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Financial Accounting Exam
Chapter 5 Income Measurement and the Income Statement
The Revenue Recognition Principle
Revenues Increases in economic resources resulting from ordinary activities such
as the sale of goods, rendering of services, or use of other entitys resources.
Revenue recognition principle Revenues are recognized in the income statement
when they are earned.
o Time-of-sale method The method used by merchandising and
manufacturing industries to recognize revenue when goods are sold.
o Percentage-of-completion method The method used by contractors to
recognize revenue before the completion of a long-term contract.
o Production method The method in which revenue is recognized when a
commodity is produced rather than when it is sold.
o Instalment method The method in which revenue is recognized at the time
cash is collected.
The Matching Principle and Expense Recognition
Matching Principle The revenues for the period are associated with the costs of
generating those revenues.
o Certain costs directly generate revenues, so they can be directly matched with
o Other costs indirectly generate revenues, so they are matched with the
periods they provide benefit.
o Other costs do not give rise to assets because no future benefits from these
costs are discernible, like the cost of heating and lighting. Thus they are
treated as expiring immediately as they are acquired.
o Unexpired Costs are called assets, expired ones, expenses.
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The Format and Content of the Income Statement
Single-step income statement An income statement in which all expenses are
added together and subtracted from all revenues. Advantage is that its simple, but
doesnt classify revenues and expenses or associate them with anything.
Multiple-step income statement An income statement that shows classifications of
revenues and expenses as well as important subtotals.
o Net Sales Sales revenue less sales returns and allowances and sales
o Gross Profit Sales less cost of goods sold, also termed gross margin.
Total sales $368,00
Less: Sales returns and allowances 6,000
Sales discounts 4,500
Net sales 0
Cost of goods sold 218,300
Gross Profit 00
o Sales Returns and Allowances Contra-revenue account (Shareholders
Equity) used to record both refunds to customers and reductions of their
accounts. Example of someone returning a $25 shirt:
Apr. 25 Sales Returns and Allowances 25
To record return of stained T-shirt by
customer for cash refund
Contra-revenue account Has a balance opposite to its related
account, and is deducted from that account on the statement. Thus the
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effect of this debit to this account is the same as if Sales Revenue had
been reduced (debited) directly. A Shareholders Equity account.
o Trade discount Selling price reduction offered to a special class of
o Quantity discount Reduction in selling price for buying a large number of
units of a product.
o Credit terms Commonly used to give customers sales discounts, 1/10, n/30
means deduct 1% from selling price if paid within 10 days of receiving the
invoice (usually starts day after invoice date), otherwise pay full invoice
amount within 30 days.
o Sales Discounts Contra-revenue account used to record discounts given
customers for early payment of their account.
Cost of goods sold model:
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o Cost of goods available for sale Beginning inventory plus cost of goods
o Cost of goods sold Cost of goods available for sale minus ending inventory.
o Gross Profit Margin = Gross Profit / Net Sales
This indicates the amount of each net sales dollar left after cost of
Operating Expenses and Income from Operations Income from operations is the
difference between gross profit and total operating expenses. A healthy income from
operations can indicate a healthy financial future.
Other Revenues and Expenses and Income before Income Taxes Any outflow or
inflow of assets resulting from non-operating activities.
Profit Margin = Net Income / Net Sales
o The ratio of net income to net sales indicates the amount of each net sales
dollar left as profit after all expenses are covered.
How Sales Affect the Cash Flow Statement
Direct method used to prepare the Operating Activities category of the cash flow
o The amount of cash collected from customers is shown as positive cash flow.
Indirect method used to prepare the Operating Activities category of the cash flow
o It is necessary to make adjustments to net income for the changes in accounts
receivable. An increase in accounts receivable is deducted because it indicates
the company is tying up its cash in these accounts. A decrease is added to net
income because the company actually reduced the amount owed by customers
and collected cash.