THE INCOME STATEMENT: ITS CONTENT AND USE

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• CHAPTER 6
• THE INCOME STATEMENT ITS CONTENT AND USE

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Chapter Overview

• Why is a companys income statement important?
• How are changes in a companys balance sheet and
  income statement accounts recorded in its
  accounting system?
• What are the parts of a retail companys
  classified income statement, and what do they
  contain?

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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 companys income statement
  to evaluate performance?
• What type of analysis is used by external
  decision makers to evaluate a companys
  profitability?

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Why the Income Statement is
Important

• A companys income statement plays a key role in
  the decision making of the users by communicating
  the companys 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
  companys operating activities for a specific
  accounting period.
• An income statement is based on the following
  equation

Revenues
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Uses of a Companys 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.

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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.

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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.

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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

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/30
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Recognizing Revenues Sales Discounts

• If one of Sweet Temptations customer takes
  advantage of 2/10, n/30 discount terms on a 50
  sale, the customers payment is accounted for as
  follows

-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 companys accounting system
  tracks the amounts, which ultimately reduce Sales
  Revenue.

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Recognizing Revenues Sales Returns/Allowances

• If one of Sweet Temptations customers returns
  two boxes of candy originally purchased for 10
  cash each, the transaction would be recorded as
  follows

-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 ExpensesCost 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 companys major
  operating expenses during an accounting period to
  produce its revenues.

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Recognizing ExpensesCost 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).

-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

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

100 (Sales Revenue)
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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 Beginning Inventory
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Cost of Goods Sold and
Gross Profit

• Because cost of goods sold is usually a retail
  companys 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.

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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

-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

-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
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Income Statement Usefulness
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 companys financial statements is
  divided by another, related item.
• Ratios provide benchmarks to compare a
  companys performance with that of previous
  periods and with other companies.
• Some ratios provide measures of a companys
  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

• 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 companys gross profit
  to its 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 companys financial activities for
  an accounting period.

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Statement of Owners Equity
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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.