unit iii & iv (income statement & statement of equity)

Unit III and IVIncome Statement and Statement of Equity

Overview

Background Owners, management and other stakeholders of the business would want to know whether the business is earning from its operations. The results of business operations are summarized and reported in the financial statement called income statement.

The interval covered by the income statement is known as the accounting period, i.e., any period usually of twelve months during which business transactions are recorded and reported upon. When the accounting period ends on December 31, it is called a calendar period. When it ends on any month, it is called a fiscal period.

Purpose The purpose of Unit III “Income Statement” is to illustrate how an income statement may be prepared and the nature of the different accounts included in the said statement.

Income Statement provides financial information regarding the results of business operations for a given period of time. It is a report that shows whether or not the business achieved its primary objective of earning a profit or net income.

An income statement is prepared by listing

the revenues earned during the period; the expenses incurred in earning the revenue; and subtracting the expenses from the revenue to determine if a net income

or a net loss was incurred.

The purpose of Unit IV “Statement of Owner’s Equity” is to show how the capital statement may be prepared and how withdrawals of proprietor and the firm’s financial performance may effect the balance of capital at the end of every accounting period.

In this unit This unit contains the following topics:

Topics See PageForms of Income Statement 2 of CIncome Accounts 7 of C

Expense Accounts 8 of C

Debit and Credit of Income Statement Accounts

10 of C

Statement of Equity or Capital Statement 12 of C

Marivic D. Valenzuela-Manalo of C

Forms of Income Statement

Overview The forms of income statement that a business prepares depend on the nature

of the business activity undertaken by the firm. As provided in the revised Philippine Accounting Standard (PAS). 1, service oriented businesses normally prepare the natural form, formerly known as the single step income statement and trading and manufacturing firms normally use the functional form, formerly known as the multiple-step income statement format.

Natural Form The income statement presentation under this form arranges all income

accounts in one group, all expense accounts in another group and then deducts the total expenses from the total income in a single-step operation of subtraction to arrive at the final result of net income or net loss.

Illustration Below is an illustration of a natural form income statement:

JOSEPH LABRADOR CONSULTANCYIncome Statement

For the year ended December 31, 20X1Revenues: Note

Service Income P 650,000Other Income (1) 50,000 P 700,000

Less: Operating ExpensesEmployee Costs (2) P 250,000Travel & Transportation 100,000Rent Expense 80,000Supplies Expense 70,000Utilities Expense (3) 50,000Janitorial & Security 32,000Depreciation Expense (4) 28,000Commission Expense 17,000Insurance 14,000Representation & entertainment 12,000Repairs & maintenance 9,500Taxes & Licenses 4,000Doubtful Accounts 2,000Miscellaneous Expense 4,000 672,500

Net Income P 27,500

Continued on next page


Forms of Income Statement, Continued

Notes to the Natural Form

The following are the notes to the natural form income statement:

Note 1 - Other IncomeInterest income P 28,000Dividend income 22,000Total other income P 50,000

Note 2 - Employee CostsProfessional fees P 175,000Salaries & Employee Benefits 75,000Total employee costs P 250,000

Note 3 - Utilities expenseTelephone & communication P 30,000Light & Water 20,000Total utilities expense P 50,000

Note 4 - DepreciationDepreciation - office equipment 18,000Depreciation - furniture & fixtures 10,000Total depreciation P 28,000




Functional Form

The income statement presentation under this form clearly shows specific sections of income, costs and expenses in a series of arithmetic operations. This form requires that cost of goods sold and the expenses be subtracted in steps to arrive at the net income. Merchandising businesses uses this format.

Illustration Below is an illustration of a functional form income statement:

Joseph Labrador Consultancy Income Statement

For the year ended December 31, 20X1

NoteNet sales revenue 1 P 193,000Cost of sales 2 (145,000)Gross profit P 48,000Other operating income 3 3,000Gross profit and other operating income P 51,000Operating expenses: Selling expenses 4 P 14,000 Administrative expenses 5 24,000 Other operating expenses 6 1,000 Interest expense 1,000 (40,000)Net income P 11,000




Notes to the Functional Form

The following are the notes to the functional form income statement:

Note 1 - Net sales revenue

Gross sales P 200,000

Less: Sales Returns & Allowances P 5,000

Sales Discount 2,000 7,000

Net sales revenue P 193,000

Note 2 - Cost of sales

Merchandise Inventory, Jan. 1 P 5,000

Add: Net cost of purchases

Purchases P 175,000

Less: Purchase Returns & Allowances P 3,000

Purchase Discounts 2,000 5,000

Net purchase P 170,000

Add: Freight-in 1,000 171,000

Cost of goods available for sale P 176,000

Less: Merchandise Inventory, Dec. 31 31,000

Cost of sales P 145,000

Note 3 - Other operating income

Rent Income P 1,500

Dividend Income 800

Interest Income 500

Gain on Sale of Furniture & Fixtures 200

Total other income P 3,000




Notes to the Functional Form (continued)

Note 4 - Selling expenses

Salesmen's Salaries and Commissions

P 9,000

Representation and Entertainment 1,200

Depreciation - Store Equipment 1,000

SSS & Philhealth Premiums 900

Freight-out 800

Miscellaneous Selling Expense 1,100

Total selling expenses P 14,000

Note 5 - Administrative expenses

Salaries Expense P 15,000

Light, Water and Telephone 3,500

Uncollectible Accounts 2,000

Depreciation Expense 1,500

SSS & Philhealth Premiums 1,300

Miscellaneous General Expense 700

Total administrative expenses P 24,000

Note 6 - Other operating expenses

Loss on Sale of Equipment P 800

Discount Lost 200

Total other operating expenses P 1,000


Income Accounts

Overview The following are the usual income statement account found in a single-step

income statement

Service Income Different businesses have different ways of earning income. The term that is

generally used to refer to any kind of income from services rendered is service income. This represents the inflow of cash or non-cash assets arising from services rendered. Other account names that may be used to refer to income from services describes the specific nature of the service rendered: (Pefianco, E., Mercado, R., 1983)

Professional Fees. These indicate income from rendering professional services without specifying the particular nature of professional service rendered.

Medical Fees. This refers to income received from rendering medical services.

Legal Fees. This refers to income received from rendering legal services.

Dental Fees. This refers to income received from rendering dental services.

Accounting Fees. This refers to income received from rendering accounting services.

Management Fees. This refers to income received from rendering various management consultancy services.

Other Income This refer to income from sources other than the principal line of activity of

the business.

The examples of other income are:

Interest Income. The revenue to the payee for loaning out a principal amount to a borrower. This may also refer to income earned from money deposited in a bank.

Dividend Income. Income earned in investing cash in stocks of other businesses.


Expense Accounts

Overview Expenses are the cost of goods or services that are used or consumed in the

operations of a particular business activity. In service businesses, the following are the common expenses

Salaries This is the cost of services rendered by the employees and/or laborers of a

business firm. This account may be used to include the cost of all emergency allowances, 13th month pay, and other employee fringe benefits.

Rent The rental cost of office space, equipment, etc.

Office Supplies This refers to the cost of office stationery; coupon bond, carbon paper,

typewriter or computer ribbons, envelopes, pencils, ball pens, and office supply items that are consumed in business operations.

Utilities This refers to the cost of light and water consumed as well as the cost of

using telephone facilities.

Taxes and Licenses

This refers to all payments required to be made to the Bureau of Internal Revenue and the Municipal Treasurer for privilege taxes, mayor’s permits, municipal taxes and licenses, business taxes and others.

Transportation This is the cost incurred by office employees when commuting from the

office to the place of business of clients, e.g., jeepney fares, taxi fares, and bus fares. Also included are transportation fares from the office to any place on official business. Travelling Expense is used when business trips are made out of town, the cost of transportation fares by plane, by boat, or by bus.



Expense Accounts, Continued

Gas and oil This refers to the cost of gas and oil consumed whenever transportation vehicles or company cars are used in official business trips.

Representation The cost incurred when entertaining clients or prospective clients. Included

are the costs incurred when office employees represent the firm in some official functions.

Depreciation This refers to the expense associated with the use of the company’s plant

assets, i.e., spreading (allocating) the cost of a plant asset over its useful life.

Bad Debts Selling or rendering services on credit create both a benefit and a cost. Credit

customers who fail to pay their liabilities will create an expense in the company. The allocation or provision for this future uncollectibility of some of the accounts of credit customers is called bad debts expense or doubtful accounts expense or uncollectible account expense.

Donations and Contributions

This refers to contributions made to charitable institutions or any other worthwhile projects.

Miscellaneous Any other costs of operations that may not be sufficiently big in amount to be

classified separately are charged to this account.


Debit and Credit of Income Statement Accounts

Overview A business transaction is an activity that involves the exchange of values.

This exchange would result to a situation or receiving a value equal to the value given away. In this part, we would learn the simple mechanics of these activities which bring about changes in the income statement.

Revenues The purpose of a business, other than to render service to the community, is

to increase assets and owner’s equity through revenues, which are amounts earned by delivering goods or services to customer. Revenues increase owner’s equity because they increase the business’s assets but not its liabilities. As a result, the owner’s interest in the assets of the business increases.

Example: Jose Labrador earns service income by providing professional accounting service for his clients. Assume he earns P10,000 and collects this amount in cash. The effect on the accounting equation is an increase in the asset cash and an increase in Labrador Capital due to the income generated.

Assets - Cash = Liabilities + Labrador, Capital

10,000 increase 10,000 increase - Service income

Expenses In earning revenue, a business incurs expenses. Expenses are decreases in

owner’s equity that occur in the course of delivering goods and service to clients. Expenses decrease owner’s equity because they use up the business assets.

Example: During the month, Labrador paid the salary of the company secretary for P5,000. The effect on the accounting equation is a decrease in the asset, cash and a decrease in capital due to the expense incurred.

Asset - Cash = Liabilities + Labrador, Capital

5,000 decrease 5,000 decrease - Salaries expense



Debit and Credit of Income Statement Accounts, Continued

Normal Balance

Upon analyzing the effects of income and expense accounts in the owner’s equity, one may conclude that, since owner’s equity or capital has a normal credit balance, it must follow that all income accounts will also have normal credit balances since they cause an increase in the capital account. On the contrary, since expenses have a decreasing effect in the capital account, the normal balance of all expense accounts would be debit.

The illustration presents two main sources of owner’s equity, namely: investments and revenues. On the other hand, withdrawals and expenses decrease the owner’s equity.

INCREASES DECREASES


ExpensesRevenues

Owner ‘s Equity

Owner withdrawalsfrom the business

Owner investmentsin the business

Statement of Equity or Capital Statement

Overview Capital Statement or Statement of Owner’s Equity presents a summary of

the changes that occurred in the owner’s equity of the entity during a specific time period, e.g., month or a year. Increases in owner’s equity arise from investments by the owner and net income earned. Net loss for the period causes the owner’s equity to decrease. Net Income or net loss comes directly from the income statement. Investments and withdrawals by the owner are capital transactions between the business and its owner, so they do not affect the income statement.

Withdrawals The owner of the firm would at times withdraw assets from the business for

personal use. These personal withdrawals would be treated differently depending on the intention of the owner in withdrawing such assets

Types of Withdrawals

Temporary Withdrawal. The owner withdraws business assets (e.g. cash) for personal use in anticipation of profits derived from the operations of the business. This type of withdrawal uses the drawing account when recorded in the books of the company.

The pro-forma entry to record this type of withdrawal is:

Joseph Labrador, Drawing xxx

Cash or Other Assets xxx

To record withdrawal of owner for personal use

Permanent Withdrawal. Capital withdrawal that is substantial in amount. The owner in this type of withdrawal of the assets has the intentions of removing the asset permanently from the business operations. This type of drawing uses the capital account.

The pro-forma entry to record this type of withdrawal is:

Joseph Labrador, Capital xxx

Cash or Other Assets xxx

To record permanent withdrawal of asset of owner from the business.



Statement of Equity or Capital Statement, Continued

Statement of Owner’s Equity

The statement of owner’s equity opens with the owner’s capital balance at the beginning of the period. Add net income, (deduct in the case of net loss) which directly comes from the income statement. Subtract withdrawals by the owner and the statement ends with owner’s capital balance at the end of the period.

Illustration Below is the illustration of the statement of the owner’s equity.

JOSEPH LABRADOR, CPAStatement of Owner’s Equity

For the year ended December 31, 20X1

Joseph Labrador, Capital, January 1 P 620,500Add: Net Income 34,500Sub-Total P 655,000Less: Joseph Labrador, drawing 10,000Joseph Labrador, Capital, December 31 P 645,000


unit iii & iv (income statement & statement of equity)

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