Operating income is the residual amount of revenue left after deduction of the cost of goods sold (COGS) and operating expenses from the revenue or net sales during the specific period or during the year. It is one of the measures of the profitability of the operations of an organization.
The increase or decrease of operating income is really depending on revenue or net sales and the cost of goods sold. Operating income increase will result in an increase in gross profit margin.
It infers investors and owners about the amount of revenue that would eventually turn out to be profits for the company.
It is one of the primary indirect indicators of the measure of the efficiency of an entity. Higher the operating income, higher is the operating efficiency and profitability from the core operations.
Operating income can be calculated by the formula:
Operating income = Total Revenue – Direct Costs – Indirect Costs
Operating income = Net Earnings + Interest Expense + Taxes
Net income
Net Income is the profit remaining after all costs incurred during the period have been subtracted from sales revenue. It is important since it helps to calculate Earnings Per Share (EPS). It is the last line of the income statement and often referred to as the “Bottom line number”.
It includes every type of income and expenses. If a company is able to steadily increase the net income of a company over a period of time, its share price will eventually rise.
Net income = Operating Income – Expenses – Taxes
The differences between Operating Income and Net Income are discussed below:
Basis
Operating Income
Net Income
Definition
It signifies the income from the principal revenue-generating activities of the company.
It is the income generated from all the operations of the company.
Significance
It calculates how much revenue converts into profit.
It depicts the earning potential capacity of the company.
Formula
Gross income- Operating expense- Depreciation and amortization
Operating income + Other Income-Interest expense + Extraordinary income- Extraordinary Expense-Taxes
Taxes
Taxes are not considered to calculate income.
Taxes are deducted to calculate income.
Uses
Used to calculate ROCE (Return on Capital Employed)
Used to calculate EPS, ROA or ROE
Evaluation
It gives evaluation of operational performance of company.
It simply offers earnings evaluation rather than performance evaluation.
Position
It sits much above the net income in the income statement.
It sits at the bottom of the income statement.
Income
It doesn’t include profit/loss from investment or sale of capital goods.
It includes profits/loss from investment or sale of capital goods.
Transfer
It is not transferred to capital Account of shareholders.
It is transferred to capital account of shareholders.
Presentation
It is presented in income statement only.
It is presented in income statement and balance sheet
Non-operating income
It doesn’t include non-operating income.
It includes non-operating income.
Non-operating expenses
It doesn’t include non-operating expenses.
It includes non-operating expenses.
Other names
It is also called Earnings Before Income and Tax
It is also called Earning After Tax
Taxation purpose
This income is not used in calculating taxable income.
This income is used to calculate total taxable income.
Purpose
It is used to understand and eliminate the unnecessary operating expenses.
It is useful in knowing the financial performance of the entity.
Ratio used
The operating profit ratio is used to gauge operating profit vis-à-vis sales.
Net profit ratio is used to gauge operating profit vis-à-vis sales.
Share price
It doesn’t affect share price.
Increase in net profits increase the share price.
Use to investors
Investors are not interested in knowing the operating profit.
A huge net profit results in distribution of higher dividends to shareholders.
Under the accrual basis of accounting, the financial transactions are to be recorded as and when they occur. When the seller provides services or sells goods, then he has to recognize the revenue even if the customer has not made payment.
This is in line with the accrual concept. It is the revenue that the company earned after selling its goods or services although it hasn’t received its payment yet.
This recording of transactions is even mandated as per the Revenue recognition principle that defines when revenue is to be recorded. As per AS 9 on revenue recognition, revenue can be only recognized when these two conditions are fulfilled:
It is usually recorded as a current asset because the gap period between earning revenue and receipt of cash is usually less than a year or a working capital cycle. It is shown in the balance sheet as a current asset when the related revenue is shown in the income statement.
As the payments are received, the accrued revenue gets deducted by the amount of cash received, with no further effect on the income statement. A high accrued revenue signifies that the business is not receiving timely payments for its products or services and can be alarming for the financial health of the company.
The conditions required for booking the accrued revenue are as follows:
Situations when accrued revenue arises and needs to be booked:
Example of accrued revenue:
A sold goods to B on December 30, 2019, for Rs 5000. He closes the books of accounts on December 31. He received the payment on January 10, 2020. How should he record revenue?
Here,
On December 31, 2020, A should recognize the revenue of Rs 5000 after the conditions of revenue recognition have been duly met. Such conditions are
The journal entries to be passed are:
At the point of sales being made:
Date
Particulars
Debit
Credit
Debtors A/C
5000
To Sales revenue
5000
At the time of receipt of cash:
Date
Particulars
Debit
Credit
Cash A/C
5000
To Debtors
5000
Accrued revenue is the revenue that has been recognized but not yet realized. It is also called unbilled revenue. It is recorded when there is a mismatch between the time of the payment and delivery of goods and services.
This can arise in following cases:
Presentation of accrued revenue in financial statements:
Accrued revenue is shown as adjusting journal entry under the current assets category in the balance sheet and as an earned revenue in the income statement of the company. When the payment is cleared, it is recorded as an adjusting entry to the asset account for accrued revenue.
Example:
A bank grants a loan to a customer of Rs 500000 at 10% per annum on January 1, 2020. The amount will be collected after a period of 1 year. After the passage of 1 month, the bank is entitled to revenue of 1-month interest. Hence, the entry would be:
Date
Particulars
Debit
Credit
Jan 31
Interest receivable A/C Dr
4167
To Interest income A/C
4167
Interest receivable of Rs 4167 would be shown as a current asset in the balance sheet and as earned revenue in the P&L statement as per the accrual principle.
Example:
ABC IT services company agrees to build a software for PQR company in 12 months for Rs. 400000. According to the contract, ABC is expected to deliver the first milestone in 6 months which is valued at Rs. 250000. A second milestone would be delivered at the end of the contract in another 6 months.
Hence ABC must record accrued revenue at the end of first milestone. The entry would be:
Date
Particulars
Debit
Credit
June 30
Accrued revenue A/C Dr
250000
To Revenue A/C
250000
After the completion of the milestone and total bill being issued, ABC must record the following:
A lease is defined as a contract or part of a contract that conveys the right to use an asset for a period of time in return for a quid-pro-quo. They are considered as off-balance sheet financing items. It means that leased assets and liabilities are not reflected in the balance sheet of a company. Lessor retains the ownership of the leased asset.
As per IFRS 16,
For the lessor, an operating lease is defined as every lease other than the finance lease.
IFRS 16 mandates lease to be termed as a finance lease if all the following conditions are met:
There is the transfer of ownership to the lessee at the end of the lease period
The lease contains a purchase option by the lessee
The period of the lease exceeds 75% of the economic life of the asset
The present value of lease payments should exceed 90% of the asset’s fair market value.
If none of these conditions is met, the lease would be classified as an operating lease.
Operating lease is used to lease for a short period of time and is similar to renting as the transfer of ownership is not involved. Periodic annual lease payments are treated as operating expenses of the company and are shown in the income statement of the company. The firm doesn’t own the asset hence, the asset is not shown in the balance sheet on the asset’s side. Depreciation is not calculated for assets taken under an operating lease. The lessee has the option either to buy the asset or return the asset to the lessor at the end of the lease period.
For the lessee, the distinction between operating lease and finance lease has been extinguished. All leases will be shown on the balance sheet as liabilities, at the future value of the present lease payments, along with the asset showing the right to use the asset over the lease period.
The advantages of operating lease are given below:
Greater flexibility: Companies can replace or update the assets more often hence; it provides more flexibility to the lessor.
There is no risk of obsolescence as there is no transfer in ownership
Accounting is simpler
Lease rentals are tax-deductible.
Features of operating lease:
Lessor retains the right to the ownership of the asset.
The lease agreement doesn’t contain bargain purchase option.
PV of lease payments is lease than 90% of the fair market value of the asset.
Lease rentals are shown as operating expenses and charged to P/L Account.
Lessee has the right to use only, the risk and benefits lie with the lessor. Lessee pays the costs of maintenance of the asset.
The term of the lease is less than 75% of economic life of an asset.
Accounting of operating lease:
Lessee records rental payments as expense in the books of accounts and lessor records the property as an asset and depreciate it over its useful life.
Impact of operating lease on financial statements:
The effect of operating lease on the balance sheet is given below:
Effect on the income statement: Lease payments will be expensed in the P/L statement.
Effect on cash flows:
Lease payments are deducted from cash flow from operations.
Operating leases do not affect the lessee’s liabilities and hence, are off-balance-sheet items
Footnote disclosure of lease payment for each of the lease life is required
Example of an operating lease:
Let us take the example of a company that has entered into an operating lease agreement for an asset and has agreed to a rental payment of Rs. 24000 for a period of twelve months. Since it is an operating lease accounting, the company will book the lease rentals uniformly over the next twelve months, which is the lease term. The monthly rental expense will be calculated as follows,
Rental expense per month = Total lease rental / No. of months = Rs.24,000 / 12 = Rs.2,000
Now, let us have a look at the journal entry for recording the operating lease rental transaction for each month. Each month company will record the following entry:
Particulars
Debit
Credit
Rental expenses A/C Dr
2000
To Cash
2000
Operating lease accounting by both the parties:
The lessee should recognize the following during the lease period:
Cost of the lease in each period where the total cost of the lease would be allocated over useful life on the straight-line method
Any variable lease payments which have not been included in lease obligation
Any impairment of the right-of-use asset
The lessor should recognize the following;
Lease payments are charged to P/L Account over the term of the lease on the straight-line method.
Variable lease payments are recorded in P/L in the same reporting period of the events which caused lease transaction
Initial direct costs are recognized as expense over the term of the lease.
There are three concrete parts to the Balance sheet. The parts comprise of assets, liabilities, and Equity. These three parts are also based on the accounting equation is:
Shareholder’s equity= Assets – Liabilities
In simple words, the primary difference is that equity is the investors’ resources in the company and liabilities are the outsiders’ resources used by the company for time being for consideration called interest or for operating purposes. Now, let’s discuss the top 7 differences on the basis of the following:
1) Definition
Equity is the capital of the business. It is the money that is invested by the owner of the business i.e., the shareholders of the company.
In other words, equity can be defined as the assets which are created by the company after discharging its liabilities. It is always shown on the liabilities side of the balance sheet. It has a credit balance.
Liabilities are the obligations of the company arising out of past actions where is a probable outflow of money in the future. It is shown on the left side of the balance sheet. It is classified as a current and non-current liability.
2) Classification
Equity is two types with various iterations in them in terms of features. These are equity share capital and preference share capital. The retained earnings are attributable to equity shareholders.
Hence, it also forms part of equity. Equity is also termed stockholders’ equity. Technically equity does not have any classification.
Liabilities can be classified in two categories as Long-term liabilities or Non-current liabilities and Current Liabilities. Long term liabilities are those liabilities which are payable after one year. Current liabilities are those liabilities which are payable within current year.
3) Line Items
Line items are the presentation items as being shown in the balance sheet. Equity consists of contributed capital, treasury stock, preferred shares, and retained earnings. It is shown on Liabilities and Capital Side and under journal entries, these items are always credit items.
While making journal entries, liabilities are always credited unless there in decrease in liabilities. Liabilities consist of Non-current liabilities and Current liabilities. The line items consist of notes payable, long term debts, advance receipts, accounts payables, etc
4) Nature
Equity is the kind of fund invested by the shareholders to accrete value i.e. generate profits and optimize the value of the company as a whole.
On the other hand, liabilities are resources from the outsiders for the time being either a result of arrangement or transaction. The liabilities out of arrangements are long term liabilities and out of transactions are current liabilities.
5) Accounting Equation
The fundamental concept of the accounting equation is based on
Assets = Liabilities + equity
Here, Equity can be derived by subtracting liabilities from assets. Liabilities on the other hand is derived by subtracting equity from assets.
6) Link with Income Statement
Assets and Equity both are balance sheet items. However, they are closely linked to profit and loss statement. Retained earnings is part of equity.
Every year, the net profits are transferred to retained earnings after making the required payment of dividends.
On the other hand, liabilities are not directly related with income statement. However, all those payables which are accrued for the current year are still being shown on both income statement and balance sheet due to concept of accruals.
7) Outflows
Under equity, outflows are necessary only under the case of dividend distribution or when the company is liquidated.
On the other hand, there is regular payments being made to current liabilities and occasional cash flows to long term liabilities.
The summary of differences between them are given below:
Basis of difference
Equity
Liabilites
Definition
It is the money invested by owners in the business
It is the money owed by the company.
Purpose
Used for buying assets or discharging debts of company
Laibilities are burden to the company and are paid off by the company in due course.
Classification
Divided into equity share capital, preference share capital, reserves and surplus etc.
Classified as current and non-current liabilities.
Ownership
Equity is the fund of owner.
Funds go out from the company in payment of liabilities.
Accounting equation
Equity= Assets- Liabilities
Liabilities = Assets- Equity
Nature
Equity is the source of funds to acquire resources
Liabilities arise during procurement of funds and application of funds.
Link with income statement
Retained earnings link equity with income statement.
There is no direct link between liabilities and income statement
Line items
Equity consists of contributed capital, treasury stock, preferred shares and retained earnings.
The line items consist of notes payable, long term debts, advance receipts, accounts payables, etc
There are three concrete parts to the Balance sheet. The parts comprise of assets, liabilities, and Equity. These three parts are also based on the accounting equation is:
Shareholder’s equity= Assets – Liabilities
In simple words, the primary difference is that equity is the investors’ resources in the company and assets is that of the company whose balance sheet is prepared. Now, let’s discuss the top 7 differences on the basis of the following:
1) Definition
Equity is the capital of the business. It is the money that is invested by the owner of the business i.e., the shareholders of the company.
In other words, equity can be defined as the assets which are created by the company after discharging its liabilities. It is always shown on the liabilities side of the balance sheet. It has a credit balance.
Assets are the resources controlled by the entity from which the future economic benefits are expected to flow to the enterprise.
Examples include land and building, furniture, debtors, stock, cash in hand, etc. Assets are shown on the debit side of the balance sheet.
2) Classification
Equity is two types with various iterations in them in terms of features. These are equity share capital and preference share capital.
The retained earnings are attributable to equity shareholders. Hence, it also forms part of equity. Equity is also termed stockholders’ equity.
Assets can be classified as tangible assets (can be touched) and intangible assets (can’t be touched). Examples of tangible assets are land and building, furniture etc.
Examples of intangible assets are goodwill, patents, copyright, trademark, etc. Assets are the application of funds hence; they have a debit balance.
3) Line Items
Line items are the presentation items as being shown in balance sheet. Equity consists of contributed capital, treasury stock, preferred shares and retained earnings.
It is shown on Liabilities and Capital Side and under journal entries, these items are always credit items.
While making journal entries, assets are always debited unless there in a decline in assets. Assets consist of Non-current Assets and Current assets.
Non-current assets consist of fixed assets and intangible assets. Current assets consist of cash and cash equivalent, inventory, accounts receivables, and prepaid expenses
4) Nature
Equity is the kind of fund invested by the shareholders’ to accrete value i.e. generate profits and optimize the value of the company as a whole.
On the other hand, Assets are the resources of the company needed to run the daily affairs of the enterprise. Current assets are for example very helpful in the operating cycle of the revenue.
5) Accounting Equation
The fundamental concept of the accounting equation is based on
Assets = Liabilities + equity
Here, Equity can be derived by subtracting liabilities from assets. Assets on the other hand is the sum of equity and liabilities.
6) Link with Income Statement
Assets and Equity both are balance sheet items. However, they are closely linked to profit and loss statement. Retained earnings is part of equity. Every year, the net profits are transferred to retained earnings after making the required payment of dividends.
On the other hand, depreciation is operating expense in income statement which is transferred to accumulated depreciation which is reduced from the historical cost of the asset to show assets at written down value.
7) Depreciation & amortization
There is no depreciation in the equity. While fixed assets are reported at historical cost i.e. gross fixed assets less accumulated depreciation to arrive at written down value. A similar case is for amortization which is applicable for intangible assets.
Comprehensive differences between Equity and Assets
The differences between equity and assets including above top 7 differences and others are given below:
Basis of difference
Equity
Assets
Definition
It is the money invested by owners in the business
They are the resources controlled by the entity.
Purpose
Used for buying assets or discharging debts of company
Gives economic benefits to the entity
Categorization
No category
Classified as fixed assets and current asset
Ownership
Equity is the fund of the owner.
Assets are the property of company. Owner doesn’t have right over the assets of company.
Accounting equation
Equity= Assets- Liabilities
Assets= Equity + Liabilities
Balance
It has credit balance
It has debit balance.
Presentation in balance sheet
Reflected on the left side i.e., liability side of balance sheet
Reflected on the right side i.e., asset side of balance sheet
Accounts type
It is personal account
It is a real account
Accounting principle
It is based on principle of Cr the giver.
It is based on what comes in.
Reduction in value
There is no reduction in value
There is reduction in value due to wear and tear.
Appreciation
There is no appreciation in equity
Assets value get appreciated in due course of time
Depreciation
Equity don’t get depreciated
There will be a gradual decline in its value due to depreciation
Line items
Equity comprises capital, retained earnings, reserves, and surplus
Assets comprise land and building, cash and cash equivalent, receivables etc.
Nature
Equity is the source of funds to acquire resources
It is the resource required to operate a business
Reporting
It is reported at book value
It depends on the asset whether it will be recorded at book value or market value
Consignment inventory represents stock legally owned by one company or business but held by another. Usually, the risks and rewards associated with consignment inventory remain with the company that owns it.
Consignment inventory is common in industries where companies transfer their goods to the dealer, which distribute or sell them further. The dealer, in this case, is only responsible for its distribution or retail operations.
As mentioned, there are usually two parties involved in the consignment deal. The first party, the consignor, is the company that provides the goods. The other party, the consignee, is the company or business that holds the physical inventory.
The consignee also has the option to return any unsold or damaged goods to the consigner. Other names used for consignment inventory are consignment goods or consignment sales.
Accounting Treatment:
When it comes to the accounting treatment of consignment inventory, the standards are clear about it. Since the risks and rewards of the goods do not transfer due to the transfer, the consignor cannot record the inventory as sold.
However, some companies may still choose to convert inventory from one account to another to keep their records organized.
With consignment inventory, the consignor transfers the goods to the consignee, which sells the goods to customers. Once the consignee sells the goods, the risk and rewards related to the inventory get transferred.
The consignee also keeps a percentage of the sale proceeds and pays the consignor a predetermined sales amount.
Once the consignee sells the inventory, the consignor can record the sale amount. As with any other sale transaction, it consists of two double entries to the accounts.
The first double entry is to record the sale made through the consignee, while the second double entry is to record the decrease in inventory. Therefore, the consignor can only reduce its inventory account once it receives the sale proceeds.
On the other hand, if the consignee fails to sell all the goods transferred, they will return those goods to the consignor. In that case, the consignor doesn’t need to pass any double entry since the risks and rewards stay the same.
If the consignor had transferred the inventory into a different account, then they can convert the goods back to their finished goods account.
Journal Entry:
As mentioned, when the consignor transfers goods to the consignee, the risks and rewards still remain. Therefore, the consignor doesn’t need to pass a journal entry to the accounts.
However, some consignors may use the following double entry to transfer inventory into a different account, for the organization.
Entry
Description
Amount
Dr
Consignment inventory
x
Cr
Finished goods
x
Once the consignee sells the goods, it will repay the consignor the sale proceeds. It is when the risks and rewards transfer and the consignor can record the sale.
As mentioned, the consignor must use two double entries to record the transaction. The first journal entry used to record the sale proceeds is as follows.
Entry
Description
Amount
Dr
Cash or Bank
x
Cr
Sales
x
The next journal entry is to reduce the inventory. The treatment will differ according to whether the consignor has transferred the goods to a temporary consignment inventory account. The journal inventory is as follows.
Entry
Description
Amount
Dr
Cost of sales
x
Cr
Consignment inventory / Finished goods
x
In case the consignee returns unsold goods, the consignor doesn’t need any accounting entries. However, if the consignor had transferred the goods to a temporary consignment inventory account, it must reverse the accounting treatment.
Example:
A company, ABC Co., transfers its goods to another company, XYZ Co., which further sells their goods to customers. At the start of the year, ABC Co. sends goods valued at $100,000 to XYZ Co.
Subsequently, at the end of the year, XYZ Co. returns $20,000 worth of goods to ABC Co.
For the $80,000 goods sold, XYZ Co. gives ABC Co. $120,000 sale proceeds collected from its customers through a bank transfer.
Firstly, ABC Co. must record the sale proceeds for goods sold by XYZ Co. The accounting treatment will be as follows.
Entry
Description
Amount
Dr
Bank
$120,000
Cr
Sales
$120,000
Similarly, ABC Co. must record the transfer of its inventory to customers, which marks a transfer of risks and rewards. The accounting treatment is as follows.
Entry
Description
Amount
Dr
Cost of sales
$80,000
Cr
Finished goods
$80,000
For the goods that XYZ Co. returned, ABC Co. does not need to pass any accounting entries.
Conclusion:
Consignment inventory refers to goods transferred from a company to another party while still holding its risks and rewards.
Therefore, there are two parties in a consignment inventory deal, the consignor and the consignee. The accounting treatment for consignment inventory depends on whether the consignee sells the goods or not.
