In a financial report, the income statement may seem like a tub standing on its own feet, disconnected from the balance sheet and the statement of cash flows. Nothing is further from the truth. The three financial statements set are interdependent and interconnected. For example: if sales-revenue or one of the expenses had been just $5 different than the amount reported in the income statement, a $5 difference would appear somewhere in the balance sheet and statement of cash flows.
As you know, an income statement reports sales revenue, expenses, and profit or loss. But an income statement doesn’t report how sales revenue and expenses change the financial condition of the business. Example: a $26,000,000 sales revenue is reported in the annual income statement of a business. The business also reports $24,310,000 total expenses for the year. How did the sales revenue and expenses change its financial condition? The income statement doesn’t say.
Business managers rely on their accountants to explain how sales and expenses change the assets and liabilities of their businesses. Business lenders and shareowners also need to understand these effects in order to make sense of financial statements.
Suppose you’re the chief accountant of the business whose income statement is presented. The president asks you to explain the financial effects of sales revenue and expenses reported in its latest annual income statement at the next meeting of its board of directors. To help organize your thoughts for the presentation, you decide to prepare summary sales revenue and expense journal entries for the year. Based on your analysis, you prepare summary journal entries for sales revenue and for each of the four expenses reported in the income statement.
Sales – Revenue:
[Debit]. Cash = $25,000,000
[Debit]. Accounts Receivable = $1,000,000
[Credit]. Sales Revenue = $26,000,000
The business makes credit sales. When recording a credit sale, the asset account accounts receivable is debited. When the customer pays, accounts receivable is credited. The business collected $25,000,000 from customers. Therefore, its accounts receivable balance increased $1,000,000.
[Debit]. Inventory = $16,300,000
[Credit]. Cash = $14,500,000
[Credit]. Accounts Payable = $1,800,000
The business purchases $16,300,000 of products during the year, so, its inventory increased $16,300,000. It didn’t pay for all its $16,300,000 of purchases. Its accounts payable for inventory purchases increased $1,800,000. Therefore, cash outlay for products during the year was $14,500,000.
[Debit]. Interest Expense = $400,000
[Credit]. Cash $350,000
[Credit]. Accrued Expenses Payable $50,000
The business paid $350,000 interest during the year. The amount of unpaid interest at yearend increased $50,000. A general liability account for accrued expenses is shown in this entry (The business may credit a more specific account, such as accrued interest payable).
Income Tax Expense:
[Debit]. Income Tax Expense = $910,000
[Credit]. Cash = $830,000
[Credit[. Accrued Expenses Payable = $80,000
At the end of last year, the business didn’t owe any income tax. During the year, it made $830,000 installment payments toward its estimated income tax (as required by law). Based on the final determination of its income tax for the year, the business still owes $80,000, which will be paid when its return is filed. The general liability account for accrued expenses is shown in this entry. (The business may credit a more specific account, such as income tax payable).
These four summary entries aren’t actual journal entries recorded by a business; they simply help summarize the effects of sales and expenses on the assets and liabilities of the business. Also, I should point out that to develop the information for these entries, the accountant has to analyze the balance sheet accounts affected by sales and expenses, which takes time.