The Income Statement, Cash & Accruals

Financial Performance & Management Control - TUHH Institute of Management Accounting & Simulation, Hamburg · part of my Technology Management MBA · study notes for revision.

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Chapter 2 gave us the balance sheet: a photo of what the firm owns and owes at one instant. This chapter adds the film that runs between two photos - the income statement. It answers a question a single balance sheet cannot: why did owner’s equity move from one date to the next, and was the business actually any good at what it does?

The second half of the chapter is the idea that makes financial accounting genuinely different from watching a bank balance: accruals. A company has no natural end date, so we chop its life into artificial years and quarters and then have to decide which revenues and expenses belong in which slice. Cash timing is a poor guide for that. Revenue recognition and the matching principle are the two rules that do the slicing, and they are exactly what makes profit and cash flow disagree in any single period.

Tip

The one idea to carry through. The income statement is the detail behind one balance-sheet line: owner’s equity. Revenues push equity up, expenses pull it down, the net is profit, and profit lands inside equity. Because the statement is built on accruals rather than cash, the profit of a period is not the cash collected in that period - only over the whole life of the firm do the two totals meet.

1 · Income: the growth in wealth over a period

Income simply means the increase in wealth over a stretch of time. That immediately raises a question the balance sheet never had to face: which stretch of time? Three conventions exist side by side:

• Calendar year - 1 January to 31 December.
• Fiscal year - any twelve-month stretch: it can start whenever the company chooses and ends 365 days later. Many firms pick a year-end that avoids their busiest season so the books can be closed in peace. Either way, this is the period behind the annual financial report.
• Interim periods - weekly, monthly or quarterly slices inside the year. The quarterly report (three months) is the most familiar one. The shorter the slice, the sharper the timing questions of section 7 become.

2 · Revenues, expenses, gains, losses and retained earnings

Four building blocks carry the whole statement. Note the phrase from operations in the first two: equity can also rise when the owner injects money, but that is a contribution, never income.

Revenues usual and frequent

• An increase in owner’s equity that arises from operations
• Typically net assets received from customers in return for goods or services delivered
• e.g. fees for services, rent collected from tenants

Expenses usual and frequent

• A decrease in owner’s equity that arises from operations
• Net assets given up or used up while delivering to customers
• e.g. rent, salaries, materials consumed, depreciation

Gains and losses unusual and/or infrequent

• Also move equity, but come from one-off events outside the routine business
• e.g. selling a property above or below its book value
• Shown separately so a reader can tell what is repeatable from what is not

Retained earnings the running total

• All the income earned since the business began, minus all dividends paid out
• The slice of equity the firm has built itself, as opposed to the capital owners put in

Income Income (profit, earnings) = Revenues - Expenses for one reporting period

Retained earnings Retained earnings = all income to date - all dividends to date since inception

Equity owner contributions (common stock) + retained earnings

3 · Classifying transactions: does it touch equity?

The practical skill behind the definitions is sorting real events. The slides use a small law office: a lawyer opens her own practice on 1 July and the first month brings seven transactions (the full table sits in the worked example below). For every event, the same three questions decide where it goes:

1. Which assets or liabilities change? Every transaction moves at least one balance-sheet line.
2. Does owner’s equity move at all? If the event only shuffles assets and liabilities (buy equipment on credit, borrow from the bank), equity is untouched and nothing reaches the income statement.
3. If equity moves, did it come from operations? Money the owner invests raises equity but is capital, not revenue. Fees earned are revenue; rent and salaries are expenses - these are the lines of the income statement.

No equity effectassets and liabilities only

Equipment on account 3,000equipment up, payable up

Bank loan 700cash up, note payable up

Equity upcapital or revenue

Owner invests 10,000capital, not revenue

Services for cash 1,500revenue

Services on account 2,000revenue, receivable up

Equity downexpenses

Rent 800expense, cash down

Salaries 500, utilities 300, phone 100expenses, cash down

The seven law-office transactions sorted by their effect on equity. Only the green and amber boxes appear on the income statement; the owner’s investment raises equity without being income; the slate boxes never leave the balance sheet.

Two of these deserve a second look because they preview the rest of the chapter. The 2,000 of services on account is revenue although no cash has arrived: the client now owes a legally enforceable amount, so a receivable is booked and equity rises. And the 3,000 of equipment is not an expense even though it will be paid for: it is an asset that will serve the office for years, so its cost reaches the income statement later, in slices.

4 · The income statement is the sub-ledger of equity

The income statement reports the flows of revenues and expenses over a period (a year, a quarter, a month). Its balance - net income, positive or negative - is nothing other than the change in equity that came from operating. That is why the slides call it the sub-account or sub-ledger of owner’s equity: the balance sheet shows one equity number; the income statement opens that number up and explains the sources of profit and loss behind it.

Revenuesequity up from operations: resources gained

→minus

Expensesequity down from operations: resources used up

→balance

Net incomeprofit or loss of the period

→is part of

Owner’s equityon the balance sheet, opposite assets and liabilities

The income statement as the sub-ledger of equity. Expenses are traditionally shown on the left and revenues on the right with net income as the balancing figure, but both statements can just as well be written as one list, item below item.

Three lessons the slides draw from this relationship:

• The income statement gives the reasons for a change in equity - where profit or loss came from.
• It measures the change in wealth between two discrete points of time, which is exactly what income was defined to be in section 1.
• It is built on accruals, so its revenues and expenses are not the same as cash in and cash out (sections 7 and 8).

5 · The functional P&L structure

Real income statements are not a random list of revenues and expenses. The common functional layout groups costs by the job they did and walks down from sales to the bottom line in stages:

Revenuessales of goods and services

↓minus cost of goods sold / cost of sales

Gross marginwhat is left after the direct cost of what was sold

↓minus selling & marketing, general & administrative, R&D, other operating cost or income

EBITearnings before interest and taxes

↓plus or minus the financial result

Profit before taxoperating result plus finance result

↓minus corporate income taxes

Profit after taxthe bottom line that flows into equity

The functional P&L waterfall. Everything down to EBIT is the operating business; the financial result and the tax line are added below it so a reader can judge operations separately from financing and tax.

The waterfall has three distinct sections:

• Operating section everything from revenues to EBIT - producing and selling goods and services, including the functional cost blocks (cost of sales, selling and marketing, general and administrative, research and development, other operating items).
• Finance section the financial result - finance expenses and finance revenues such as interest.
• Tax section corporate income taxes - what goes to the tax authorities.

The slides illustrate the layout with the published statement of the BASF group; it is worth looking at a real one once so the labels stop being abstract.

6 · Balance sheet vs income statement: stock vs flow

The cleanest way to hold the two statements together is a roll-forward of equity:

Equity roll-forwardEquity at start + increases - decreases = Equity at end

The operating part Revenues - Expenses = Net income which appears as a thereof line inside equity

On the balance sheet side you see non-current (fixed) assets and current assets (thereof cash and cash equivalents) against owner’s equity (thereof net income) and liabilities. On the income statement side you see only the flows that produced that “thereof net income”.

	Balance sheet	Income statement
Nature	A stock - a snapshot	A flow - a film
Time reference	One point in time (e.g. 31 December)	A period (e.g. the year ended 31 December)
Question answered	What do we own and owe right now?	How did equity change through operations, and why?
Link	Equity contains the net income of the period	Net income is the equity increase (or decrease) from operations

Because the income statement covers the gap between two balance sheets, shorter statements chain together:

Balance sheet31 Dec 20X1

→income statement for January

Balance sheet31 Jan 20X2

→income statement for February

Balance sheet28 Feb 20X2

→income statement for March

Balance sheet31 Mar 20X2

Monthly statements chain into a quarter: the three monthly income statements add up to the income statement for the quarter ended 31 March 20X2, and each balance sheet is the closing snapshot of one month and the opening snapshot of the next.

7 · Cash and accruals: accounting in a multi-period world

Now the deeper question. Picture the whole life of a firm: cash is invested at the start, more cash goes in and comes out at many later points, and there is no pre-determined end to the story - accountants call this the going concern assumption. Later decisions depend on earlier results (a feedback loop), and owners, lenders and managers all demand periodic figures, above all a performance figure. So accounting makes an artificial cut of the firm’s life into annual (or quarterly) periods.

Cash investedat the start, and again later

→periods 1, 2, 3 … no natural end

Operations run oncash in and out at many points, feedback from prior results

→somewhere, someday

Cash returnedto the owners

The multi-period world. Because the firm is a going concern, the periods are an artificial device for reporting, and the crucial question becomes: which information belongs to which period?

There are two honest answers to that question, and financial reporting uses both:

Cash accounting the wallet view

• Record cash flows directly, when they happen
• Works like a normal wallet: cash in minus cash out
• Looks erratic (a machine bought this year, nothing next year), but it is real and hard to argue with
• It has its own statement: the cash flow statement

Accrual accounting the economic view

• The income statement is built on this idea
• Revenues are not the same as cash inflows; expenses are not the same as cash outflows
• When cash moves is not the point. The time-based delimitation dominates: what is the real economic increase or decrease of resources in this period? (the matching principle)
• Only over all periods together does the sum of all net incomes equal the sum of all cash flows

Put bluntly: accounting uses accruals to transform cash flows into economically “correct” earnings, and that transformation is precisely what produces the gap between cash flow and earnings in any one year. The two accrual principles that do the transforming are next.

8 · The two accrual principles: revenue recognition and matching

Revenue recognition - when has income been earned?

The convention is called realisation, and everyone agrees on one thing first: realisation does not mean receiving the cash. Revenue is recognised earlier - when the earnings process is substantially complete, which in practice means the moment a legal claim (a receivable) can be booked. Under IFRS 15 “Revenue” (which replaced IAS 18) the wording is: recognise revenue when, or as, the entity satisfies a performance obligation - when control of the goods or service has passed to the customer.

The slides make this concrete with a manufacturing batch:

12 Jan · buy raw materials and store theman asset (inventory), not revenue

↓

19 Feb · start processing the materialscosts build up in work in progress

↓

3 Apr · finished goods produced and storedstill inventory, nobody has bought anything

↓

10 May · order received and accepteda promise only, nothing delivered yet

↓obligation satisfied, control passes

17 May · goods delivered, customer invoicedREVENUE recognised, receivable booked

↓

5 Jun · invoice paidreceivable becomes cash, no new income

The manufacturing timeline. Revenue belongs on 17 May: the goods have been handed over and the customer legally owes the money. Everything before is cost accumulation; the June cash receipt just swaps one asset (a receivable) for another (cash).

Matching - which efforts belong to which benefits?

Match efforts to the benefits they generate. Two working rules follow:

1. Capitalise expenditure that benefits future periods, and expense it as the benefits are realised. Materials bought today sit in inventory until they are used; a machine sits in fixed assets and is depreciated over its useful life.
2. Recognise liabilities when efforts that benefit the current period will only be paid in cash later - salaries earned but unpaid, interest owed but not yet transferred.

Both rules deliberately break the link between cash and expense, which is exactly why cash flow and earnings differ. The materials example in the worked example below shows it in numbers: over three years the firm pays out 55,000 for materials but expenses 50,000, with the other 5,000 waiting in inventory.

Caution

Two traps that cost marks. Expenditure is not expense: paying for something (cash out) and using it up (expense) are different events, often in different periods. And receipt is not revenue: cash arriving in June does not make June the month of the sale. Ask “when was the obligation satisfied?” and “when was the resource consumed?”, never “when did the money move?”.

Worked example

(a) Matching in numbers - the materials example

A producer buys materials for 40,000 in 2006 and for 15,000 in 2008, nothing in 2007. Material used up in production: 30,000 in 2006, 10,000 in 2007, 10,000 in 2008.

Statement	2006	2007	2008	Three-year total
Cash flow statement (operating cash out)	-40,000	0	-15,000	-55,000
Income statement (material expense)	-30,000	-10,000	-10,000	-50,000
Balance sheet (inventory at year end)	10,000 (Δ +10,000)	0 (Δ -10,000)	5,000 (Δ +5,000)	5,000 still on the shelf

Read it year by year. In 2006 cash out is 40,000 but only 30,000 was consumed, so the expense is 30,000 and 10,000 is capitalised as inventory. In 2007 no cash leaves at all, yet 10,000 of expense appears - it comes straight out of last year’s inventory. In 2008 15,000 is bought, 10,000 used, 5,000 remains. The totals reconcile: cash out 55,000 = expenses 50,000 + closing inventory 5,000. When that last 5,000 is used up in a later year, total expense will finally equal total cash - the “only over all periods” rule in action.

(b) The law-office transactions classified

#	Transaction (July)	Affects equity?	Which accounts move
1	Owner invests 10,000 cash	Yes, up 10,000 - capital contribution, not revenue	Cash +10,000; owner’s capital +10,000
2	Pays 800 cash for July rent	Yes, down 800 - expense	Cash -800; equity (rent expense) -800
3	Buys office equipment on account, 3,000	No	Equipment +3,000; accounts payable +3,000
4	Legal services for cash, 1,500	Yes, up 1,500 - revenue	Cash +1,500; equity (service revenue) +1,500
5	Borrows 700 from the bank on a note	No	Cash +700; notes payable +700
6	Legal services on account, 2,000	Yes, up 2,000 - revenue, although no cash yet	Accounts receivable +2,000; equity (service revenue) +2,000
7	Pays salaries 500, utilities 300, telephone 100	Yes, down 900 - expenses	Cash -900; equity (expenses) -900

Adding it up: revenues 1,500 + 2,000 = 3,500; expenses 800 + 500 + 300 + 100 = 1,700; net income for July = 1,800. Equity ends at 10,000 + 1,800 = 11,800. The closing balance sheet checks: cash 10,500 + receivables 2,000 + equipment 3,000 = 15,500 = payables 3,000 + note 700 + equity 11,800. And notice the accrual gap already: operating cash was 1,500 - 800 - 900 = minus 200, while profit was plus 1,800 - the whole difference is the 2,000 receivable.

Case corner

The Accounting Monopoly team - profitable, and nearly out of cash. The course’s Monopoly spreadsheet gives one team’s statements after a round of play:

Income statement		Cash flow statement
Rental revenue - land (Oxford Street 52, Bond Street 28)	80	Cash flow from operating activities	+865
Rental revenue - houses and hotels (Park Lane)	350	Cash flow from investing activities	-2,120
Salary revenue	800	Cash flow from financing activities	+100
Investment revenue - utilities / railroads	40 / 50	Net change in cash	-1,155
Total revenues	1,320
Rent 125, tax 200, repairs 80, interest 0, depreciation 40, misc 60
Total expenses	505
Gains and losses	0
Earnings	815

The team made 815 of profit - and its cash fell by 1,155, from the opening 1,500 to just 345. Both numbers are correct; they answer different questions.

• The investing outflow of 2,120 (land 1,370, a railroad 200, a utility 150, two houses 400) is not an expense. Under the matching principle these are capitalised assets that will earn rent in future rounds. Only the houses lose value now, as depreciation of 40; land is never depreciated.
• Operating cash (865) is actually higher than earnings (815): depreciation of 40 is an expense that never leaves the wallet, and a further 10 sits in interest payable - owed but not yet paid out.
• Financing added just 100, a mortgage on Kings Cross Station.
• On the balance sheet the profit is all still there: retained earnings 815 (no dividends), equity 1,500 + 815 = 2,315, total assets 2,425. The wealth has simply changed shape - from cash into streets and houses.

That is the chapter in one board game: income measures the growth in wealth; cash flow measures the movement of money. A team can be richer and poorer at the same time, depending on which statement you read.

Key terms

Term	What it means in plain words
Income (profit, earnings)	The increase in wealth over a period; revenues minus expenses
Fiscal year	Any twelve-month reporting year, starting on the date the company chooses
Interim period	A slice inside the year - week, month or quarter - with its own statements
Revenue	Increase in owner’s equity from operations, usually net assets received from customers
Expense	Decrease in owner’s equity from operations, net assets used up to serve customers
Gains and losses	Equity changes from unusual or infrequent events, shown apart from routine revenue and expense
Retained earnings	All income since the business started minus all dividends paid; the self-built part of equity
Functional P&L	Income statement layout grouped by function: cost of sales, selling, admin, R&D, then EBIT, financial result, tax
EBIT	Earnings before interest and taxes; the end of the operating section
Going concern	The assumption that the firm has no pre-determined end, which forces artificial reporting periods
Cash accounting	Recording cash in and cash out when they happen; the wallet view, home of the cash flow statement
Accrual accounting	Assigning revenues and expenses to the period of the real economic change, regardless of cash timing
Revenue recognition (realisation)	Book revenue when the performance obligation is satisfied and control passes, i.e. when a receivable exists - not when cash arrives (IFRS 15)
Matching principle	Put efforts in the same period as the benefits they create: capitalise future-benefit spending, expense it as used, accrue liabilities for unpaid current-period efforts

Test yourself

1. Define revenues and expenses in one sentence each, and explain why a gain on selling a building is reported separately from revenue.
2. In the law-office example, which of the seven July transactions change owner’s equity? Compute July net income and closing equity, and explain why the owner’s 10,000 investment is not part of net income.
3. A firm buys materials for 40,000 in year 1 and uses 30,000 of them; in year 2 it buys nothing and uses 10,000. State what the cash flow statement, the income statement and the balance sheet show in each year.
4. In the manufacturing timeline (12 Jan materials, 19 Feb processing, 3 Apr finished goods, 10 May order accepted, 17 May delivery and invoice, 5 Jun payment), on which date is revenue recognised, on what principle, and why not on 10 May or 5 Jun?
5. “Only over the whole life of the firm do total income and total cash flow coincide.” Explain this using the three-year materials example (cash out 55,000, expenses 50,000).
6. The Monopoly team reports earnings of 815 but a net cash change of minus 1,155. Reconcile the two in words using the three cash flow sections.

Answers

1. Revenue is an increase in owner’s equity arising from operations, typically net assets received from customers for goods or services delivered; an expense is a decrease in equity from operations, the net assets used up to deliver them. A gain on selling a building is unusual or infrequent, so it is shown apart from routine revenue to let readers see what is repeatable.
2. Equity changes: 1 (up, capital), 2 (down, rent expense), 4 (up, revenue), 6 (up, revenue on account), 7 (down, expenses). Not 3 (equipment vs payable) or 5 (cash vs note payable). Net income = 3,500 - 1,700 = 1,800; closing equity = 10,000 + 1,800 = 11,800. The 10,000 raises equity but is an owner contribution, not an increase from operations, so it is capital rather than income.
3. Year 1: cash flow statement -40,000; income statement expense -30,000; balance sheet inventory 10,000. Year 2: cash flow 0; expense -10,000; inventory falls to 0. Cash and expense differ each year but the inventory line carries the difference between them.
4. 17 May. Revenue recognition (realisation) under IFRS 15: revenue is recognised when the performance obligation is satisfied and control passes, which is when the goods are delivered and a receivable can be booked. 10 May is only an accepted order, nothing has been delivered; 5 Jun is merely the receivable turning into cash, and realisation does not mean receipt of cash.
5. Each year cash and expense differ because matching parks unused materials in inventory (10,000 after 2006, 0 after 2007, 5,000 after 2008). Over the three years cash out is 55,000 and expense 50,000, the gap being exactly the closing inventory of 5,000. Once that 5,000 is consumed in a later year, cumulative expense reaches 55,000 and equals cumulative cash out - the timing differences net to zero over the whole life.
6. Operating cash was +865, even above earnings of 815, because depreciation (40) is a non-cash expense and 10 of interest is owed but unpaid. Investing consumed 2,120 on land, a railroad, a utility and houses - capitalised assets under matching, not expenses. Financing added 100 from a mortgage. 865 - 2,120 + 100 = -1,155. The team is richer (retained earnings 815) but its wealth is now in property, not cash.

Revision summary

Tip

The one-minute recap

• Income = the increase in wealth over a period; periods are the calendar year, a fiscal year (any 365 days) or interim weeks, months and quarters.
• Revenues raise equity from operations, expenses lower it; both are usual and frequent. Gains and losses are the unusual or infrequent ones. Income = revenues - expenses; retained earnings = all income since inception minus dividends.
• Classify a transaction by asking: which assets or liabilities move, does equity move, and did the change come from operations? Owner investments and loans are not income; services on account are revenue; equipment is an asset, not an expense.
• The income statement is the sub-ledger of owner’s equity: it explains why equity changed and measures the change in wealth between two points in time. Net income sits inside equity on the balance sheet.
• Functional P&L: revenues, minus cost of sales = gross margin, minus selling, admin, R&D and other = EBIT, plus or minus the financial result = profit before tax, minus taxes = profit after tax - operating, finance and tax sections.
• Balance sheet = stock at a point; income statement = flow over a period. Equity at start + increases - decreases = equity at end; monthly statements chain into the quarter.
• The firm is a going concern with no natural end, so periods are artificial and the crucial question is what belongs to which period. Cash accounting (the wallet, the cash flow statement) records money when it moves; accrual accounting (the income statement) records the real economic change - only over all periods do the totals coincide.
• Revenue recognition: not at cash collection but when the performance obligation is satisfied and control passes (IFRS 15) - 17 May in the timeline, delivery and invoice. Matching: capitalise what benefits the future and expense it as used; accrue liabilities for current efforts paid later. Materials: cash 55,000 vs expense 50,000 vs inventory 5,000.
• Monopoly: earnings 815, cash -1,155 - profitable and cash-poor at once, because the investing cash went into assets.

Next: IFRS: Who Sets the Rules, and How Items Get In → - the rulebook behind recognition and measurement.