CHAPTER 6
THE INCOME STATEMENT:
ITS CONTENT AND USE
1
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?
2
Chapter Overview
 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?
3
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.
4
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
5
Uses of a Company’s
Income Statement
Exhibit 6-1
6
Expanded Accounting System
 In Chapter 5, we learned that Owners’ Equity
has several components:
These are
called
temporary
accounts
 Even though revenues and expenses are part
of Owners’ Equity, a company keeps separate
accounts for each revenue and expense
during an accounting period.
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Expanded Accounting System
 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.
=
+
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
-
Expenses
=
Net Income
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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
+$100
(Cash)
= Liabilities + Owners’ Equity
+$100 (Sales
Revenues)
10
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.
The customer
is allowed a
2% discount if
they pay within
10 days of the
invoice date
2/10, n/30
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
+$49 (Cash)
-$50 (Accounts
Receivable)
= Liabilities + Owners’ Equity
-$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
-$20
(Cash)
= Liabilities + Owners’ Equity
-$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.
15
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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Recognizing Expenses:
Cost of Goods Sold
 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)
An increase in
an expense has
an inverse effect
on net income
and owners’
equity
-$45 (Cost of
goods sold
account)
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Inventory Systems
 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.
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Perpetual Inventory Systems
 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:
Assets
= Liabilities + Owners’ Equity
+$100 (Cash)
The sales
event
-$45
(Inventory)
The inventory
event
+$100 (Sales
Revenue)
-$45 (Cost of
goods sold)
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Periodic Inventory Systems
 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:
Assets
+$100
(Cash)
= Liabilities + Owners’ Equity
+$100 (Sales
Revenue)
20
Periodic Inventory Systems
 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:
Cost of
Goods Sold
=
Cost of
Beginning
Inventory
+
Cost of
Net
Purchases
-
Cost of
Ending
Inventory
The physical count of ending inventory
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Cost of Goods Sold
and Gross Profit
 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.
Net sales
Cost of goods sold
Gross profit
$ 8,100
$ 3,645
$ 4,455
22
Operating Expenses
 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:
Assets
-$300
(Cash)
= Liabilities + Owners’ Equity
An increase in
an expense has
an inverse effect
on net income
and owners’
equity
-$300 (Advertising
expense)
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Operating Expenses
 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:
Assets
-$15
(Store
Equipment)
= Liabilities + Owners’ Equity
An increase in
an expense has
an inverse effect
on net income
and owners’
equity
-$15 (Depreciation
expense)
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Operating Expenses
 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.
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Operating Expenses
26
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
 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.
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Profit Margin Ratio
 Profit margin (sometimes called return
on sales) relates net income to net
sales:
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
 Gross margin percentage (sometimes
called gross profit margin) relates a
company’s gross profit to its net sales.
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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Statement of Owners’ Equity
 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.
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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
 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 move
these
balances
into the
permanent
owners’
equity
account.
Permanent account
Temporary accounts
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