In This Chapter
▶ Discovering two ways to present an income statement
▶ Classifying the three business types
▶ Identifying the common income statement sections
▶ Keeping an eye out for unusual income statement accounts
▶ Preparing an income statement
▶ Staying current with regulations
T
his chapter gives you a comprehensive overview of how to prepare an income statement: the financial document that reflects a company’s rev- enue and expenses. The ultimate purpose of an income statement is to show whether a company made or lost money during the accounting period.In this chapter, you learn the difference between setting up the income state- ment in a single-step format and setting it up in a multiple-step format. You also discover how the type of business causes the presentation of the income statement to change slightly.
I introduce each section commonly found on the income statement, and I dis- cuss unusual items that sometimes show up. Finally, the income statement in all its glory is laid out on the table, from the entrée — gross revenues — to the dessert — net income after taxes.
Presenting the Income Statement in One of Two Ways
Before I get into the details of what you find on an income statement, I want you to realize that not every income statement looks exactly the same. That’s because you can prepare the basic income statement in one of two ways:
single-step and multiple-step. The multiple-step method provides just a bit more information than the single-step method and is the preferred format for the vast majority of publicly traded companies (those whose stock is for sale to the general public, like you and me, on one of the stock exchanges such as the NASDAQ).
In this section, I show you an example of each income statement format.
Looking at them, you may think that even the multiple-step format isn’t all that informative — neither type of statement contains very many numbers.
But as I show you later in the chapter in the section “Examining Income Statement Sections,” the income statement is actually chock-full of great information.
Recognizing the single-step format
In Figure 10-1, I offer an example of a single-step format income statement. All the main players in the income statement game are present — notably net sales and net income. I offer more details later in the chapter, but for now just know that net sales is gross sales less sales returns and allowances, and net income is what the company has made at the end of the day after sub- tracting out all expenses.
Figure 10-1:
A single- step format
income statement.
ABC, Inc.
Income Statement
For the Year Ending December 31, 2012
Net sales Cost of goods sold
Selling, general & administrative expenses Interest expense
Other income Income before taxes Provision for income taxes Net income
Basic earnings per share of common stock
$100,000 45,000 12,000 500 100 42,600 6,400
$ 36,200 $ 3.25
Completing the statement is the calculation for basic earnings per share of common stock, which shows net income allocated to investors based on the number of shares of common stock outstanding. This bottom line number is very important to the users of financial statements (see Chapter 1) because it tells them how well their investment in the stock of the company is faring.
Breaking it out with the multiple-step format
Using the same facts and circumstances as in Figure 10-1, Figure 10-2 shows the multiple-step format for an income statement. The big differences between the single- and multiple-step formats are the following:
Figure 10-2:
A multiple- step format
income statement.
ABC, Inc.
Income Statement
For the Year Ending December 31, 2012
Net sales Cost of goods sold Gross profit
Selling, general & administrative expenses Income from operations
Other income (expense):
Interest expense Other income Income before taxes Provision for income taxes Net income
Basic earnings per share of common stock
$100,000 45,000
$ 55,000 12,000
$ 43,000 (500) 100 42,600 6,400
$ 36,200
$ 3.25
✓ The multiple-step format has line items for gross profit and income from operations. This information is very helpful when doing ratio analysis (see Chapter 14).
✓ The multiple-step format uses parentheses to indicate certain items that are subtracted rather than added. The single-step format assumes the readers can figure out this information on their own.
✓ Finally, the multiple-step format has a separate section showing other income and (expense), while on the single-step format other income and other expense merely show up as line items.
I know, I know, these differences must seem insignificant. But they’re worth noting from the start of our discussion because in your career you’ll run across both types of income statements.
Defining Different Types of Businesses
You can break every business into one of three types: service, manufacturing, and merchandising. It’s important to realize which type you are working with when reviewing or creating any financial statement — including the income statement. That’s because not every type of account (which I introduce in Chapter 5) shows up on the financial statements for every company.
Providing a service
When the true value of what a business provides derives from any type of personal service rather than a tangible product, that business is a service type. Accountants, attorneys, physicians, and hair stylists are examples of people who run service businesses.
Here’s an example: As a certified public accountant (CPA), I create reports that are on paper and bound in client folders for my clients. Each client folder is a tangible product, but the client isn’t paying me for the relatively small cost of the paper and ink; it’s paying me for the intellectual product I provide on the paper.
One major tipoff that a company is a service type is if it doesn’t have any appreciable inventory. Most service type companies make purchases only for the job at hand so they won’t carry an inventory; the purchases are expensed to each job. If the company does retain some purchases, the amount is incon- sequential, especially when compared to a merchandising company (which sells products another company makes) or a manufacturing company (which makes the products it sells). I discuss these two types of companies next.
Merchandising to the public
A merchandiser is a retail business like Target or Sears or your local grocery store. The business purchases goods from a manufacturer (see the next sec- tion) and in turn sells them to the end user — a consumer like you or me.
Unlike a service business, the merchandiser has an inventory. The inventory consists of goods available for sale, which are ready to be stocked on the
produce, canned goods, baked goods, and so on. I show you how to account for merchandise inventory in Chapter 13.
Manufacturing a product
The finished goods sold by merchandisers have to come from somewhere, and that somewhere is the manufacturer. Because the manufacturer makes products from scratch, accounting for this type of inventory is much more complicated than accounting for products held by a merchandiser.
Manufacturers have three types of inventory:
✓ Direct materials: This is the inventory the company purchases to make the products. For example, to make a dress, it purchases fabric, thread, and buttons.
✓ Work in process: This inventory category includes all materials that have been partially but not completely made into sellable products. A work-in-process item could be a dress whose sleeves have not yet been sewn to the body of the dress.
✓ Finished goods: Finished goods are all products that are completely assembled but not yet sold to a customer. So our dresses are ready to leave the manufacturing plant as soon as a buyer puts in an order.
You learn how to account for manufacturing inventory in Chapter 13.
Examining Income Statement Sections
As you see in Figures 10-1 and 10-2, income statements are broken out into different sections. The main reason that items of revenue and expense are separated and reported in distinct sections is so the business owner can better use the income statement to make decisions and to isolate problems with the way the business is being run. (This will make more sense after you review all the income statement parts in this section — I promise.)
Before you get into the meat of the matter — all the different types of revenues and expenses — you have to know how to prepare a heading for a financial statement. The first line of the heading is always the name of the company. The second line identifies the type of report — in this case, ”Income Statement.” The third line in an income statement indicates the period covered by the statement; for example, “For the year ending December 31, 20XX.” (Note that the date on the report is not the date when the report itself was prepared.)
Two types of revenue
In this section, I explain two revenue accounts that appear on an income statement: gross sales and other income.
Gross sales
The first account on the income statement is always gross sales, which is the amount of income the company brings in doing whatever it’s in the business of doing. Some accountants refer to gross sales as gross receipts. Both names mean the same thing: revenue before reporting any deductions from revenue.
(I discuss these deductions later in this chapter in the section “Contra rev- enue accounts.”)
Gross sales start with an implicit or written contract between a company and its customer (and end with reporting the gross sales after they are earned and realizable, which I discuss in a moment). The contract states that an agreed-upon good or service is to be provided for a set amount of money.
Here’s an example of an implicit contract: I walk into a department store and buy a pair of pants. It is implicitly understood that when I take that garment to the checkout, I will exchange cash or a claim for cash (a credit card trans- action) for the amount on the pants’ price sticker.
An example of a written agreement is a contract for sale. Say that a depart- ment store signs a contract stating it wants to buy 500 pairs of pants from the manufacturer. This contract states all the expenses and obligations on the side of both the seller and the purchaser.
A company’s gross sales revenue includes only transactions that relate to the purpose of the business. In the department store example, revenue includes the gross amount of merchandise sold to customers. If that same company sells one of its company cars, you record the gain or loss on that transaction in the line called “other income or loss,” not gross sales. That’s because the company isn’t in the used car sales business. Income or loss unrelated to the business purpose isn’t part of gross sales. Find out more about this subject in the upcoming “Other income” section.
Financial accounting uses the accrual method of accounting (see Chapter 6) so a company can’t record gross receipts unless that money is earned and realizable. Here’s what these terms mean:
✓ For revenue to be earned, the job, whether it involves goods or services, has to be complete based upon the terms of the contract between the company and the customer.
✓ For revenue to be realizable means there is an expectation that the com- pany performing the service or providing the goods will be paid. When might revenue not be realizable? If, after the job is complete (but before the company is paid), a customer closes its doors and disappears or goes into bankruptcy, the revenue is no longer realizable.
Based on the above information, you can understand that cash doesn’t have to change hands for gross receipts to be earned and realizable. To address this fact, a company has an “accounts receivable” account holding the dollar amount of revenue that has not been paid. I discuss accounts receivable in Chapter 7.
Other income
You classify all other income the company brings in peripherally as other revenue or other income. (Either name is fine.) Your financial accounting text- book highlights three kinds of other income:
✓ Interest: Revenue a company earns from money on deposit
✓ Dividends: Revenue a company earns on investments it owns, such as stock in other businesses
✓ Gain on disposal of an asset: Revenue a company earns when it sells one of its assets, such as a car or desk, and makes money on the deal Note that while the gross sales account is your first income statement account, other income does not appear until later in the statement. That’s because, frankly, it’s not quite as significant as some of the other financial facts about the business. But the biggie reason in financial accounting is because that’s what generally accepted accounting principles (GAAP) dic- tate. (I explain why following GAAP is important in Chapter 4.)
Contra revenue accounts
In Chapter 5, I give you the lowdown on the rules of debits and credits. One of the immutable rules of accounting is that revenue accounts normally carry a credit balance. However, in the wonderful world of accounting, you have what are called contra accounts, which means the account carries a balance contrary to the normal balance. So a contra revenue account carries a debit balance instead of a credit balance.
The two contra revenue accounts you cover in your financial accounting class are “sales discounts” and “sales returns and allowances,” which I dis- cuss here.
Sales discounts
Sales discounts reflect any discount a business gives to a good vendor who pays early. For example, a customer’s invoice is due within 30 days of receipt of the good or service. If the customer pays early (what is considered early is spelled out in the terms of the contract), it gets a 2 percent discount. So if the invoice is for $100, the customer has to pay only $98. This doesn’t seem like such a big deal, but consider the difference between the invoice amount and payment amount if the invoice is for $10,000 or $100,000.
Sales returns and allowances
Sales returns reflect all products that customers return to the company after the sale is complete. For example, after I buy a pair of pants, per- haps I decide that I no longer want them. Back to the department store I go to return the garment and get a full refund for the purchase price plus sales tax.
Sales allowances reflect a discount in price given to a customer wanting to purchase damaged merchandise. A perfect example is that some stores sell scratch-and-dent appliances.
Gross sales less sales discounts and sales returns and allowances equals net sales. Figure 10-3 shows an example of how this calculation looks if a com- pany has gross sales of $300,000, sales discounts of $25,500, and sales returns of $1,000.
Figure 10-3:
Net sales.
Sales Sales
Less: Sales discounts
Sales returns and allowances Net sales
$300,000
$25,500
1,000 (26,500)
$273,500
The examples of income statements in your financial accounting textbook may show all three accounts (gross sales, sales discounts, and sale returns and allowances) with a net sales total like I show in Figure 10-3 and Figure 10-7 at the end of this chapter. Or your textbook may show just the consolidated line item “net sales,” which I show in Figures 10-1 and 10-2. Either mode of presen- tation is fine as long as you understand the accounting behind how gross sales turns into net sales.
Also, keep in mind that net sales is not an account in the chart of accounts.
It’s merely a total reflecting the ending figures in the revenue and contra rev- enue accounts.
Cost of goods sold
The cost of goods sold (COGS) on the income statement reflects all costs directly tied to any product a company sells, be it a merchandiser or a manu- facturing company. A service company will not have a COGS line because it does not sell a tangible product.
Because merchandisers sell products they purchase from manufacturers, their COGS is fairly easy to compute. That’s because merchandisers have only one type of inventory to keep track of: goods they purchase for resale.
As I note earlier in the chapter, a manufacturer has several different types of inventory, so figuring its COGS is a little trickier.
In this section, I talk about the easier COGS (merchandising) first and then tackle the more difficult COGS of the manufacturing company.
Merchandising COGS
Figuring COGS for a merchandising company starts with beginning inventory, which is the merchandise the company has available for sale at the beginning of the month (in other words, the leftover inventory from the prior month). I discuss inventory in depth in Chapter 13.
Next, you have to figure the cost of purchases. To do so, you add together two items:
✓ Purchases: Any new merchandise the company buys during the current month
✓ Freight-in: The shipping expense the business incurs in order to get the merchandise purchases from the manufacturer to its location
For example, if purchases for the month of April are $125,000 and freight-in is
$10,500, your cost of purchases is $135,500.
Your next step is to figure net purchases, which means cost of purchases less contra purchases. Once again, contra accounts raise their ugly heads! Two contra purchase accounts exist:
✓ Purchase discounts: This contra account reflects any discount a com- pany receives because it pays a merchandise invoice early. It’s the flip side of the contra revenue account “sales discount” — looking at the same event from the eyes of the customer rather than the seller.
✓ Purchase returns and allowances: This contra account consists of items a merchandiser orders that it returns to the supplier. Items may be returned if an order arrives too late to use, arrives damaged, or doesn’t contain what the company actually ordered. This account is the flip side of “sales returns and allowances” — looking at the same event
Because purchases are an expense and normally carry a debit balance, a contra purchase expense will carry a credit balance.
Cost of purchases less the two contra purchase accounts equals net pur- chases. For example, start with our cost of purchases of $135,500. Figure pur- chase discounts being $5,000 and purchase returns and allowances equaling
$7,000. Your net purchases amount is $123,500.
Adding net purchases to beginning inventory gives you cost of goods avail- able for sale. So if beginning inventory is $5,000, costs of goods available for sale is $128,500 ($123,500 + $5,000).
Okay, just one more calculation! Subtract ending inventory, which is the merchandise the company still has available for sale on the last day of the accounting period, from cost of goods available for sale. (Because the ending inventory was not sold, we are subtracting its costs from the goods available for sale.) Then you have your cost of goods sold! Continuing our example, if ending inventory is $10,000, your cost of goods sold is $118,500 ($128,500 –
$10,000).
Manufacturing COGS
Earlier in the chapter, I explain that manufacturers have three types of inventory: direct materials, work in process, and finished goods. To figure a manufacturing company’s COGS, you first have to calculate the cost of goods manufactured. What appears to be a simple single line item in the cost of goods sold for a manufacturing company is really a calculation in which many different variables are added and subtracted.
Check out Figure 10-4 to see how the manufacturing company’s COGS shows up on the income statement. Looks pretty bare-boned, doesn’t it?
Figure 10-4:
Computing COGS for a manu- facturing company.
Beginning finished goods inventory
Add: Costs of goods manufactured during the period Equals cost of goods available for sale
Minus: Ending inventory finished goods Equals cost of goods sold
$ XXXX XXX
$ XXXX ( XXXX)
$ XXXX
Here, I walk you through the preparation of the COGS line item “cost of goods manufactured during the period.” Most of the terms I use in this calculation have already been explained in this chapter, but I throw in a couple new ones as well: