4.0 Capturing and Reporting Value Flows: Income and Activities Statements and Temporary Accounts

Now we look at the income statement in more detail. We begin by defining pivotal concepts such as income, revenue, and expenses.

Income

Here are the three important levers that make up the definition of income and loss:

• Increase (or decrease) in net assets
• Resulting from an entity’s operations (recall what operations entail)
• Over a period of time

Let us go back to the accounting identity to make sense of this:

Assets - Liabilities = Equities (for-profit) or Net Assets (not-for-profit)

Net assets are the excess of the entity’s economic resources (assets) over its obligations (liabilities) at a point in time. An increase in Net Assets occurs when the ending Net Assets are greater than the beginning Net Assets:

[Net Assets]_ENDING  >  ]Net Assets] _BEGINNING 

[Assets - Liabilities]_ENDING  >  [Assets - Liabilities]_BEGINNING

Net assets can increase and decrease for a variety of reasons. For example, we saw that Nathan’s Famous net assets decreased very sharply between March 30, 2014 and March 29, 2015 because Nathan’s borrowed heavily, then paid a large dividend. These financing decisions caused the overall decrease, not Nathan’s operations. Recall that Nathan’s recognized net income of $11.7 million.  The Statement of Stockholders’ (Deficit) Equity tells the whole story about how net assets changed:

[ Open the Nathan’s statement as an Excel spreadsheet ]

The Income Statement gives a lot of information on the change in net assets due to operations. Here is Nathan’s Income Statement for the 52 weeks ended March 29, 2015:

[ Open the Nathan’s statement as an Excel spreadsheet ]

There are two main sections on the income statement: Revenues and Expenses.

Revenues

Revenues are gross inflows of net assets resulting from the sale of goods and services. The main accounting issue with revenue is recognition - when do we recognize in the formal accounting system that revenues have been earned?

GAAP about revenue recognition has changed recently to acknowledge the increasingly complex relationships between customers/clients and sellers/service providers. The new rules focus on the evidence that must be obtained before revenue recognition. Here is what two SEC Staff Accounting Bulletins (SAB 101 and SAB 104) say must be met before revenue can be recognized:

1. There is persuasive evidence of an arrangement with a customer/client.
2. Goods have been delivered or services have been provided.
3. The price to the customer/client is fixed or determinable.
4. There is reasonable assurance that the price will be paid - i.e. that any related receivables will be collected.

Recognition is the act of formally entering an item into the accounting records. We must designate a convention for revenue recognition so that there is consistency in accounting metrics across different companies and industries. The convention for revenue recognition i s when the earnings process is complete or substantially complete, when an exchange has occurred, and when the amount of revenue can be measured with some accuracy and the entity is reasonably sure of collection.

There are five steps in the implementation:

1. Identify the contract with the customer.
2. Identify performance obligations.
3. Determine the price, which is the amount the seller/provider expects to be entitled when it has performed all activities required in the contract.
4. Allocate the price to separate performance obligations
5. Recognize revenue when the goods are delivered or the services provided.

Most of the examples we study in this first course are fairly straightforward, but you need to be aware of the complexities.

Expenses

Expenses are the assets used or liabilities incurred in the process of carrying out operations. Expenses are things that decrease income, the costs incurred in the generation of revenues.

Certain expenses such as rent, insurance, and building costs are called period expenses .

The process of looking for the expenses corresponding to recognized revenue is called matching. Matching is a process of looking for assets consumed or liabilities incurred in the generation of revenues. A lot of the identification of expenses comes from looking at assets to see if they have been consumed or liabilities to see if they have been increased.

Temporary Accounts

To keep track of revenues and expenses, it is most efficient to develop a set of accounts with which to do this. These accounts will be temporary, meaning that they will begin with a zero balance and end with a zero balance. These temporary accounts, therefore, will not appear on the balance sheet. Their net effect will be transferred into Retained Earnings in what is called a closing entry. A closing entry is an entry that takes the balance of an account to zero.

Two types of temporary accounts are Revenues and Expenses. For example, Nathan’s has thee revenue accounts: Sales, License Royalties, and Franchise Fees and Royalties. Here is what their T-accounts looked like at the close of business on March 30, 2014:

Actually, there is one more account that reports gross inflows on Nathan’s Income Statement: Interest Income. Of course, that has nothing to do with selling hot dogs, so it is shown after Income from Operations. Here is how that account would appear at the close of business on March 30, 2014:

Notice that all these accounts have no beginning balances. That’s because they were closed at the end of the day on March 30, 2014.

Here are some entries that Nathan’s would have made over the year. For simplicity, I assume all sales were on credit and all interest income was recorded before it was received:

Posting these gives:

and

The closing entry:

When posted, we have zeroed out the accounts:

>

and

The best way to bring all this to life is to do an example. As usual, we will start small and build complexity as we get more sure of the basics.