufacturing overhead often includes items such as plant utilities, property taxes and insurance on the factory, and depreciation on the factory plant and equipment. In both merchandising and manufacturing, firms expense product costs when the firms generate revenues from the sale of the product.

20. Net Income, or earnings, for a period measures the excess of revenues (net asset inflows) over expenses (net asset outflows) from selling goods and providing services.

21. Dividends measure the net assets distributed to shareholders. Dividends are not expenses and do not appear in the income statement.

22. The Retained Earnings account on the balance sheet measures the cumulative excess of earnings over dividends since the firm began operations.

23. Revenues increase net assets (that is, assets minus liabilities) with debits and increase shareholders’ equity with credits. Conversely, expenses decrease net assets with credits and decrease shareholders' equity with debits. Although they are not expenses, dividends also decrease net assets with credits and decrease shareholders' equity with debits.

24. At the end of the accounting period, firms record entries to adjust or correct account balances in order to measure all revenues and expenses for the proper reporting of net income and financial position. Examples of such adjustments include the cost of insurance that has expired, salaries that have been earned but not paid, and interest that has been accrued with the passage of time but not yet paid.

25. Depreciation accounting is a cost-allocation procedure whereby a firm allocates the cost of a long-lived asset to the periods in which a firm receives or uses benefits. The charge made to the current operations for the portion of the cost of such assets consumed during the current period is called depreciation. Firms use an account called Accumulated Depreciation to record the write-down in the cost of the asset for services used during the period. The Accumulated Depreciation account appears on the balance sheet as a subtraction from the acquisition cost of the asset. Accountants refer to accounts such as Accumulated Depreciation as contra accounts because they appear as subtractions from the amounts in other related accounts.

25. Firms record revenues and expenses in separate revenue and expense accounts during an accounting period, identifying the nature of the revenue or expense in the account title. The accountant uses the amounts in these accounts at the end of the accounting period after making adjusting entries to prepare an income statement. The accountant then closes the revenue and expense accounts to the Retained Earnings account, leaving zero balances in the revenue and expense accounts.

26. The income statement provides information for assessing the operating profitability of a firm. Common-size income statements express each expense and net income as a percentage of revenues and permit an analysis of changes or differences in the relations between revenues, expenses, and net income.

27. Financial statement users can employ common-size income statements in time series analysis and cross section analysis.

28. Time series analysis compares common-size income statements for two or more periods. Such comparisons may reveal trends that would help the statement reader interpret and analyze the firm’s operations.

29. Cross section analysis involves using common-size income statements to compare two or more firms. Such analysis provides information about the different strategies that firms follow.