Basic Accounting Concepts: The Income statement

• The Income Statement: A "flow" report, and Balance Sheet: A "status" report.

Income Statement or Income and Expenditure Statement?

In accounting, the Income Statement includes revenues (in-flow) and expenses (out-flow). The term "income" is the excess of revenues over expenses. Sometimes, it is also known as the "net income".

However, in social welfare agency reports, we can frequently find "income and expenditure statement" or "income and expenditure account". They use the term "income" instead of "revenue". This is basically improper. However, this practice in social welfare agencies is usually tolerated. For a for-profit organization, "income" is the net increase in the owner's equity.

Income - revenue - cash

Income = Revenues - Expenses

Increase in cash has nothing to do with revenue or income. One borrows $10,000 from the bank. Then, the person has an increase of $10,000 cash (i.e. of asset), and liability of $10,000 to the Bank. He then uses the $10,000 to buy a piece of equipment, i.e. a reduction of $10,000 in cash, and an increase in fixed asset of $10,000.

Expense or Expenditure

Strictly speaking, an "expenditure" is not necessarily an "expense". For example, we buy $400 fuel for our car. It is an expenditure. If we do not use the fuel, it remains to be our asset, and we have not incurred an expense. If we use 3/4 of the fuel, the expense will then be $300 and we still have an asset of fuel which is valued at $100.

Similarly for equipment items, at the time of acquisition we have an "expenditure" item and no "expense". When we depreciate the equipment item, we then have an "expense" equal to the amount of depreciation.

The above distinction between expense and expenditure is frequently ignored in social welfare agencies. For example, when a centre buys a piece of Hi-Fi for $4,000. It is an expenditure. The centre has an expenditure of $4,000 cash and yet has an increase of asset value equivalent to $4,000. There is not expense yet. When the centre "depreciates" the Hi-Fi, say by $1,000, the centre has an expense of $1,000 and with $3,000 asset. However, since many social welfare agencies depreciate the equipment totally during the year of acquisition, expenditure becomes expense at the same time. The distinction between expense and expenditure becomes unimportant.

• The Income Statement is prepared periodically, such as monthly, quarterly, half-yearly or annually.
• Most social welfare agencies choose the annual accounting period between April 1 to March 31 of the following year to coincide with the government financial year. For for-profit organizations in HK, many choose the same period to coincide with the government financial year for tax-reporting reason.
• Financial activities are continuous. The act of chopping the stream of activities into time periods is basically arbitrary.
• Some organizations manipulate the timing of events in order to fit into different accounting periods. The reasons for doing this may be for taxation (e.g. to reduce tax burden of a particular year, the organization may "incur" some expenses before the actual date) or cosmetic (i.e. making the net position of the organization in a particular financial year looks better or worse).

The Realization Concept

Revenues result from providing goods and services to customers. The agency may not actually receive the cash payment. However, revenue is "realized" at the time of providing such service or goods. In many occasions, the revenue is "realized" in a period different from when the actual "dollars" are received. If we sell a product by credit, revenue is "realized" at the time of sale though we may receive the actual payment in a much later date. In the balance sheet, the item "accounts receivable" reflects this situation, i.e. revenue realized in the current or previous period and the actual payment expected in the subsequent or later period. The item "pre-bcollected revenue" or "deferred income" refers to the payment received in advance of the actual rendering of service or delivery of goods, e.g. rent collected for the next month is in fact a liability. The "rent revenue" is only realized after the service (of use of premises) is actually rendered.

The Matching Concept

The matching concept provides guidelines for deciding which items of cost are expenses in a given accounting period.

Relation of Cost and Expense

The amount of resources used for any purpose is a cost. "Cost of goods sold" is the amount we spent to acquire the goods, we buy in $10,000 value of goods and sell it at $15,000. The revenue is $15,000. The "cost" of the goods sold is $10,000 which is then an "expense" item. However, "cost" is not necessary an "expense" in the same accounting period. Acquisition of a piece of equipment is an expenditure. The value of the equipment is its cost. Depreciation of the equipment is an expense.

In the case of cost of goods sold, if we purchase the goods in one accounting period and sell the goods in another accounting period, we would have the following situation:

In the period of purchase, assuming we purchase the goods of $10,000 in cash, we have a reduction in cash and an increase in inventory of goods, i.e. no change in total asset. This activity brings no revenue or expense in this period. In the subsequent period, we sell the goods for $15,000 in cash. Then, we have $15,000 of revenue and an expense of $10,000 (cost of goods sold). At the same time, there is a net increase of asset, i.e. increase in $15,000 value of cash, reduction of $10,000 in inventory, matched with an increase of owner's equity of $5,000, which is the "income" in that accounting period.

The Consistency Concept

The consistency concept requires that once an organization has decided on one accounting method, it will treat all subsequent events of the same character in the same fashion unless it has a sound reason for doing otherwise. The application of this concept makes comparison of an organization's accounting figures in different accounting periods meaningful. Conversely, if an organization changes its accounting method in a particular period, then comparing the accounting figures of that period with those of the previous periods can be misleading. Frequently, we find in auditor's report a comment like this: "in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year". For example, if a social welfare agency begins by depreciating the total value of equipment in the same accounting period of acquisition, then in subsequent periods it should use the same method to deal with acquisition of equipment.

However, this Consistency Concept has a "narrow meaning", i.e. it requires consistent application of accounting method to the same class of events but not across different class of events. For example, the Senior Citizens Home Safety Association may depreciate the total value of computer equipment in the year of acquisition, but only depreciates only 20% of the emergency control units rented and placed in the homes of the elderly.

The Materiality Concept

We do not record events so insignificant that work of recording them is not justified by the usefulness of the results. There is no hard and fast rule for this principle. It is a matter of judgement.

One obvious example is office stationery. We buy a dozen of pencils. Though we can treat the pencils as assets at the time of acquisition. Then at the end of the period we can estimate what portion of pencils has been used up. It is obviously that the value of information gained by doing this does not worth the efforts spent in recording the events and estimating the portion of pencils used up. The purchase of stationery is usually treated as an expense in the same period of acquisition.

Questions for Discussion:

1. How should we treat a telephone bill particularly the international calls.
2. How should we treat the payment of a fire insurance policy at the middle of the financial year covering a one-year period starting from the date of payment.
3. How should we treat the purchase of a personal computer? Its consumables? Its peripherals such as modem?