CHAPTER F5
Tools of the Trade,
Part II: Income
Statement and
Statement of Owners’
Equity
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Learning Objective 1:
Describe how the income
statement provides
information about the
past performance of a
business.
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Income Statement
 This financial statement is intended to
provide information related to the results
of an entity's operations for a specific
time period; typically a year, quarter, or
month.
 It is more formally known as the
Statement of Earnings or the
Statement of Results of Operations.
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Revenues
 Inflows of assets to an entity from
delivering or producing goods,
rendering services, or carrying out
other activities. (FASB definition)
 Basically, revenues represent the things
of value that our customers have agreed
to pay us in exchange for the business
that we have conducted with them.
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Expenses
 Outflows or other using up of assets
from delivering or producing goods,
rendering services, or carrying out
other activities. (FASB definition)
 Basically, expenses represent the things
of value that we have used in order to
generate revenues for our business.
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Net Income
 Revenues - Expenses = Net Income
 Therefore, as revenues increase, net income
also increases. As expenses increase, net
income decreases.
 Similar to cost-benefit analysis, we usually
choose to incur expenses only if we believe
that they will generate revenues greater than
the cost of the expenses.
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Learning Objective 2:
Distinguish between
single-step and multistep
income statements.
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Basic Format
Com pan y A
In com e Statemen t
Fo r the Year En din g Decem ber 31, 2000
Reven ues:
Rev en ue type #1
Rev en ue type #2
Rev en ue type #3
To tal r even ues:
$4,000
3,000
2,000
Expen ses:
Expen se type #1
Expen se type #2
Expen se type #3
Expen se type #4
Expen se type #5
To tal exp enses:
$2,500
2,000
1,500
1,000
500
Net in co me:
$9,000
7,500
This basic
format is
also known
as the
Single-step
format of
the income
statement.
$1,500
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Cost of Goods Sold
 Both merchandising and manufacturing
companies sell products as their major
source of revenue. The costs associated
with the purchase or production of these
products is known as Cost of Goods
Sold.
 Cost of goods sold is also sometimes
called “cost of sales.”
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Discussion Question
Think of a fast-food restaurant, such as
your favorite burger joint. Make a list
of the costs you think the restaurant
incurs in its day-to-day operations.
Which of these costs do you think
should be included in the cost of goods
sold and which ones are other
expenses? Explain.
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Single-Step Format
Company A
Income Statement
For the Year Ending December 31, 2007
Revenues:
Sales
$4,000
Rent revenue
3,000
Interest revenue
2,000
Total revenues:
$9,000
Expenses:
Cost of goods sold $2,500
Wages expense
2,000
Utilities expense
1,500
Insurance expense
1,000
Interest expense
500
Total expenses:
7,500
Net income:
$1,500
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The different
revenues are added
together on top
The different
expenses are added
together on bottom
Expenses are
subtracted in a
“single step.”
Multistep Format
 The multistep format of the income statement
provides some subtotals that are not apparent
on the single-step statement.
 Gross margin (or gross profit) is shown as the
difference between sales revenue and the cost
of goods sold.
 Operating income is shown as the amount of
profit earned from the company’s primary
business activity.
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Multistep Format
Company A
Income Statement
For the Year Ending December 31, 2007
Sales
$ 4,000
- Cost of goods sold
2,500
Gross margin
$ 1,500
Wages expense
$ 2,000
Utilities expense
1,500
Insurance expense
1,000
Total operating expenses
4,500
Operating income
$ (3,000)
Other revenues:
Rent revenue
$ 3,000
Interest revenue
2,000
5,000
Other expenses:
Interest expense
(500)
Net income:
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1st subtotal
2nd subtotal
Bottom Line
$ 1,500
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Discussion Questions
 Try to identify two or three companies that
you think would have a large gross margin
on sales. In other words, which companies
do you think have a high markup for their
products?
 Try to identify two or three companies that
you think would have a low gross margin on
sales. Why would this be the case?
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Gross Margin Examples
 Intel Corp. 2005
Sales
COGS
Gross
Gross margin %
 Eli Lilly Co. 2005
38,826
15,777
23,049
59%
 Kimberly-Clark 2005
Sales
15,902
COGS
10,828
Gross
5,075
Gross Margin % 32%
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Sales
14,645
COGS
3,474
Gross
11,171
Gross margin % 76%
 Pepsico 2005
Sales
32,562
COGS
14,176
Gross
18,386
Gross Margin % 56%
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Discussion Questions
 Consider the following simplified multistep
income statement for Terrell and Co.:
 Sales (1,000 units)
$500,000
 LESS: Cost of goods sold
(550,000)

Gross margin
($50,000)
 LESS: Other expenses
($45,000)

Net income (loss)
($95,000)
 What can you learn from Terrell’s gross margin?
 How many units must be sold to earn a profit?
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Relationship Between Net
Income and Owners’ Equity
 Any net income earned by a business
during an accounting period is considered to
be an increase in the owners’ equity in the
business.
 If the company suffers a net loss for the
period, the amount of the loss is reflected as
a reduction in the owners’ equity in the
business.
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Learning Objective 3:
Explain the impact of net
income or net loss on
owners’ equity.
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Relationship Between Net
Income and Owners’ Equity
 Remember from Chapter 3 that there
are two sources of equity: owner
investments and company earnings.
 Therefore, income (or losses)
“become” a part of owners’ equity.
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Statement of Owners’ Equity
 The Statement of Owners’ Equity
“connects” the Balance Sheet to the
Income Statement.
 It shows the beginning balance and ending
balance of the owners’ equity accounts
(from the balance sheet), and the
increases or decreases in each of the
accounts.
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Learning Objective 4:
Construct statements of
capital for proprietorships
and partnerships.
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Statement of Owners’ Equity
 The exact format of the statement
depends on the form of business
organization: corporation, partnership, or
proprietorship.
 A proprietorship or partnership will have
a Statement of Capital.
 A corporation will have a Statement of
Stockholders’ Equity.
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Statement of Capital Proprietorships
Company A
Statement of Capital
For the Year Ending December 31, 2007
Owner, Capital, 1/1/2007
ADD: Net Income
LESS: Drawings
Owner, Capital, 12/31/2007
$9,750
1,500
11,250
-2,000
$9,250
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Statement of Capital Partnerships
Company B
Statement of Capital
For the Year Ending December 31, 2007
Partner #1, Capital, 1/1/2007
ADD: Net Income
LESS: Drawings
Partner #1, Capital, 12/31/2007
Partner #2, Capital, 1/1/2007
ADD: Net Income
LESS: Drawings
Partner #2, Capital, 12/31/2007
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$15,000
2,500
17,500
-1,000
$16,500
1st partner
$12,000
1,500
13,500
-2,000
$11,500
2nd partner
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Learning Objective 5:
Identify the differences between
statements of stockholders’ equity
and statements of retained
earnings for corporations and
construct the statement of
stockholders’ equity.
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Statement of Stockholders’
Equity - Corporations
Corporation C
Statement of Stockholders' Equity
For the Year Ending December 31, 2007
Common
Add'l Retained Total
Stock
Paid
Earnings Equity
Balance, 1/1/07
Net income
Dividends
Balance 12/31/07
$2,000
$40,000
$2,000
$40,000
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$8,000 $50,000
10,000 10,000
-7,500 -7,500
$10,500 $52,500
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Statement of
Retained Earnings
 If there has been no change in the amount
of contributed capital, a corporation can
choose not to issue a Statement of
Stockholders’ Equity.
 Instead, a Statement of Retained
Earnings can be issued. This statement
shows the beginning R.E. balance, net
income or loss, dividends, and ending
R.E. balance.
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Statement of Retained
Earnings - Corporations
Corporation C
Statement of Retained Earnings
For the Year Ending December 31, 2007
Retained earnings, 1/1/2007
ADD: Net Income
LESS: Dividends
Retained earnings, 12/31/2007
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$8,000
10,000
18,000
-7,500
$10,500
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Learning Objective 6:
Compare and contrast the
impact of drawings on
statements of capital and the
impact of dividends on the
statements of stockholders’
equity and statements of
retained earnings.
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Distributions to Owners
 At some point, business owners usually
either desire or require a distribution of cash
from the business. These distributions
reduce the amount of owners’ equity.
 In most cases, these distributions represent
a return on investment for the owners, but it
is possible that they are a return of
investment.
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Drawings - Proprietorships
and Partnerships
 When a proprietor or a partner receives a
distribution from the business it is called a
drawing or withdrawal.
 A proprietor can determine when and how
much of a drawing to take.
 Partners are somewhat restricted and
usually are allowed withdrawals that have
been previously agreed to by all partners.
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Learning Objective 7:
Explain why dividends are
paid and under what
circumstances they can be
paid.
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Corporate Distributions
 Distributions to stockholders of a
corporation are called dividends.
 Many corporations pay fairly predictable
dividends on a regular basis, usually every
quarter. Other corporations choose not to
pay dividends in order to help the
company grow by reinvesting earnings.
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Cash Dividends
 To pay cash dividends to stockholders, a
corporation must have the following:
1) Sufficient retained earnings: after paying
the dividend, there must be a positive
balance in retained earnings.
2) Sufficient cash: just like paying a bill to a
supplier, the corporation must have enough
cash on hand in order to pay the dividend.
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Dividend Dates
There are three important dividend dates:
1) Date of Declaration: when the board of
directors decides to pay a dividend.
2) Date of Record: stockholders who own
the stock on this date will receive the
dividend.
3) Date of Payment: the corporation settles
the dividend liability by making payment to
the stockholders.
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Discussion Questions
 If Company A has paid a steadily
increasing dividend every year for thirty
years, and Company B has never paid a
dividend, would that influence you if you
were deciding in which of these two
companies to buy stock?
 Can you think of reasons why you still
might prefer Company B over A?
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Learning Objective 8:
Describe in your own
words the articulation of
income statements,
balance sheets, and
statements of owners’
equity.
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Articulation
 There is a linkage between the three
financial statements known as
articulation.
Statement
of
Capital
Income
Statement
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Balance
Sheet
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Articulation
 Income Statement: the revenues and
expenses are listed to determine net
income (or loss).
 Statement of Capital: the net income
is added to help determine the ending
capital balance.
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Articulation
 Balance Sheet: the ending capital
balance is reported in the owners’
equity section of the balance sheet.
Therefore, net income flows forward
into the balance sheet.
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Discussion Questions
 The balance sheet for the corporate form of
business is a bit more detailed than that for
the proprietorship. Comparing the two, what
can you learn from the corporate balance
sheet that you would not know from looking at
the proprietorship’s balance sheet?
 In particular, what can you learn about past
earnings of the company?
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End of Chapter 5
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