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CHAPTER 6

THE INCOME STATEMENT: ITS

CONTENT AND USE

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Chapter Overview

Why is a company’s income statement important?

How are changes in a company’s balance sheet and income statement accounts recorded in its accounting system?

What are the parts of a retail company’s classified income statement, and what do they contain?

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What is inventory and cost of goods sold, and what inventory systems may be used by a company?

What are the main concerns of external decision makers when they use a company’s income statement to evaluate performance?

What type of analysis is used by external decision makers to evaluate a company’s profitability?

Chapter Overview

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Why the Income Statement is Important

A company’s income statement plays a key role in the decision making of the users by communicating the company’s revenues, expenses, and net income (or net loss) for a specific time period.

Companies use different titles for their income statements, such as statement of income, statement of earnings, or statement of operations, but they all communicate the same information.

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Why the Income Statement is Important

The income statement summarizes the results of a company’s operating activities for a specific accounting period.

An income statement is based on the following equation:

Revenues

Expenses-Net Income=

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Uses of a Company’s Income Statement

Exhibit 6-1

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Expanded Accounting System In Chapter 5, we learned that Owners’ Equity

has several components:

Even though revenues and expenses are part of Owners’ Equity, a company keeps separate accounts for each revenue and expense during an accounting period.

These are called

temporary accounts

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Asset, liability, and owners’ equity accounts are used for the life of the company to record the effects of its transactions on its balance sheet.

+=

Expanded Accounting System

These are called permanent accounts

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Revenues and Expenses

Revenues are the prices charged to customers and result in increases in assets (cash or accounts receivable) or decreases in liabilities (unearned revenues).

Expenses are the “efforts” or “sacrifices” to earn revenue. Expenses are the costs of providing goods and services and result in decreases in assets or increases in liabilities.

Revenues Net Income=Expenses-

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Recognizing Revenues

When a customer buys goods for cash or on credit, retail companies uses a Sales Revenue account to record the transaction.

When Sweet Temptations sells 10 boxes of milk chocolate for cash of $10 a box, a $100 sale occurs. The Cash account and the Sales Revenue account increase:

Assets = Liabilities + Owners’ Equity

+$100 (Cash)

+$100 (Sales Revenues)

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Recognizing Revenues: Sales Discounts

When a customer take advantage of credit terms that allow a discount for early payment, a sales discount arises.

Companies separately account for sales discounts given to customers, which ultimately reduces Sales Revenue.

2/10, n/30The customer is allowed a 2% discount if they pay within 10 days of the invoice date

The total invoice price is due in 30 days of the

invoice date

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Recognizing Revenues: Sales Discounts

If one of Sweet Temptation’s customer takes advantage of 2/10, n/30 discount terms on a $50 sale, the customer’s payment is accounted for as follows:

Assets = Liabilities + Owners’ Equity

+$49 (Cash)-$50 (Accounts

Receivable)

-$1 (Sales

Revenue)

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Recognizing Revenues: Sales Returns/Allowances

When a customer returns damaged or unacceptable merchandise, a sales return occurs.

When a customer is given an allowance for damaged merchandise kept, a sales allowance occurs.

In both cases, a company’s accounting system tracks the amounts, which ultimately reduce Sales Revenue.

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Recognizing Revenues: Sales Returns/Allowances

If one of Sweet Temptation’s customers returns two boxes of candy originally purchased for $10 cash each, the transaction would be recorded as follows:

Assets = Liabilities + Owners’ Equity

-$20 (Cash)

-$20 (Sales Revenue)

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Recognizing Revenues: Net Sales

At the end of an accounting period, the balance in the Sales Revenue account includes the initial sales revenue, less sales discounts and sales returns and allowances.

The balance in the sales revenue account is called “Net Sales” because the initial sales revenue is net of sales discounts and sales returns and allowances.

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Recognizing Expenses:Cost of Goods Sold

When retail companies sell merchandise to customers, they recognize the decrease in their inventory by matching this cost with the revenue recognized on the sale.

This account is known as “Cost of Goods Sold.” This represents one of a retail company’s major operating expenses during an accounting period to produce its revenues.

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When Sweet Temptations sells 10 boxes of milk chocolate inventory that costs $4.50 a box, the Inventory account decreases $45, which decreases Assets.

The Cost of Goods Sold (expense) account increases for $45, which decreases Owners’ Equity).

Assets = Liabilities + Owners’ Equity

-$45

(Inventory account)

-$45 (Cost of goods sold

account)

An increase in an expense has an inverse effect on net income and owners’

equity

Recognizing Expenses:Cost of Goods Sold

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How a company calculates its cost of goods sold depends on the type of inventory system used.

A company uses an inventory system to keep track of inventory purchased and sold during an accounting period.

There are two methods: the perpetual inventory system and the periodic inventory system.

Inventory Systems

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In a perpetual inventory system, a company keeps a continuous record of the cost of inventory on hand and the cost of inventory sold. Two entries are recorded every time there is a sale.

When Sweet Temptations sells chocolate for $100 cash that cost $45, the event is recorded as follows:

Perpetual Inventory Systems

Assets = Liabilities + Owners’ Equity

+$100 (Cash)

-$45 (Inventory)

+$100 (Sales Revenue)

-$45 (Cost of goods sold)

The sales event

The inventory event

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In a periodic inventory system, a company only records the sales that are made and does not keep a continuous record of the cost of inventory on hand.

When Sweet Temptations sells chocolate for $100 cash that cost $45, the event is recorded as follows:

Periodic Inventory Systems

Assets = Liabilities + Owners’ Equity

+$100 (Cash)

+$100 (Sales Revenue)

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In a periodic inventory system, the ending inventory is determined by physically counting the merchandise at the end of the accounting period.

The cost of goods sold, then, is computed using the following model:

Periodic Inventory Systems

Cost of Beginning Inventory

Cost of Net

Purchases+

Cost of Ending

Inventory-Cost of

Goods Sold =

The physical count of ending inventory

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Because cost of goods sold is usually a retail company’s largest expense, many companies subtract the cost of goods sold from net sales to determine gross profit.

Gross profit is the amount of revenue left over after recovering the cost of the products sold.

Cost of Goods Sold and Gross Profit

Net sales 8,100$ Cost of goods sold 3,645$ Gross profit 4,455$

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Activities such as having a sales staff, occupying building space, or running advertisements in the newspaper also cost money. These items are called operating expenses.

A company keeps track of its operating expenses in separate accounts. If Sweet Temptations pays $300 for advertising, the event is recorded as follows:

Operating Expenses

Assets = Liabilities + Owners’ Equity

-$300 (Cash)

-$300 (Advertising expense)

An increase in an expense has an inverse effect on net income and owners’

equity

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At the end of an accounting period, a company might also record additional expenses to ensure recognition in the correct accounting period. These are called adjusting entries.

If Sweet Temptations recognizes $15 in depreciation at the end of an accounting period, the event is recorded as follows:

Operating Expenses

Assets = Liabilities + Owners’ Equity

-$15 (Store

Equipment)

-$15 (Depreciationexpense)

An increase in an expense has an inverse effect on net income and owners’

equity

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A company might divide its operating expenses into two categories on its income statement.

Selling expenses relate to the sales activities of the company such as sales salaries, advertising, and delivery expense.

General and administrative expenses relate to the general management of the company such as office salaries expense, insurance expense, and office supplies expense.

Operating Expenses

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Operating Expenses

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Income Statement Usefulness

External users can assess a company’s ability to earn a stable stream of operating income to sustain its future, by evaluating current and prior results.

A company’s risk factors affects the expected investment return needed to attract investors and also affects the interest rate creditors charge on loans.

Ratios such as profit margin and gross profit percentage

provide benchmarks for risk, operating

capability,and financial flexibility.

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Ratio analysis consists of computations in which an item on a company’s financial statements is divided by another, related item.

Ratios provide “benchmarks” to compare a company’s performance with that of previous periods and with other companies.

Some ratios provide measures of a company’s profitability, which affects risk, operating capability, and financial flexibility.

Ratio Analysis

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Profit margin (sometimes called return on sales) relates net income to net sales:

Profit Margin Ratio

Net Income

Net Sales

A profit margin of 7.43% means that, on average, a company earns 7.43 cents on every $1.00 of sales.

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Gross margin percentage (sometimes called gross profit margin) relates a company’s gross profit to its net sales.

Gross Margin Percentage

Gross Profit

Net Sales

A gross margin of 55% means that, on average, 55 cents of every $1.00 in sales (after the cost of goods sold) is left over to cover operating expenses and produce a profit.

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This statement summarizes transactions affecting owners’ equity during an accounting period.

A company presents this statement to “bridge the gap” between its income statement and the amount of the owners’ capital on the balance sheet.

By summarizing the transactions affecting owners’ equity, this statement helps to complete the picture of the company’s financial activities for an accounting period.

Statement of Owners’ Equity

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Statement of Owners’ Equity

The amount reported on the income

statement for January

The amount of owners’ capital reported on the

balance sheet on January 31, 2004.

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Closing entries are made by a company to transfer the ending balances from its temporary revenue and expense accounts into its permanent owners’ equity account.

Closing Entries

Temporary accounts

Closing entries move

these balances into the

permanent owners’ equity

account.

Permanent account