Paul Newton

Understanding Accounting Principles

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Understanding Accounting Principles

1st edition
2014 Paul Newton & bookboon.com
ISBN 978-87-403-0784-9

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Understanding Accounting Principles

Contents

Contents
Preface

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Introduction

Basic Accounting Concepts

10

1.1

An Income Statement

10

1.2

Cash Accounting

14

1.3

Accrual Accounting

20

Basic Financial Terms

22

2.1

The Revenue Recognition Principle

25

2.2

The Matching Principle

28

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Understanding Accounting Principles

Contents

3 A Sample Income Statement Using the Accrual Method

29

4 Summary

34

5 References

35

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Understanding Accounting Principles

Preface

Preface
This eBook explains all of the basic accounting concepts and terminology you will need to understand
the three primary financial statements that appear in every organizations annual report and most internal
monthly reports.
You will learn:
The precise definition of essential accounting terms
The purpose of the income statement, balance sheet, and cash flow statement
The differences between cash-based and accrual-based accounting
The revenue recognition principle and the matching principle
How depreciation, prepayments, and bad debt are allowed for

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Understanding Accounting Principles

Visit Our Website

Visit Our Website

Essential templates and checklists for managers are available to download free of charge to your computer,
iPad, or Amazon Kindle.
We are adding new templates and checklists every month, so dont forget to check our website regularly
for the latest releases.
Visit http://www.free-management-ebooks.com

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Understanding Accounting Principles

Introduction

Introduction
As a manager, you may be asked to produce or contribute towards an income statement for your
own business unit. This provides senior management with an indication of how your business unit is
performing against its targets over a specific period, for example quarterly. In addition, you will usually
be expected to understand simple financial reports and communicate effectively with financial people
in your own organization.
This eBook explains all of the basic accounting concepts and terminology you will need to understand
the three primary financial statements that appear in every organizations annual report and most internal
monthly reports as well.

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These are:
The Income Statement An accounting of revenue, expenses, and profit for a given
period. This can also be an internal document that can be used to make management
decisions about almost any activity where you have a record of the money spent and
the associated return.
The Balance Sheet An itemized statement that summarizes the assets and liabilities
of the business at a given date.
The Statement of Cash Flow A report that shows the effect of all transactions that
involved or influenced cash but did not appear on the income statement.

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Understanding Accounting Principles

Introduction

If you work in a nonprofit sector then do not be put off by words like business and profit. Even if your
organization is not a business that exists to make a profit, it is still important to understand the basic
principles of finance and management reporting so that you can monitor efficiency and control your
budget effectively.

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Your organization may not be concerned with sales and profit as such, but there will be some metrics
for measuring the service delivered and the costs incurred in delivering it.
Financial reporting requires an understanding of: basic financial terms, the differences between cashbased and accrual accounting, and an appreciation of when revenue and costs are recognized. All of
these topics are dealt with in this eBook, which is an ideal introduction to basic accounting principles.
Key Point

You should make sure that you know the basic concepts and terminology needed to understand income
statements, balance sheets, and statements of cash flow as these are widely used, even by nonprofit organizations.

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Understanding Accounting Principles

Basic Accounting Concepts

1 Basic Accounting Concepts

The basic principles of accounting are best understood by considering some simple businesses and how
they might document their financial activities.

1.1

An Income Statement

This is a financial statement that measures an organizations financial performance over a specific
accounting period by giving a summary ofhow it incurs itsrevenues and expenses. It also shows the
net profit or loss incurred over that period and is often referred to as a Profit and Loss or Revenue
and Expenses statement.

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An income statement consists of two sections: operating and non-operating activities.

The operating section details the revenue and expenses directly associated with business
operations, for example the purchase of raw materials.
The non-operating section details revenue and expenses that result from activities outside of
normal business operations, for example the sale of an office or land.
This division of revenue and expenses into operating and non-operating is particular to each
organization and is dealt with in detail in the eBook What are Income Statements, which you can read
at bookboon.com Premium.

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Understanding Accounting Principles

Basic Accounting Concepts

For the moment we will use a simple income statement to illustrate the financial principles you need
to be familiar with, since this type of income statement does not distinguish between operating and
non-operating revenues and expenses.
1.1.1

A Sample Simple Income Statement

This sample simple income statement covers a twelve-month period for Suzys Signs, a one-person
business that designs signage. It details the amount of revenue and expense that comes in and goes out
of the organization without distinguishing between operating and non-operating items.

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Understanding Accounting Principles

Basic Accounting Concepts

The income statement uses three terms that can be defined as:
Revenue incoming assets in return for sold goods or services.
Expenses outgoing assets or liabilities incurred.
Net Income the difference between Revenue and Expenses. This shows whether you are
generating a profit or you are operating at a loss.
In our example, Suzy runs her own design agency called Suzys Signs. She works from her home office
and offers a design service for customers who need a sign for their business premises. The design is done
according to a brief supplied by the customer.
Once the design has been approved, Suzy obtains quotes for its manufacture from three suppliers. She
then sends the design and the quotes to the customer including her invoice for the total number of hours
spent on this design, based on an hourly rate of $45.
The following table gives you an example of what a simple income statement would look like for
Suzy Signs.
Suzys Signs Income Statement Jan 1Dec 31

$
8,000

Revenue (Design)

Less Expenses:

Travel

420

Stationery

140

Telephone

80

Broadband

120

Miscellaneous

25
785

Expenses Total

7,215

Net Profit Before Tax

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Understanding Accounting Principles

Basic Accounting Concepts

The net profit or loss is the difference between the income received and all of the costs paid out. In this
case Suzy has made a profit for the year of $7,215.

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She may need this information to give to the tax authorities or she could use it to compare this years
performance to last years, or even to her expectations at the beginning of the year.
As simple as this document is, there are some practical issues that it raises. For example:
Suzy sends out an invoice in December, but it has not been paid by 31 December.
What does she do?
Should the invoice amount appear on the statement or not, and does it matter?
The answer to this question depends on the type of accounting that Suzy is using. There are two types,
known as cash accounting and accrual accounting.

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The practical implications of each type for your organization are explained in the next sections using
our example of Suzys Signs.

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Understanding Accounting Principles

1.2

Basic Accounting Concepts

Cash Accounting

This is an accounting method where receipts are recorded on the date they are received, and the expenses
on the date that they are actually paid. As a small business, Suzy has the option of cash accounting,
which means that she only needs to record transactions at the point of payment. In other words when
the money leaves or is paid into her bank account.

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So referring back to Suzys query:

If her December invoice is not paid until the following January, then she does not
need to enter it on the income statement for this period.
Similarly, if she received a bill in December (for example a phone bill) but she does
not pay it until January, then that amount will not appear either.
Accounting rules stipulate that, with few exceptions, businesses should not use this method but should
prepare their accounts on the accrual basis. However, it is acceptable for very small companies to use
the cash accounting method. In Suzys case, cash accounting confers two advantages.
1. It reflects exactly what she has in her bank account.
2. It helps her cash flow.

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Understanding Accounting Principles

Basic Accounting Concepts

Whilst the first point is obvious, the second point needs some explanation.
In November and December Suzy raised invoices for $2,500 worth of work, which
she is awaiting payment for.
Under the cash accounting rules, she does not have to declare this income during
the period and she will not have to pay any tax due on it until the end of the next
accounting period (the period when the money will actually be paid into her account).
This is counterbalanced by the fact that she cannot include any expenses. For example,
her December telephone bill cannot be included until she has actually paid it,
irrespective of the date on the invoice.
Suzys business has relatively low expenses and because her clients can be slow to pay, cash accounting is
probably the best option for her to use. By using cash accounting, she will only be paying tax on money
she has actually received. It is also straightforward: if she uses a tax adviser, she could simply give him
her checkbook and bank statements and he could calculate her tax liability from those two things alone.

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Understanding Accounting Principles

Basic Accounting Concepts

Key Points

1.1.2

Under cash accounting rules, transactions are recorded at the point of payment.
Very small businesses and traders can use cash accounting.
It reflects exactly what the business has in its bank account and can help with cash flow.

The Limitations of Cash Accounting

In cash-based accounting, expenses are not recorded until they have been paid, which means that there
is nowhere on the books to show unpaid bills.

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These limitations can create serious problems if the business is much more complex than Suzys Signs.
In fact, cash-based accounting can create a situation that leads to insolvency while reporting that the
organization is making a profit.
When an organization is termed Insolvent it means:
The inability of a debtor to pay their debt and can result from either cash flow
insolvency or balance sheet insolvency.
The definitions of these two types of insolvency are:
Cash flow insolvency involves a lack of funds to pay debts as they fall due.
Balance sheet insolvency involves having negative net assets. In other words, the business
owes to others more than it has in assets including the money that it is owed.

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Understanding Accounting Principles

Basic Accounting Concepts

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Many people confuse bankruptcy with insolvency and it is important to understand the difference.
An organization may be cash flow insolvent but balance sheet solvent if it holds assets
that it cannot turn into cash if it needs to do so.
Conversely, an organization can have negative net assets showing on its balance sheet
but still be cash flow solvent if ongoing revenue is able to meet debt obligations, and
thus avoid default. (Many large corporations operate permanently in this state.)
Bankruptcy is not the same as insolvency. It is a determination of insolvency made
by a court of law with resulting legal orders intended to resolve the insolvency.
To illustrate why cash-based accounting can lead to insolvency, imagine an organization that receives
income prior to completion of the job, but where major costs are not paid out until after completion.
This could lead to a situation where the organization receives say $100,000 in sales for the period, but
most of the associated costs (say $60,000) do not appear on the income statement for that period.

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Understanding Accounting Principles

Basic Accounting Concepts

Consequently, the income statement shows a profit for the period, which is overstated by the $60,000
in as yet unpaid costs. The organization is then taxed on this notional profit. Several weeks later, the
$60,000 expenses need to be paid, but there is no cash available because it has already been paid out in
tax. The organization is now insolvent.

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Understanding Accounting Principles

Basic Accounting Concepts

This is a very simple example, but in many organizations there may be large amounts of money flowing
through the business and profits may appear to be high. As time goes by, cash deficits accumulate year
after year and with the unpaid expenses not recorded, the cash-based income statement will report that
the business is profitable even though it may be insolvent.
Another problem with cash-based accounting is that it does not create an accurate historical trend of
business operations. This is because transactions are recorded only when cash changes hands. It does
not (as a rule) represent the sale date of goods or services. Major purchases or other asset acquisitions
can also distort the picture.
This can be illustrated using the Suzys Signs example and looking at her first three years income statement
figures, shown in the table below. These cash-based net profit figures appear to show a steady growth
year on year. But to fully understand her growth you need to know more about her costs.
Cash Accounting
Net Profit Before Tax
Year 1

6,500

Year 2

7,000

Year 3

7,300

What these figures are unable to show are:

Her set-up costs including office furniture, computer, printer, and stationery. These were
allocated to her first year, even though she is still getting the benefit of these things in years
two and three.
Her outstanding invoices by the end of her third year this amounts to $4,000. This is a
substantial amount given the size of her business and yet it does not appear anywhere in
the accounts.
In order to overcome the problems associated with cash-based accounting, most organizations use an
alternative system called accrual accounting and this is dealt with next.
Key Points

The main limitations of cash accounting are that: there is nowhere to show unpaid bills; there is no way of
seeing any historical trend in the figures; and no allowance is made for major purchases or asset acquisition.
Cash-based accounting can create a situation that leads to insolvency while reporting that the organization is
making a profit.

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Understanding Accounting Principles

1.3

Basic Accounting Concepts

Accrual Accounting

Accrual accountingis considered to bethe standard accounting practice for most organizations, and is
mandated for organizations of any real size.
If Suzy were using this method then she would need to include all of her invoiced amounts for the
period as sales even if she had not actually received payment by the period end. Similarly, if she has a
bill with an invoice date within the period she must include it even though she knows that she wont be
paying it until after the period end.

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The accrual methodrecognizes a sale at the pointat which the customer takes ownership of the goods or
the point when the service is delivered, even though the cashisnt yet in the bank. Similarly, costs may
be recognized before an invoice is received if the organization accepts that the cost has been incurred
during the accounting period.
This method provides a more accurate picture of the organizations current condition, but it is more
complex to administer when payments received are less than the amount invoiced. This can happen
if the customer disputes the amount or simply refuses to pay. The need for the accrualmethodarose
out of the increasing complexity of an organizations transactions and a desire for more accurate
financial information.

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Understanding Accounting Principles

Basic Accounting Concepts

Selling on credit and projects that provide revenue streams over a long period of time affect the
organizations financial circumstancesat the point ofthe transaction. It makes sense thatthis is reflected
on the financial statements during the same reporting period that these transactions occurred.
Before looking at an example of an income statement using the accrual method, there are some financial
terms that you need to know. You will also need to appreciate some accounting principles like the revenue
recognition principle and the matching principle.
Key Points

Accrual accountingis considered to bethe standard accounting practice for most organizations, and is mandated
for organizations of any real size.
Revenue is recognized once the customer has ownership.
Costs are incurred in the period in which they arise.
It provides a more accurate financial picture, but is more difficult to administer.

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Understanding Accounting Principles

Basic Financial Terms

2 Basic Financial Terms

All of the following terms have precise definitions when used in business accounting:
Sales or revenue
Cost of goods sold
Expenses
Gross profit
Fixed assets
Current assets
Current liabilities
Working capital
Liquidity
Debtor
Creditor
Bad Debt
Depreciation
Accrual Accounting
Even though you may be familiar with some of them, it is important to know their exact meanings
otherwise you may find the rest of this eBook and the others in this series difficult to follow. For example,
you may hear the terms revenues and receipts used interchangeably in casual office conversation.
However, as far as business accounting is concerned they are different things and you will find yourself
becoming confused if you dont appreciate the difference.
Read the following definitions carefully and make sure that you understand exactly what is meant by
each of these accounting terms.
Sales or Revenue
Revenue is the income that flows into an organization, and it is often used almost synonymously with
sales. In government and nonprofit organizations it includes taxes and grants.
Dont confuse revenues with receipts. Under the accrual basis of accounting, revenues are shown in the
period they are earned, not in the period when the cash is collected. Revenues occur when money is
earned; receipts occur when cash is received.

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Understanding Accounting Principles

Basic Financial Terms

Cost of Goods Sold

This is the purchase cost of the merchandise that was subsequently sold to customers.
Expenses
Refers to the other costs that are not matched with sales as part of the cost of goods sold. They may
be matched with a specific time, usually monthly, quarterly, or annually or they may also be one-off
payments. Expenses include: staff wages, rent, utility bills, insurance, equipment, etc.
Gross Profit
Refers to what is left after you subtract the cost of goods sold from the sales. It is also called gross
margin. For example, if an organization buys in an item for $50 and sells it for $75 (plus sales tax), then
the gross profit will be $25.
Fixed Assets
This refers to all of those things that the business owns which will have a value to the business over a
long period. This is usually understood to be any time longer than one year. It includes freehold property,
plant, machinery, computers, motor vehicles, and so on.
Current Assets
This refers to assets with the value available entirely in the short term. This is usually understood to
be a period of less than a year. This is either because they are what the business sells or because they
are money or can quickly be turned into money. Examples include inventory/stock, money owing by
customers, money in the bank, or other short-term investments.
Current Liabilities
This refers to those things that the business could be called upon to pay in the short term within the
year. Examples include bank overdrafts and money owing to suppliers.
Working Capital
This is the difference between current assets and current liabilities. An organization without sufficient
working capital cannot pay its debts as they fall due. In this situation it may have to stop trading even
if it is profitable.

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Understanding Accounting Principles

Basic Financial Terms

Liquidity
This is the ability to meet current obligations with cash or other assets that can be quickly converted
into cash in order to pay bills as they become due. In other words the organization has enough cash or
assets that will become cash so that it is able to write checks without running out of money.
Debtor
A debtor is a person owing money to the business, for example a customer for goods delivered.
Creditor
A creditor is a person to whom the business owes money, for example a supplier, landlord, or utility
organization.
Bad Debt
All reasonable means to collect a debt have been tried and have failed so the amount owed is written
off as a loss and becomes categorized as an expense on an income statement. This results in net income
being reduced.

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Understanding Accounting Principles

Basic Financial Terms

Depreciation
Assets have a certain length of time in which they operate efficiently, referred to as an assets useful life.
During this period the value of that asset depreciates due to age, wear and tear, or obsolescence. The loss
in value is recorded in accounts as a non-cash expense, which reduces earnings whilst raising cash flow.
Accrual Accounting
Accrual accounting relies on two principles, which have already been alluded to:
The revenue recognition principle states that revenues are recognized when they are
realized or realizable, and are earned (usually when goods are transferred or services
rendered), no matter when the payment is received.
The matching principle states that expenses are recognized when goods are
transferred or services rendered, and offset against recognized revenues, which were
generated from those expenses, no matter when the cash is paid out.
These two principles are absolutely central to understanding how accrual accounting works and are
described in detail in the next sections.
Key Points

2.1

Terms like revenue, expenses, gross profit, depreciation, bad debt, and fixed assets have precise definitions
when used in business accounting.
You need to understand exactly what is meant by accounting terms like these.

The Revenue Recognition Principle

Organizations all have primary activities and it is the revenue or incomes generated by these activities
that are referred to as sales or sales revenue. For example, a retailer will buy goods, which they then
sell on. It is the sale of these products that creates their revenue.
For service organizations the primary activities are the acquisition of and selling of skills and expertise.
These revenues are often referred to as fees earned, income, or service revenues.

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Basic Financial Terms

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Under accrual accounting, revenues are reported as they occur that is when they are recognized
and not when the payment is received. For instance, your organization sells its service to a customer
for $5,000 in December, offering them 60 days to pay. Your accounts would show a revenue figure of
this amount in December.
When at the end of February the invoice is paid your accounts would show a receipt of cash for that
amount. It would also show a reduction in your accounts receivable (some organizations refer to this as
collection). It is important to appreciate the distinction between receipts and revenues so that the latter
are only recorded once when the primary activity has been performed.
You also need to appreciate how the following will be represented in your organizations accounts:
When a pre-payment or deposit is taken
When payment is made in cash
When funds are received in the form of a loan (e.g. from a bank)
Where your organization requests a payment (or deposit) for a service or product in advance of any work
being performed this is known as a receipt. Only once the customers work begins will it be shown in
your accounts as a revenue item. For example:
Your organization sells a product for $800 in May and requests a $200 partial payment
at the time of sale, prior to delivery in June. This $200 appears in your accounts as a
liability in May and only when the product has been delivered to the client will the
accounts show $800 revenue.

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Understanding Accounting Principles

Basic Financial Terms

In circumstances where organizations are concerned about a customers ability to pay or their
creditworthiness a deposit can be requested prior to the work starting. This deposit would be recorded
in the same way as a pre-payment in your accounts, i.e. as a receipt.
In the event that your organization receives cash in direct exchange for its product or service this will
be recorded in the accounts as both a receipt and revenue. This is because it has been given the cash
receipt on the same day the actual service or product (the revenue) occurred. For example:
A dealership sells a car on April 23 for $650 cash. This sale would be represented in
the dealers accounts as both a receipt of $650 and revenue of $650 on that date.
In a situation where your organization needs to extend its mortgage or seeks a short-term loan, such
funds are shown in your accounts as a receipt and referred to as a current liability. There would not be
revenue for this amount within your accounts because no goods or services have been exchanged or
performed. For example:
The $12,500 extension to your organizations overdraft would be shown in your
accounts only as a receipt of $12,500 on the date such funds became available. It
cannot be recorded as revenue because it was not earned as a result of delivering a
product a service.
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Understanding Accounting Principles

Basic Financial Terms

Key Points

2.2

Revenue is something that is generated by the business in exchange for goods or services.
It does not include things like bank loans or overdraft facilities.
Any payment for a service or product in advance of any work being performed is a receipt.
It only becomes a revenue item once work (on behalf of the customer) actually begins.

The Matching Principle

Your organization may prefer to use the matching principle when deciding how to record its financial
performance. This is because it enables your financial accounts to show a better evaluation of actual
profitability and performance.
This principle achieves this by minimizing, wherever possible, the mismatch in timing between when your
organization incurs costs and when it realizes its revenue. This still has to be attained whilst adhering to
the accounting standards of recording costs as they occur and revenue when it is earned.
The degree to which this can be achieved will be influenced by how complex your operations are. The
more complicated they are, the more difficulty your organization will have in matching the date costs
occur with the date revenue or income is received.
This is especially true in the case of provisions for bad debt and depreciation. It is difficult to be exact
in such cases because they are influenced by numerous factors, and many, such as changes within the
economic climate, are outside of an organizations control. The way in which an organization can interpret
an item of high-value capital equipment designed for longevity is open to interpretation, and a new
model or changes in technology can drastically alter its life span.
The accounting standards and regulations of your operating country will dictate how such items are
represented in your organizations published accounts. If you are required to produce such figures for
internal use then you need to adhere to its internal definitions.
Key Point

The matching principle aims to minimize any mismatch in timing between when an organization incurs costs
and when it realizes any associated revenue.

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Understanding Accounting Principles

A Sample Income Statement Using the Accrual Method

3 A Sample Income Statement

Using the Accrual Method
This example is based on a small organization that buys washing machines directly from the manufacturers,
which it then sells online and through a network of retail distributors. Even though this organization has
a straightforward business model it provides a good illustration of the issues you will need to consider
when interpreting or compiling an income statement.
Here is the income statement for Wendys Wholesale for the first quarter of the year. The organization
uses the accrual method of accounting.
Wendys Wholesale Income Statement
January 1March 31
$
Revenue (Sales)

$
55,000

Stock at March 31

34,000

Purchases

12,000
SUB TOTAL

Less Stock at January 1

46,000
(20,000)

Costs to deduct from Revenue

(26,000)
GROSS PROFIT

29,000

Less Overheads:

Wages

8,000

Rent

1,500

Electricity

700

Insurance

500

Distribution

800

Other Expenses

1,800

Reserve for Bad Debts

2,750

Depreciation

200
Less Total Overheads

(16,250)

NET PROFIT Before Tax

12,750

29
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Understanding Accounting Principles

A Sample Income Statement Using the Accrual Method

This income statement looks similar to that for Suzys Signs except that there are some additional entries
and considerations.
Stock
Gross Profit
Net Profit
Accruals (Costs not yet entered)
Prepayments (Costs entered in advance)
Bad Debt Reserve
Depreciation
Each of these items is described below.
Stock
Wendys must hold a stock of washing machines, so that they can be dispatched on the same day as they
are ordered. An inaccurate net profit figure will result if costs include washing machines purchased but
still in stock at the end of the period. This is allowed for by counting stock at the beginning and end of
the period.

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Understanding Accounting Principles

A Sample Income Statement Using the Accrual Method

Counting stock can be done manually, if little stock is carried, but larger organizations will have these
figures supplied by their computerized stock control system. A physical stock take is usually conducted
periodically to avoid discrepancies accumulating and causing problems.
Gross Profit
An organizations gross profit is calculated by taking away the cost of producing and selling its goods
sold from revenues earned.
Net Profit
Net profit or net income is calculated by subtracting all other overhead expenses from the gross profit.
Profit Margin
An organizations profit margin can be expressed as a ratio or by product as a percentage. The ratio is
calculated as net profits (or net income) divided by revenue (sales). It measures howmuch outof every
dollarof sales an organization actually keeps in earnings. For Wendys this ratio would be:

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When referring to the profit margin of an individual product it is the difference between the selling price
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This is often expressed as a percentage where the difference between the selling price and the cost price is
divided by the selling price. This answer is then multiplied by 100 to become a percentage. For example:

31
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Understanding Accounting Principles

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Accruals (Costs not yet entered)

An accrual is an allowance for costs that have not yet been invoiced. For example, Wendys have not yet
received their electricity bill for this quarter. Since the purpose of the income statement is to present an
accurate picture of the finances for the period it needs to recognize this liability even though no invoice
has been received. In this instance Wendys would look at last years bill for the same period, which was
$667, and then enter a figure of $700 as a realistic estimate for the quarter.
Prepayments (Costs entered in advance)
A prepayment is the opposite of an accrual. Wendys received an invoice from its insurers for $2,000 in
January, which is their insurance premium for the year. In the income statement they would apportion
this invoice into equal amounts for each quarter. So a figure of $500 is entered this quarters expense on
the income statement.

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Understanding Accounting Principles

A Sample Income Statement Using the Accrual Method

Bad Debt Reserve

Even though Wendys has a carefully controlled policy of extending credit, sometimes one of its retailers
becomes insolvent or bankrupt before the invoice is paid. This creates a bad debt, which means that
payment will never be collected and so becomes an expense. Technically, a bad debt becomes a bad debt
when the chances of payment become so small as to be nonexistent.
Many organizations know from experience the sort of percentage of total sales that will never be paid
for. In Wendys case they estimate a 5% bad debt expense has happened when the sale is made. Even
though no check is actually written to cover this percentage, it exists as a total against which the actual
bad debt can be subtracted from.
The way that bad debt is handled in the accounts is explained more fully in our eBooks titled What are
Income Statements and Reading a Balance Sheet which you can download free by visiting bookboon.
com Premium.
Depreciation
All organizations have fixed assets such as office and capital equipment, which have a useful and productive
life longer than the period of an annual income statement. Many of these items have a useful life that
will span several years.
It would be unreasonable to apportion the costs of these to the quarter in which they were purchased.
This problem is overcome by charging only a portion of the cost of these assets to each quarter of their
expected useful life.

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For example, Wendys bought a new lorry for $4,000 in January and it has a productive life of five years.
This allows for $800 a year ($4,000 divided by 5 years life) in depreciation, which for the quarterly income
statement enables $200 to be entered under overheads as depreciation.
Key Points

An accrual is an allowance for costs that have not yet been invoiced. In other words, a charge incurred in one
accounting period that has not been paid by the end of it.
A prepayment is a payment in advance for a good or service not yet received.
Many organizations know from experience the sort of percentage of total sales that will never be paid for and
make an allowance for this bad debt.
Depreciation is a method of allocating the cost of a tangible asset over its useful life.

33
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Understanding Accounting Principles

Summary

4 Summary
You should now have an understanding of basic financial terms, the differences between cash-based and
accrual accounting, and an appreciation of when revenue and costs are recognized in the accounts. This
is sufficient background information to be able to understand the financial statements that make up an
organizations annual report and most internal monthly reports as well.

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The most widely used financial statements are:

The Income Statement An accounting of revenue, expenses, and profit for a given
period. This can also be an internal document that can be used to make management
decisions about almost any activity where you have a record of the money spent and
the associated return.
The Balance Sheet An itemized statement that summarizes the assets and liabilities
of the business at a given date.
The Statement of Cash Flow A report that shows the effect of all transactions that
involved or influenced cash but did not appear on the income statement.
This eBook has used the income statement as a basis for explaining the basic principles of accounting. If
you need to interpret or prepare an income statement then you should read the eBook What are Income
Statements which can be downloaded from bookboon.com Premium.
Other free financial skills eBooks are:
Reading a Balance Sheet
What is Cash Flow Analysis
Understanding Financial Performance
What are Income Statements
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Understanding Accounting Principles

References

5 References
Mason, Roger (2012), Finance for Non-Financial Managers in a Week, Hodder Education & The McGrawHill Companies Inc.
Investopedia, www.investopedia.com
Insite Partners, www.insitepartners.com/Newsletters
Shoffner G.H., Shelly S., and Cooke R.A. (2011). The McGraw-Hill 36-hour Course Finance for Nonfinancial Managers, 3rd edn, The McGraw-Hill Companies Inc.
Siciliano, Gene (2003), Finance for Non-Financial Managers, The McGraw-Hill Companies Inc.

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