Chapter 15 Notes
Chapter 15.1 Preparing an Income Statement
Review of Accounting Principles
 Record financial activities of a business in journals and ledgers during a fiscal period.
 Prepare a work sheet at the end of the fiscal period to organize and summarize the
financial information.
 Use the completed work sheet to prepare financial statements.
Financial Statements
 Provide the primary source of information needed by owners and managers to make
decisions on the future activity of a business
 Hobby shack prepares three financial statements
o Income Statement
o Statement of Stockholders’ equity
o Balance sheet
Terms
 Net Sales
o Total sales less sales discount and sales returns and allowances
 Cost of Merchandise Sold
o The original price of all merchandise sole during a fiscal period
 Also called cost of goods sold
 Cost of sales
 Gross Profit on sales
o The revenue remaining after cost of merchandise sold has been deducted
 Financial Ratio
o A comparison between two items of financial information
 Earnings per Share
o The amount of net income after federal income tax belonging to a single share of
stock.
 Price-earnings ratio
o The relationship between the market value per share and earnings per share of a
stock
 Statement of stockholders’ equity
o Shows changes in a corporation's ownership for a fiscal period contains two
major sections capital stock and retained earnings.
 Par Value
o A value assigned to a share of stock and printed on the stock certificate
 Supporting Schedule
o A report prepared to give details about an item on a principal financial statement
Objectives
 Define accounting terms and concepts related to financial statements for a merchandising
business organized as a corporation.
 Prepare an income statement for a merchandising business organized as a corporation
Preparing an Income Statements
5.1 Uses of Financial Statements
Uses of Financial Statements
 Provide primary source of information needed by owners and managers to make
decisions on the future activity of a business
 Provide information about a business’s financial condition, changes in this financial
condition and progress of operations.
o Allows for more sound business decisions
 Hobby Shack prepares three
o Income statement, balance sheet and Statement of Stockholders’ equity.
Income Statement Information on a Work Sheet
 Income statement is used to report a business’s financial progress during a fiscal period.
 Information from a completed work sheet is used to prepare an income statement.
 Income Statement of a merchandising business has three main sections
1. Revenue
2. Cost of Merchandise Sold
3. Expenses
 Most information reported on the income statement is taken from the income statement
columns of the work sheet.
Revenue Section on an Income Statement
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More accounts to report on the income statement.
The accounts Sales and its contra accounts, Sales Discount and Sales Returns and
Allowances, are reported in the Revenue Section.
Total sales less sales discount and sales returns and allowances is called net sales.
Cost of Merchandises sold section of an Income statement
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The original price of all merchandise sold during a fiscal period called the cost of
merchandise sold also called Cost of goods sold or Cost of Sales. Concept: Historical
Cost
The cost of merchandise sold is calculated from five amounts found on the work sheet. 3
are found in the income statement. Other amounts are found in the Trial Balance and
Balance Sheet columns of the worksheet.
Income Statement Cont.
 Gross Profit of Sales = the revenue remaining after cost of merchandise sold has been
deducted.
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Management uses gross profit on sales as a measure for how effectively the business is
performing in its primary functions of buying and selling merchandise.
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Calculating a ration between gross profit on sales and net sales enables management to
compare its performance to prior fiscal periods.
Income Statement
The percentage relationship between one financial statement item is known as a component
percentage.
Completing An Income Statement
Component Percentage
Audit Your Understanding
1. What is the major difference between the income statement for a merchandising business
and a service business?
 The cost of merchandise sold section
2. How is the cost of merchandise sole calculated?
 Merchandise Inventory + Purchases = Total Cost of Merchandise Available for Sales Ending Merchandise Inventory = Cost of Merchandise Sold.
3. How can the amount of net income calculated on the income statement be verified?
 By comparing the amount calculated on the income statement with the amount on the
work sheet.
15.2 Analyzing Income Statement
Objectives
Analyze an Income statement using component percentages and financial ratios.
Terms
Financial Ratio
A comparison between two items of financial information
Earnings per Share
Amount of net income after federal income tax belonging to a single share of stock
Price-Earnings Ratio
The relationship between the market value per share and earnings per share of a stock
report.
15.2 Analyzing an Income Statement
Objectives
 Define accounting terms related to financial statements
 Identify accounting concepts and practices related to financial statements for a
merchandising business organized as a corporation.
 Analyzing an Income Statement using component percentages and financial ratios
Using Component Percentages
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A percentage relationship between one financial statement item and the total that includes
that item is known as a component percentage.
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Using Component %
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Every sales dollar reported on the Income Statement includes four components
1. Cost of Merchandise Sold
2. Gross Profits on sales
3. Total Expenses
4. Net Income Before Income Tax
To make decisions about future operations Hobby Shack analyzes relationships between these
four income statement components and sales.
Component Percentages
 In order for the percentage to be useful, a business must know:
1. Industry standards
2. Past performance of the company in more than one fiscal period
3. Company’s goals and objectives
Cost of Merchandise Sold Component Percentage
 The cost of merchandise sold is a major cost and must be kept as low as possible
 Hobby Shacks is 44.9%
 Less than maximum acceptable percentage of 46%
 Considered acceptable
Gross Profit on Sales Component Percentage
 Gross Profit must be large enough to cover total expenses and the desired amount of net
income.
 Acceptable Industry standards show that at least 54 cents or 54% of each sales dollar
should result in gross profit.
 Hobby Shack’s GP on sales is 55.1% or 55 cents per each sales dollar.
 GP 55.1% is not less than the minimum acceptable percentage 54.0%
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Therefore is acceptable.
Total Expenses Component Percentages
 Total expenses must be less than gross profit on sales to provide a desirable net income.
 Acceptable industry standards show that no more than 35 cents or 35% of each sales
dollars should be devoted to total expenses.
 Hobby Shack’s is 33.9%
 Is that acceptable?
 Yes!!
Net Income Before Federal Income Tax Component Percentage
 Shows progress being made by a business.
 Acceptable industry standards show that 19 cents or 19% of each sales dollars should
result in net income.
 Hobby Shack shows 21.25%
 Hobby Shacks is 21.2% is NOT less than the minimum acceptable percentage, 19.0%.
 Is it acceptable?
 Yes!!
Analyzing an Income Statement
 Actions to Correct Unacceptable Component Percentages
 Goal of a business is to have Net Income!
Unacceptable Percentage for Gross Profit on Sales
 Increase Sales Revenue
 Decrease cost of merchandise sold
 Increase sales revenue and decrease cost of merchandise sold
Unacceptable Component Percentages for Total Expenses.
 Each expense account must be reviewed to determine if major increases have occurred.
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This review should include comparisons with prior fiscal periods as well as with industry
standards.
Actions then must be taken to reduce any expenses for which major increases have occurred
or that are beyond industry standards.
Unacceptable component Percentage for Net Income before Federal Income Tax
 If component percentages for cost of merchandise sole, gross profit on sales, and total
expenses are brought within acceptable ranges
 This will also be acceptable.
 Financial Ratio
Comparison between two items of financial information.
 Most ratios include at least one amount reported on the financial statements.
Earnings Per Share
 Amount of Net Income after federal income tax belonging to a single share of stock.

Most recognized measure of a corporation’s financial performance.
Price-Earnings Ratio
 Relationship between the market value per share and earnings per share of a stock.
 PE ratio
 Provides information related to the price of the stock relative to earnings.
 Low PE Ratio - Slow Growth Company
 High PE Ratio – Dynamic Growth
Finacial Ratios
Audit Your Understanding
1. For a merchandising business, every sales dollar includes what four components?
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2. How does a company determine acceptable component percentages?
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3. What is the result if total expenses are greater than gross profit on sales?
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15.3 Preparing a Statement of Stock Holder’s Equity
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Statement of Stockholders Equity
• Shows changes in a corporation's ownership for a fiscal period
• Two Sections
• Capital Stock
• Retained Earnings
• (amount earned by corporation but not yet distributed)
• Shows account balances the par value and number of shares issued – prior,
current, and total
Par Value
• A value assigned to a share of stock and printed on the stock certificates.
• Does NOT represent the fair market value of the stock
LESSON 15-4 - Preparing a Balance Sheet
Balance Sheet Who Cares?
 Reports businesses financial condition on a specific date
 Three main sections: assets, liabilities, and stockholders’ equity
 Concept Accounting Period Cycle
Used for:
 Making business decisions
 Determine whether the corporation should incur additional liabilities to acquire additional
plant assets.
Information needed is obtained from:
 Balance sheet columns of a work sheet
 Owners’ equity statement
CURRENT ASSETS SECTION OF A BALANCE SHEET
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Assets classified into current and plant.
Listed separately on the balance sheet by headings.
Some asset accounts have related contra accounts that reduce the related account on the
balance sheet.
Difference between as asset’s account balance and its related contra account balance is
known as book value.
Book value is reported on a balance sheet by listing three amounts:
1. Balance of the asset account
2. Balance of the asset’s contra account
3. the book value
PLANT ASSETS SECTION OF A BALANCE SHEET
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Plant Assets section:
The accumulated depreciation account balance is deducted from its related plant account
balance to calculate the book value of each asset category.
Note that the total current assets amount was calculated on the previous page.
LIABILITIES SECTION OF A BALANCE SHEET
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Just like assets liabilities are divided into current and long-term. Current are due within a
year and long term more than a year. Example of a long term liability is Mortgage
Payable.
Note Payable, Interest Payable, Dividends Payable
STOCKHOLDERS’ EQUITY SECTION OF A BALANCE SHEET
Aplia Time!!
Print the problems for the
worksheets so you know where
to get the information needed