Chima points out that an income statement will show how profitable Fast Delivery has been during the time interval shown in the statement's heading. This period of time might be a week, a month, three months, five weeks, or a year—Femi can choose whatever time period he deems most useful.
The
reporting of profitability involves two things: the amount that was earned
(revenues) and the
expenses necessary to earn the revenues. As you will see
next, the term revenues is not the same as receipts, and the term expenses
involves more than just writing a check to pay a bill.
A.
Revenues
The
main revenues for Fast Delivery are the fees it earns for delivering parcels.
Under the accrual basis of accounting (as
opposed to the less-preferred cash method of accounting),
revenues are recorded when they are earned, not when the company receives
the money. Recording revenues when they are earned is the result of one of the
basic accounting principles known as the revenue recognition principle.
For
example, if Femi delivers 1,000 parcels in December for N500 per delivery, he
has technically earned fees totalling N500,000 for that month. He sends
invoices to his clients for these fees and his terms require that his clients
must pay by January 10. Even though his clients won't be paying Fast Delivery
until January 10, the accrual basis of accounting requires that the N500,000 be
recorded as December revenues, since that is when the delivery work
actually took place. After expenses are matched with these revenues, the income
statement for December will show just how profitable the company was in
delivering parcels in December.
When
Femi receives the N500,000 worth of payment checks from his customers on
January 10, he will make an accounting entry to show the money was received.
This N500,000 of receipts will not be considered to be January revenues, since
the revenues were already reported as revenues in December when they
were earned. This N500,000 of receipts will be recorded in January as a
reduction in Accounts Receivable. (In December Femi had made an
entry to Accounts Receivable and to Sales.)
B.
Expenses
Now
Chima turns to the second part of the income statement—expenses. The December
income statement should show expenses incurred during December
regardless of when the company actually paid for the expenses. For
example, if Femi hires someone to help him with December deliveries and Femi
agrees to pay him N75,000 on January 3, that N75,000expense needs to be shown
on the December income statement. The actual date that the N75,000 is
paid out doesn't matter. What matters is when the work was done—when the
expense was incurred—and in this case, the work was done in December.
The N75,000 expense is counted as a December expense even though the money will
not be paid out until January 3. The recording of expenses with the related
revenues is associated with another basic accounting principle known as the matching principle.
Chima
explains to Femi that showing the N75,000 of wages expense on the December
income statement will result in a matching of the cost of the labor used
to deliver the December parcels with the revenues from delivering the December
parcels. This matching principle is very important in measuring just how
profitable a company was during a given time period.
Chima
is delighted to see that Femi already has an intuitive grasp of this basic
accounting principle. In order to earn revenues in December, the company had to
incur some business expenses in December, even if the expenses won't be paid
until January. Other expenses to be matched with December's revenues would be
such things as gas for the delivery van and advertising spots on the radio.
Femi
asks Chima to provide another example of a cost that wouldn't be paid in
December, but would have to be shown/matched as an expense on December's income
statement. Chima uses the Interest Expense on borrowed money as an example.
She asks Femi to assume that on December 1 Fast Delivery borrows N3million from
Femi's aunt and the company agrees to pay his aunt 6% per year in interest, or
N180,000 per year. This interest is to be paid in a lump sum each on December 1
of each year.
Now
even though the interest is being paid out to his aunt only once per year as a
lump sum, Femi can see that in reality, a little bit of that interest expense
is incurred each and every day he's in business. If Femi is preparing monthly
income statements, Femi should report one month of Interest Expense on each
month's income statement.
The
amount that Fast Delivery will incur as Interest Expense will be N15000 per
month all year long
(N3million x 6% ÷ 12).
In
other words, Femi needs to match N150,000 of interest expense with each month's
revenues. The interest expense is considered a cost that is necessary to earn
the revenues shown on the income statements.
Chima
explains to Femi that the income statement is a bit more complicated than what
she just explained, but for now she just wants Femi to learn some basic
accounting concepts and some of the accounting terminology. Chima does make
sure, however, that Femi understands one simple yet important point: an income
statement, does not report the cash coming in—rather, its purpose
is to (1) report the revenues earned by the company's efforts during the
period, and (2) report the expenses incurred by the company during the
same period. The purpose of the income statement is to show a company's profitability
during a specific period of time. The difference (or "net") between
the revenues and expenses for Fast Delivery is often referred to as the bottom
line and it is labeled as either Net Income or Net Loss.
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