An income statement may be prepared in either the multiple step Or the single-step format. The multiple-step income statement is more useful in illustrating accounting concepts. A multiple-step income statement for Computer Barn is illustrated below:
The multiple-step income statement is so named because of a series of Steps in which costs and expenses are deducted from revenue. As a first step, the cost of goods sold is deducted from sales revenue to determine the subtotal gross profit. As a second step, operating expenses are deducted to obtain a subtotal called operating income (or income from operations). As a final step, “non operating” items are taken into consideration to arrive at net income.
Notice that the income statement is divided into four major sections (1) revenue, (2) cost of goods sold, (3) operating expenses, and (4) non operating items. Multiple-step income statements are noted for their numerous sections and the development of significant subtotals.
The Revenue Section
The revenue section of an income statement usually contains only one line, entitled Net sales. Net sales represents the balance in the sales revenue account, less some minor adjustments for transactions such as refunds made to customers. These adjustment to sales revenue usually are not material in dollar amount and seldom are shown as separate items in the body of the income statement.
The trend in net sales from period to period is considered by many users of financial statements to be a key indicator of a company’s future prospects. Increasing sales suggest the probability of larger profits in future periods. Declining sales, on the other hand, may provide advance warning of financial difficulties.
In our economy, most prices increase over time. The average increase in prices during the year is called the rate of inflation. Because of inflation, a company’s total dollar sales may increase somewhat from year-to- year without any increase in the quantity of merchandise sold. If a company is selling more merchandise each year, its net sales usually increase faster than the rate of inflation.
The Cost of Goods Sold Section
The matching principle requires that revenue be offset by the costs and expenses incurred in generating that revenue. Therefore, revenue from sales must be offset by the cost to the merchandising business of acquiring the goods which it sells. The cost of goods sold usually is shown as a single amount in the income statement.
A Key Subtotal Gross profit is the different between the sales revenue earned during the period and: the cost to the business of the merchandise it has sold. In evaluating the performance of a merchandising company, many analysts find it useful to express the gross profit as a percentage of net sales. This percentage is called the gross profit rates In 1994, Computer Barn has an average gross profit rate of 40% (gross profit, $360,000, divided by net sales, $900,000, equals 40%).
By computing the gross profit rate earned in successive accounting periods, users of financial statements may gain insight into the strength of the company’s products in the market place. A rising gross profit rate usually means that demand for the company’s products is strong enough that the company has been able to increase its sales prices. A declining gross profit rate, on the other hand, generally indicates a weakness in demand for the company’s products.
In evaluating the rate of gross profit earned by a particular company the users of the financial statements should consider the rate earned by the company in prior periods and also the gross profit rates earned by Other companies in the same industry In most merchandising companies the gross profit rate remains reasonably consistent from one Period to the next.
Gross profit rates usually lie between 30% and 50% of net sales, depending upon the type of merchandise sold. The gross profit rate usually
lowest on fast-moving merchandise such as groceries, and higher on volume goods, such as fine jewelry.
The Operating Expense Section
Operating expenses are incurred for the purpose of producing revenue. These expenses often are subdivided in functional classifications, such as selling expenses and general and administrative expenses. Subdividing operating expenses into functional classifications aids management and other users of the statements in evaluation different aspect of the company’s operations separately.
The classification of operating expenses into subcategories is a common practice but it is not required under accounting principles. Also, the categories into which operating expenses are classified often vary from one company to the next.
Operating income (or income from operations) shows the relationship between revenue earned from Customers and expenses incurred in producing this revenue. In effect, operating income measures the Profitability of a company’s basic business operations and “leaves out” other types of revenue and expenses.
Non operating Items
Revenue and expenses which are not directly related to the company’s primary business activities are listed in final section of the income statement following the determining to of operating income.
Two significant “non-operating items” are interest expense and corporate income taxes expense. Interest expense stems from the manner in which assets are financed, not the manner in which these assets are used in business operations. Corporate income taxes are not viewed as operating expenses because paying income’ taxes does not help produce revenue.
Any non operating revenue, such as interest revenue earned on investments, also is listed in this section of the income statement.
Most equity investors—that is, the owners—consider net income (or net loss) to be the most important figure in the income statement This amount represents the overall increase (or decrease) in owners’ equity resulting from business operations during the period.