Saturday, January 5, 2013

Decoding Income Statement - Part 1

Income statement is often misunderstood .........on a general level  intention is to record revenues generated and cost incurred in the process of generating those revenues.

Often the source of confusion is due to misunderstanding between Income and cash flow.  Cash flow statement's purpose is to record actual movement of cash where as income statement follows defined conventions known as accrued accounting.  Now the question is how to recognize 'revenue' when the cash received today and service is to be provided say over next year. Also if a machinery is sold can the cash raised be recognized as revenue?

Few examples on the income statement vs cash flow to help understand-
  • Cost is recognized when the materials are consumed not when they are paid for. Thus if a business buys machinery, cash flows out ,its recognized as cash flow (not cost).Cost is recorded as depreciation over time. 
  • Salary to be paid to the employees is recognized as cost even before its to be paid, thus no cash flow has taken place (until the end of month) but cost is recognized.  
  • A loan repayment results in cash flow but from an income statement point of view is not a cost. The outstanding liability of loan is reduced by the amount of asset reduction. 
  • Large one time gains/losses like selling a owned land is recognized a 'extraordinary income'. Such income is not to be mixed up with operating income. 
 More to come in later part so stay tuned ...