BU.210.620 Chap.2 Income Statement and Accrual Accounting
Income Statement and Accrual Accounting
A statement about a period
The income statement reports performance across a period, usually a year, and its bottom line is net income: revenues minus expenses. Because the operating cycle of buying, selling and collecting rarely ends neatly on 31 December, the time-period assumption forces two decisions for every item, when to record it and at what amount.
Revenues and expenses come from central operations; gains and losses come from peripheral events such as selling an old vehicle. Interest and income tax are shown after operating income, and earnings per share is reported with the statement.
Accrual accounting and its two recognition rules
GAAP requires the accrual basis.
Revenue is recognised when the goods are shipped or the service is performed and the company has received an asset, cash or a customer's promise to pay. Cash taken in advance is unearned revenue, a liability, until delivery. Expenses are recognised when assets are consumed: product costs when the related sale is recorded, period costs such as rent, salaries and interest as time passes.
An expenditure, meaning any cash outflow, is not automatically an expense; buying equipment or repaying a loan uses cash without creating one.
Recording operations
Revenues are credits and expenses are debits because they raise and lower equity. A merchandise sale on a perpetual system needs two entries, one at selling price for revenue and one at cost for cost of goods sold.
Prepayments, such as rent or insurance paid ahead, start as assets and become expense as they are used, while wages earned but unpaid are accrued as a liability.
At period end revenues and expenses are closed into retained earnings, so ending retained earnings equal the beginning balance plus net income minus dividends declared.
Why it matters for the quiz
The week 4 quiz does not ask for an income statement, but its transactions include revenues and expenses, so you must compute the period's net income and fold it into retained earnings on the balance sheet.
A quick way is to total the revenue credits and expense debits from your own journal before you build the equity section.
What this chapter covers
- 01
Operating cycle and the time-period assumption
- 02
Revenues, expenses, gains and losses
- 03
Cash basis versus accrual basis
- 04
Revenue and expense recognition
- 05
Journal entries for operating activities
Worked example · free
Separate December revenue and expense from December cash
- 2Revenue equals the $22,000 of work delivered; the $7,000 uncollected is a receivable.
- 2The $5,000 advance is unearned revenue, a liability, not December revenue.
- 2Wage expense is the $7,000 earned in December; the November payment settles last month's payable.
Key terms
- Unearned revenue
- Unearned revenue is a liability for cash received before the related goods or services have been delivered.
- Period costs
- Period costs are expenses recognised as time passes rather than when a product is sold, such as rent, salaries and interest.
- Gains
- Gains are increases in equity from peripheral transactions, such as selling equipment above its book value.
- Earnings per share
- Earnings per share is net income divided by the weighted-average number of common shares outstanding during the period.
- Matching principle
- The matching principle records an expense in the same period as the revenue it helped produce, or as time passes for costs such as rent that serve a period rather than a sale.
Income Statement and Accrual Accounting FAQ
Why is revenue not recorded when a customer pays in advance?
Because the company has not yet performed. The advance creates an obligation to deliver, recorded as unearned revenue, and it converts to revenue only as the goods or services are provided.
Does paying last year's tax bill create an expense this year?
No. The tax expense belonged to the year the income was earned and was recorded with a payable then; paying it now only reduces that liability and cash.
Why does a sale of merchandise need two journal entries?
One entry records the revenue at selling price, debiting cash or receivables. The second moves the goods out of inventory and into cost of goods sold at cost. Skipping the second entry overstates both inventory and profit.
Exam move
Build a two-column table for ten events, cash effect on the left and accrual effect on the right. Where the columns differ, name the balance sheet account, receivable, unearned revenue, prepaid or payable, that absorbs the difference.
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