ACT 202: Financial Accounting II

Study Session 4: Income and Expenditure Accounts

Introduction

Looking at the financial statements of a company, the massive amount of numbers in it can be
tiring. However, if you can interpret the numbers, it gives first-hand information on how well the
company is performing.

For a functioning company, income and expenditure account is necessary in order to know the
company's sales and expenses; this account indicates how the revenues (money received from the
sale of products and services before expenses are taken out) are transformed into the net income.

In this study session, you will learn what income and expenditure account is; the element of
income statement and methods of preparing income statement.

Learning Outcome

On the completion of this study session, you should be able to;

4.1 Define income and expenditure account and its major importance in an organization.
4.2 List the basic element of income and expenditure account.
4.3 Explain methods of preparing income and expenditure statement.

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4.1 What is an Income and Expenditure Account?

An income and expenditure account is a record showing the amounts of money coming in and
going out of an organization during a particular period of time. It is usually called the profit and
loss account or the income statement. However, income statement or profit and loss account will
be used interchangeably throughout this explanation.

The important thing to remember about an income statement is that it represents a single moment
in time. This contrasts with the balance sheet, which represents a particular point in time. The
purpose of the income statement is to show managers and investors whether the company made
lots money during the period being reported.

A typical example of the heading of an income statement may state as follow:

"For the Two Months Ended December 31, 2013" (The period of November 1 through
December 31, 2013).

"The Fiscal Year Ended June 30, 2013" (The period of July 1, 2012 through June 30, 2013).

Box 4.1: Definition of an income and expenditure account

An income and expenditure account is a record showing the amounts of money coming in and
going out of an organization during a particular period of time. It is usually called the profit and
loss account or the income statement.

There is no particular format for preparing income statement; however a typical income
statement must have revenue, expenses, gains, losses as its major elements. The income
statement indicates how the revenues (money received from the sale of products and services
before expenses are taken out, also known as the “top line”) are transformed into the net income
(the result after all revenues and expenses have been accounted for, also known as bottom line).
It displays the revenues recognized for a specific period, and the cost and expenses charged
against these revenues, including write-offs (e.g., depreciation and amortization of various
assets) and taxes.
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If a company was not able to operate profitably, the bottom line of the income statement
indicates a net loss on the other hand a company that has operated profitably, the bottom line of
the income statement indicates a net income.

In-text Question (ITQ) 4.1

As you have learnt in this study session, why does an organization needs income statement?

In-text Answer (ITA) 4.1

It is a record showing the amounts of money coming in and going out of an organization during
a particular period of time. It shows managers and investors whether the company made or lost
money during the period being reported.

4.2 Elements of Income Statements

Figure 4.1: Major Elements in Income Statement

1. Revenues

Revenues are inflows of assets (or reductions in liabilities) that result from providing goods and
services to customers. Revenues are earned either from primary activities or secondary activities.

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Figure 4.2: Activities through which revenues are earned

i. Revenues from primary activities

Revenue from primary activities is also referred to as operational revenue. Considering a retailer,
its primary activities are to buy goods and sell it, likewise a manufacturer whose primary
activities are to manufacture goods and sell them. Revenues generated from the primary
activities performed by the retailer, manufacturer, wholesaler etc. is referred to as sales revenue
or sales.

For companies providing services, the revenues from their primary services are referred to as
service revenues or fees earned. It is very important at this point to understand that there is a
clear difference between receipt and revenue. Revenue occurs when money is earned while
receipt occurs when cash is received.

For example, if a service provider gives customer 60 days to pay for certain services, revenues
occur when the services is delivered, not when the cash is received 60days later. If the services
are delivered in February, it is reported in February income statement and when the money is
paid for the services in April for February services, the service provider has April receipt and not
January revenues. Likewise if a company provided a 𝑁60,000 service on June 30 and gave the
customer until Sept. 16 to pay for the service, the company's January income statement will show

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revenues of 𝑁60,000. When the money is actually received in Sept., the Sept. income statement
will not show revenues for this transaction. (In Sept. the company will report a receipt of cash
and a reduction/collection of an accounts receivable.)

ii. Revenues from secondary activities

Revenues from secondary activities are often referred to as non-operating revenues. These are
the amounts a business earns outside of purchasing and selling goods and services. This can be
explained better when you consider a retailer earning interest on some of its idle cash saved in
bank, or receiving rent from some vacant space, these revenues result from an activity outside of
buying and selling.

As a result the revenues are reported on the income statement separate from its primary activity
of sales or service revenues. As is true with operating revenues, non-operating revenues are
reported on the profit and loss statement during the period when they are earned, not when the
cash is collected.

Box 4.2: Revenue

Revenues are inflows of assets (or reductions in liabilities) that result from providing goods and
services to customers.

2. Gains

A gain is reported on the income statement as the net of the proceeds received from the sale of a
long-term asset minus the amount listed for that item on the company's books (book value).A
gain occurs when the proceeds are more than the book value.

To understand the concept of gain better, let’s consider this example;

Assume that a clothing retailer decides to dispose of the company's car and sells it for N60,000.
The N60,000 received for the car (the proceeds from the disposal of the car) will not be included
with sales revenues since the account Sales is used only for the sale of merchandise. Since this

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retailer is not in the business of buying and selling cars, the sale of the car is outside of the
retailer's primary activities. Over the years, the cost of the car was being depreciated on the
company's accounting records and as a result, the money received for the car (N60,000) was
greater than the net amount shown for the car on the accounting records (N35,000).

Box 4.3: Gain

A gain is reported on the income statement as the net of the proceeds received from the sale of a
long-term asset minus the amount listed for that item on the company's books

This means that the company must report a gain equal to the amount of the difference, in this
case, the gain is reported as N25,000. This gain should not be reported as sales revenues, nor
should it be shown as part of the merchandiser's primary activities. Instead, the gain will appear
in a section on the income statement labelled as "non-operating gains" or "other income". The
gain is reported in the period when the disposal occurred.

3. Expenses

Expenses arise from consuming resources in order to generate revenues. Just like revenue,
expenses are incurred from primary activities or secondary activities.

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Figure 4.3: Activities through which expenses are earned

i. Expenses from primary activities

Expenses that are incurred in order to earn normal operating revenues are expenses from primary
activity. Under the accrual basis of accounting sales commission’s expense should appear on the
income statement in the same period that the related sales are reported, regardless of when the
commission is actually paid. In the same way, the cost of goods sold is matched with the related
sales on the income statement, regardless of when the supplier of the merchandise is paid.

It is common for expenses to occur before the company pays for them (e.g., wages earned by
employees, employee bonuses and vacations, utilities, and sales commissions). However, some
expenses occur after the company has paid for them. The matching principle governs the
recognition of expense. It states that all costs that were incurred to generate the revenue
appearing on a given period’s income statement should appear as an expense on the same income
statement.

In other words, we should match expenses against revenues. Revenues are first recognized and
expenses are then matched with those revenues.

For example, let’s say a company buys a building on December 31, 2013 for N300,000,000
(excluding the cost of land). The building is assumed to have a useful life of 30 years. The

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company paid cash for the building on December 31, 2013 but it will record depreciation
expense of N10,000,000 in each of the years 2013 through 2043.

It is also important to note that it is not every cash payment that mean expenses, for example a
company might pay N20,000 to the bank to reduce its bank loan. This payment will reduce the
company's cash and its liability to the bank, but it is not an expense.

Some expenses are matched against sales on the income statement because there is a cause and
effect linkage i.e. the sale of the merchandise caused the cost of goods sold and the sales
commission expense. Other expenses are not directly linked to sales and as a result they are
matched to the accounting period when they are consumed or used, examples include utilities
expense, office salaries expense, and depreciation expense. Some expenses such as advertising
expense and research and development expense can neither be linked with sales nor a specific
accounting period and as a result, they are reported as expenses as soon as they occur.

ii. Expenses from secondary activities

Expenses from secondary activities are referred to as non-operating expenses. For example,
interest expense is a non-operating expense because it involves the finance function of the
business, rather than the primary activities of buying/producing and selling.

Box 4.4: Expenses

Expenses arise from consuming resources in order to generate revenues.

4. Loses

Losses are similar to expenses in that they decrease assets or increase liabilities, but they are not
central to a firm’s major activities. Loses result from a transaction that is outside of a business'
primary activities. A loss is reported when difference between the amount listed for an item on
the company's books (book value) and the proceeds received from the sale of the item is less than
the book value of the item.

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Let's assume that a clothing retailer decides to dispose of the company's car. The proceeds from
the disposal are N20,800. This is less than the N30,500 amount shown in the company's
accounting records. Since this retailer is not in the business of buying and selling cars (the sale of
the car is outside of the operating activities of buying and selling clothing), the money received
for the car will not be included in sales revenues, and the loss experienced on the sale of the car
(N7000) will not be included in operating expenses. Instead, the N7000 loss will appear in a
section on the income statement labeled "non-operating gains or losses" or "other income or
losses". The loss is reported in the time period when the disposal occurs.

Box 4.5: losses

A loss is reported when difference between the amount listed for an item on the company's books
and the proceeds received from the sale of the item is less than the book value of the item.

In-text Question (ITQ)

List the major elements of income statement

In-text Answer (ITA)

The major elements of income statements are revenue, gain expenses and losses

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4.3 Methods of Preparing Income Statement

Methods of preparing income

The Single step income
statement

statement

Multi-step income
statement

Figure 4.4: Major methods for preparing income statements

The income statement can be prepared in one of two major methods:

1. The Single Step income statement and

2. Multi-Step income statement.

4.3.1 The Single Step Income Statement

The Single Step income statement takes a simpler approach, totalling revenues and subtracting
expenses to find the bottom line (The bottom line of the income statement is called net income,
earnings, or profit). It can be expressed as;

Bottom line = (Revenue + Gain) – ( Expenses + Loses)

An extremely condensed income statement in the single-step format would look like Table 4.1.

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The heading of the income statement conveys critical information. The name of the company
appears first, followed by the title "Income Statement." The third line tells the reader the time
interval reported on the profit and loss statement.
Table 4.1
LAUTECH Bakery Ltd.
Income Statement
For the Five Month Ended May 31, 2014

Naira
Revenues and Gain 1,000,000

Expenses and Loses 800,000

Net Income 200,000

Since income statements can be prepared for any period of time, you must inform the reader of
the precise period of time being covered. (For example, an income statement may cover any one
of the following time periods: Year Ended May 31, Five Months Ended May 31, Quarter Ended
May 31, Month Ended May 31, or Five Weeks Ended May 31.)

If a single step income statement is to be expressed in detail, you will have it as in Table 4.2.

Table 4.2
LAUTECH Bakery Ltd.
Income Statement
For the Five Month Ended April 30, 2014

Naira
Revenues and Gain
Sales Revenues 600,000
Interest revenues 100,000
Gain on sales of assets 300,000

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Total Revenues and Gains 1,000,000

Expenses and Loses

Cost of goods sold 680,000
Commission’s Expense 50,000
office supplies expense 35,000
office equipment expense 20,000
Advertising expense 5,000
loss from lawsuit 10,000
Total expenses and losses 800,000

200,000
Net Income

4.3.2 Multiple Step Income Statement

Multi-Step income statement (as the name implies) takes several steps to find the bottom line.
The multiple-step profit and loss statement segregates the operating revenues and operating
expenses from the non-operating revenues, non-operating expenses, gains, and losses. The
multiple-step income statement also shows the gross profit (net sales minus the cost of goods
sold). Example of a multiple step income statement is shown in Table 4.3;

Table 4.3
LAUTECH Bakery Ltd
Income Statement
For the Five Month Ended April 30, 2014
Naira
Sales 1,000,000
Cost of goods sold 680,000
Gross profit 320,000

Operating expenses

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Selling Expenses
Advertising expenses 20,000
Commissions expenses 50,000 70,000
Administrative expenses
office supplies expenses 35,000
Office equipment expenses 20,000 55,000

Total operating expenses 125,000

Operating income 195,000

Non-Operating or others
Interest revenues 100,000
Gain on sale of investments 300,000
Interest expenses -385,000
Loss from lawsuit -10,000
Total non - operating 5,000

Net Income 200,000

Using the above multiple-step income statement as an example, you will see that there are three
steps needed to arrive at the bottom line Net (Net Income);

Step 1 Cost of goods sold is subtracted from net sales to arrive at gross profit.

Gross Profit = Sales – Cost of Goods Sold

Gross Profit = 1,000,000 – 680,000

Gross Profit = 320,000

Step 2 Operating expenses are subtracted from gross profit to arrive at operating income.

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Operating income = Gross Profit – Operating Expenses

Operating Income = 320,000 – 125,000

Operating Income = 195,000

Step 3 The net amount of non-operating revenues, gains, non-operating expenses and losses is
combined with the operating income to arrive at the net income or net loss.

Net income = Operating income + Non − Operating income

Net income = 195,000 + 5,000

Net income = 200,000

Benefit of Using Multiple Step Income Statement

1. The multiple-step income statement clearly states the gross profit amount. Many readers
of financial statements monitor a company's gross margin (gross profit as a percentage of
net sales). Readers may compare a company's gross margin to its past gross margins and
to the gross margins of the industry.
2. The multiple-step income statement presents the subtotal operating income, which
indicates the profit earned from the company's primary activities of buying and selling
merchandise.
3. The bottom line of a multiple-step income statement reports the net amount for all the
items on the income statement. If the net amount is positive, it is labeled as net income. If
the net amount is negative, it is labeled as net loss.

Notes to Financial Statement

The notes (or footnotes) to the income statement and to the other financial statements are
considered to be part of the financial statements. The notes inform the readers about such things
as significant accounting policies, commitments made by the company, and potential liabilities

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and potential losses. The notes contain information that is critical to properly understanding and
analyzing a company's financial statements. It is common for the notes to the financial
statements of large companies to be 10-20 pages in length.

4.3.3 Other Income Statement Formats

The single-step and multiple-step income statement formats are the required formats when the
statement is distributed to people and places outside of the company. The company's
management, however, might prefer other formats when the profit and loss statement remains
inside the company.

For example, a company might want to prepare an income statement (for inside the company
only) that focuses on the contribution margin instead of the gross profit or gross margin. Such a
format may provide insight on how the company's profits change as sales change. This format
also shows the total amount of fixed expenses (those expenses that will not change as sales
change). This type of internal income statement is shown below (and columns have been added
to show the amounts by product line).

Table 4.4
LAUTECH Bakery Ltd
Income Statement
For the Five Month Ended April 30, 2014

Total Product line Product line

1 2
Naira Naira Naira
Sales 100,000 70,000 30,000

Variable Expenses
Cost of goods sold 75,000 50,000 25,000
Commissions expense 5,000 5,000
Total variable expenses 80,000 55,000 25,000

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Contribution margin 20,000 15,000 5,000

Fixed Expenses-Prod. Line 6,000 4,000 2,000

Subtotal 14,000 11,000 3,000

Fixed Expenses - common 2,000

Operating income 16,000

As you can see above, N2,000 of fixed expenses are common to both product lines. In other
words they cannot be traced directly to Product Line 1 or Product Line 2. Rather than mislead
someone, the expenses are not arbitrarily divided up between the product lines. Remember that
this format is not acceptable for distribution outside of the company. Its accessibility should be
limited to the members of the company's management.

In fact, this type of income statement is usually covered as part of managerial accounting, not
financial accounting. It is shown here to let you know that income statement formats other than
the single-step and multiple-step are permissible when they stay within a company, and may
prove very useful to a company's managers.

In-text Question (ITQ) 4.3

Income statement are prepared in two major ways namely ………………. And ……………….

In-text Answer (ITA) 4.3

The two major ways are; single step income statement and multiple step income statement.

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Summary of Study Session 4

In this study session, you have learnt that:

1. An income and expenditure account (income statement) is a record showing the amounts
of money coming in and going out of an organization during a particular period of time.
The purpose of the income statement is to show managers and investors whether the
company made or lost money during the period being reported.
2. A typical income statement must have revenue, expenses, gains, losses has its major
elements.
3. The income statement can be prepared in one of two methods: The Single Step income
statement and Multi-Step income statement.
4. The Single Step income statement takes a simpler approach, totaling revenues and
subtracting expenses to find the bottom line (The bottom line of the income statement is
called net income, earnings, or profit). It can be expressed as;

Bottom line = (Revenue + Gain) – ( Expenses + Loses)

5. Multi-Step income statement (as the name implies) takes several steps to find the bottom
line. The multiple-step profit and loss statement segregates the operating revenues and
operating expenses from the non-operating revenues, non-operating expenses, gains, and
losses.
6. Some of the benefit of multiple income statement is that the multiple-step income
statement presents the subtotal operating income, which indicates the profit earned from
the company's primary activities of buying and selling merchandise.

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Self-Assessment Questions (SAQs) for Study Session 4

Now that you have completed this study session, you can assess how well you have achieved its
Learning Outcomes by answering these questions. Write your answers in your Study Diary and
discuss them with your Tutor at the next Study Support Meeting. You can check your answers
with the Notes on the Self-Assessment Questions at the end of this Module.

SAQ 4.1 (Test Learning Outcome 4.1)

1. As you have studied in this study session, explain income statement and its importance to
an organization.
2. If income statement and Balance sheet report financial status of an organization, what is
the difference between them?

SAQ 4.2 (Test Learning Outcome 4.2)

1. What are the basic composition/elements of income statement?

2. Define the following terms
i. Revenue
ii. Gain
iii. Losses
iv. Expenses
3. Differentiate between revenue and receipt

SAQ 4.3 (Test Learning Outcome 4.3)

1. Explain the methods of preparing income statement.

2. From what you have studied in this study session, calculate the gross profit, total
operating expenses, operating income and net income in the following table.

LAUTECH Bakery Ltd

Income Statement
For the Five Month Ended April 30, 2014

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Naira
Sales 1,000,000
Cost of goods sold 680,000
Gross profit

Operating expenses
Selling Expenses
Advertising expenses 20,000
Commissions expenses 50,000 70,000
Administrative expenses
office supplies expenses 35,000
Office equipment expenses 20,000 55,000

Total operating expenses 125,000

Operating income

Non-Operating or others
Interest revenues 100,000
Gain on sale of investments 300,000
Interest expenses -385,000
Loss from lawsuit -10,000
Total non - operating 5,000

Net Income

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Glossary of Terms

Expenses: the cost incurred in or required for something

Losses: is reported when difference between the amount listed for an item on the company's
books and the proceeds received from the sale of the item is less than the book value of the item

Net income: if a company has operated profitably, the bottom line of the income statement
indicates a net income

Net income: the result after all revenues and expenses have been accounted for, also known as
bottom line

Net loss: if a company was not able to operate profitably, the bottom line of the income
statement indicates a net loss

Non-operating gain: Profit realized from the activities that are not directly related to the main
business of a firm

Revenues: money received from the sale of products and services before expenses are taken out
also known top line

Single-step income statement: A single-step income statement is one of two commonly used
formats for the income statement or profit and loss statement. The single-step format uses only
one subtraction to arrive at net income

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