Chapter 2
Accounting Review:
Income Statements
and Balance Sheets
2.1 Chapter Overview
2.2 The Income Statement
2.3 The Balance Sheet
2.4 The Importance of Accounting for Business Operations
After studying Chapter 2, you should be able to:
• Construct a basic income statement.
• Identify and define each item on a basic income statement.
• Construct a basic balance sheet.
• Identify and define each item on a basic balance sheet.
• Describe the difference between accounting data and cash.
• Explain the importance of accounting to a business.
• Identify the major ways in which a firm may legally manipulate its financial data.
,Chapter Overview
At most schools, accounting is a prerequisite for the introductory finance course. Thus,
you have probably recently taken an accounting course (or perhaps even two) and you may be
tempted to skip this chapter. DON’T!!!
As finance professors, it has been our experience that students exiting basic accounting
courses (though often well versed in accounting) do not have an adequate understanding of the
structure and construction of, and basic relationships between, company income statements and
balance sheets. Without this understanding, it is impossible to master financial statement analysis
- which comprises the next three chapters of this book. Thus, even if you think your accounting
background is strong, we still suggest that you read this chapter. And, if you find yourself
struggling excessively through the remaining chapters of this section of the book, we recommend
that you re-read this chapter - several times if necessary!
In this chapter, we outline the structure and composition of the two main financial
statements used by businesses: the income statement and the balance sheet. Specifically, we
present a basic description of the most common account items found on financial statements.
Keep in mind that the descriptions presented in this chapter are from the point of view of a
financial manager as opposed to an accountant. A financial manager is not particularly interested
in how accounts are kept or recorded (i.e., T-accounts). A financial manager must, however,
intuitively understand the nature of financial statement accounts before effective financial
analysis and management can be achieved.
2.1 The Income Statement
The income statement, also called an earnings statement or a profit and loss statement, is
an accounting statement that matches a company’s revenues with its expenses over a period of
time, usually a quarter or a year. The components of the income statement involve a company’s
recognition of income and the expenses related to earning this income. Revenue less expenses
results in a profit or loss.
The income statement is a flow measure statement meaning that each value on an income
statement represents the cumulative amount of that item through the given accounting period.
Thus, the revenue on a first quarter income statement equals the cumulated amount of all sales
during the first three months of the firm’s fiscal year. The revenue on the second quarter income
,statement equals the cumulated amount of all sales during the second three months of the firm’s
fiscal year. The same applies to expenses and therefore profits.
Consider the following monthly data for Bixel, Inc. for January through June:
Month Sales Expenses
January $20,000 $15,000
February $30,000 $20,000
March $40,000 $30,000
April $30,000 $20,000
May $50,000 $40,000
June $20,000 $15,000
Problem 2.1a Assuming that the first quarter of 2003 includes the months of January, February
and March, what would Bixel, Inc. report as revenue on its first quarter income statement? What
would Bixel, Inc. report as expenses on its first quarter income statement? What would Bixel,
Inc. report as profit (or loss) on its first quarter income statement?
Answers: $90,000; $65,000; $25,000
Problem 2.1b Assuming that the second quarter includes the months of April, May and June,
what would Bixel, Inc. report as revenue on its second quarter income statement? What would
Bixel, Inc. report as expenses on its second quarter income statement? What would Bixel, Inc.
report as profit (loss) on its second quarter income statement?
Answer: $100,000; $75,000; $25,000
, Problem 2.1c What would Bixel, Inc. report as profit (loss) on its income statement covering the
period January through June?
Answer: $50,000
It is important to realize that profit on an income statement seldom corresponds with a
company’s actual cash flow. In fact, while all companies seek to maximize their cash flow (since
cash is necessary to pay bills, salaries, loans, dividends and so on), not all companies attempt to
maximize reported earnings. In fact, many companies actually try to minimize reported earnings
in an attempt to reduce taxes.
The reason why income and cash flow seldom match is that most companies elect to
prepare their income statements (and thereby their balance sheets) using accrual accounting as
opposed to cash accounting. Accrual accounting recognizes revenues as earned when sales are
transacted, regardless of when the company actually receives payment. Likewise, expenses are
recognized when they are incurred rather than when the actual payment is made. In contrast, cash
accounting recognizes revenues as earned only when payment is received and recognizes
expenses as costs only when cash is actually paid out. As we will see in chapter four, one part of
the statement of cash flows (specifically, cash flows from operating activities) represents the
conversion of an accrual accounting income statement into a cash accounting income statement.
The basic structure of a multi-step income statement is outlined in Table 2.1. The term
multi-step means that four profit measures are designated on the statement: gross profit,
operating profit (sometimes referred to as operating income, Earnings before Interest and
Taxes, or EBIT), profit before taxes (sometimes referred to as Earnings before Taxes or EBT),
and net income (also referred to simply as earnings). These profit measures will be discussed in
greater detail in Chapter 5.
Note that these are not the only accounts that may appear on an income statement and
some income statements may utilize slightly different terminology. Some companies offer more
detail on their statements than others. Certain expense items that are important for one company
may be minor or nonexistent for another company. Nonetheless, these are the major items and
Accounting Review:
Income Statements
and Balance Sheets
2.1 Chapter Overview
2.2 The Income Statement
2.3 The Balance Sheet
2.4 The Importance of Accounting for Business Operations
After studying Chapter 2, you should be able to:
• Construct a basic income statement.
• Identify and define each item on a basic income statement.
• Construct a basic balance sheet.
• Identify and define each item on a basic balance sheet.
• Describe the difference between accounting data and cash.
• Explain the importance of accounting to a business.
• Identify the major ways in which a firm may legally manipulate its financial data.
,Chapter Overview
At most schools, accounting is a prerequisite for the introductory finance course. Thus,
you have probably recently taken an accounting course (or perhaps even two) and you may be
tempted to skip this chapter. DON’T!!!
As finance professors, it has been our experience that students exiting basic accounting
courses (though often well versed in accounting) do not have an adequate understanding of the
structure and construction of, and basic relationships between, company income statements and
balance sheets. Without this understanding, it is impossible to master financial statement analysis
- which comprises the next three chapters of this book. Thus, even if you think your accounting
background is strong, we still suggest that you read this chapter. And, if you find yourself
struggling excessively through the remaining chapters of this section of the book, we recommend
that you re-read this chapter - several times if necessary!
In this chapter, we outline the structure and composition of the two main financial
statements used by businesses: the income statement and the balance sheet. Specifically, we
present a basic description of the most common account items found on financial statements.
Keep in mind that the descriptions presented in this chapter are from the point of view of a
financial manager as opposed to an accountant. A financial manager is not particularly interested
in how accounts are kept or recorded (i.e., T-accounts). A financial manager must, however,
intuitively understand the nature of financial statement accounts before effective financial
analysis and management can be achieved.
2.1 The Income Statement
The income statement, also called an earnings statement or a profit and loss statement, is
an accounting statement that matches a company’s revenues with its expenses over a period of
time, usually a quarter or a year. The components of the income statement involve a company’s
recognition of income and the expenses related to earning this income. Revenue less expenses
results in a profit or loss.
The income statement is a flow measure statement meaning that each value on an income
statement represents the cumulative amount of that item through the given accounting period.
Thus, the revenue on a first quarter income statement equals the cumulated amount of all sales
during the first three months of the firm’s fiscal year. The revenue on the second quarter income
,statement equals the cumulated amount of all sales during the second three months of the firm’s
fiscal year. The same applies to expenses and therefore profits.
Consider the following monthly data for Bixel, Inc. for January through June:
Month Sales Expenses
January $20,000 $15,000
February $30,000 $20,000
March $40,000 $30,000
April $30,000 $20,000
May $50,000 $40,000
June $20,000 $15,000
Problem 2.1a Assuming that the first quarter of 2003 includes the months of January, February
and March, what would Bixel, Inc. report as revenue on its first quarter income statement? What
would Bixel, Inc. report as expenses on its first quarter income statement? What would Bixel,
Inc. report as profit (or loss) on its first quarter income statement?
Answers: $90,000; $65,000; $25,000
Problem 2.1b Assuming that the second quarter includes the months of April, May and June,
what would Bixel, Inc. report as revenue on its second quarter income statement? What would
Bixel, Inc. report as expenses on its second quarter income statement? What would Bixel, Inc.
report as profit (loss) on its second quarter income statement?
Answer: $100,000; $75,000; $25,000
, Problem 2.1c What would Bixel, Inc. report as profit (loss) on its income statement covering the
period January through June?
Answer: $50,000
It is important to realize that profit on an income statement seldom corresponds with a
company’s actual cash flow. In fact, while all companies seek to maximize their cash flow (since
cash is necessary to pay bills, salaries, loans, dividends and so on), not all companies attempt to
maximize reported earnings. In fact, many companies actually try to minimize reported earnings
in an attempt to reduce taxes.
The reason why income and cash flow seldom match is that most companies elect to
prepare their income statements (and thereby their balance sheets) using accrual accounting as
opposed to cash accounting. Accrual accounting recognizes revenues as earned when sales are
transacted, regardless of when the company actually receives payment. Likewise, expenses are
recognized when they are incurred rather than when the actual payment is made. In contrast, cash
accounting recognizes revenues as earned only when payment is received and recognizes
expenses as costs only when cash is actually paid out. As we will see in chapter four, one part of
the statement of cash flows (specifically, cash flows from operating activities) represents the
conversion of an accrual accounting income statement into a cash accounting income statement.
The basic structure of a multi-step income statement is outlined in Table 2.1. The term
multi-step means that four profit measures are designated on the statement: gross profit,
operating profit (sometimes referred to as operating income, Earnings before Interest and
Taxes, or EBIT), profit before taxes (sometimes referred to as Earnings before Taxes or EBT),
and net income (also referred to simply as earnings). These profit measures will be discussed in
greater detail in Chapter 5.
Note that these are not the only accounts that may appear on an income statement and
some income statements may utilize slightly different terminology. Some companies offer more
detail on their statements than others. Certain expense items that are important for one company
may be minor or nonexistent for another company. Nonetheless, these are the major items and
