OMM622: Financial Decision-Making

3 The Income Statement

Learning Objectives

After reading this chapter, you should be able to:

1. Examine the elements of an income statement.

2. Describe the accounts that make up an income statement.

3. Describe the different types of profit shown on an income statement.

4. Explore the elements of the statement of shareholders’ equity.

5. Examine and create a common-sized income statement.

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Introduction

Pre-Test

1. What is the purpose of an income statement?
a. to determine whether the company earned any revenues during the period
b. to determine how much the company spent to make revenues during the

period
c. to determine whether the company made a profit from its operations during

the period
d. to determine the financial position of the company during the period

2. What are the four basic groupings on an income statement?
a. Revenues, Cost of Goods Sold, Expenses, Net Profit/Loss
b. Expenses, Revenues, Inventory, Net Profit/Loss
c. Cash, Expenses, Inventory, Net Profit/Loss
d. Sales, Expenses, Inventory, Net Profit/Loss

3. What type of profit is shown on the income statement?
a. gross profit
b. operating profit
c. net profit
d. all of the above

4. Which of the following is/are found in the statement of shareholders’ equity?
a. treasury stock
b. common stock
c. retained earnings
d. all of the above

5. Which section of the income statement includes information about advertising
expenses?

Cost of Goods Sold

b. Sales and Administrative Expenses
c.

Other Expenses

d. Advertising information is not found on the income statement.

Answers can be found at the end of the chapter.

Introduction
Successful business owners and department managers often look forward to reading an
income statement (also sometimes called a statement of earnings, statement of income,
statement of operations, or profit and loss [P&L] statement) because it tells them just how
much of a profit they have made in any given accounting period. The statement could be
for a month, a quarter, a year, or some other time period that the manager deems neces-
sary. Most businesses develop monthly, quarterly, and annual income statements.

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Section 3.1The Sections of an Income Statement

For business owners or managers who are struggling to meet sales goals, the income state-
ment is often no cause for celebration—and may even be a source of dread, if it reveals
that the company is operating at a loss.

Regardless of whether a business is successful or struggling, the income statement is
always extremely important because it discloses the “bottom line,” or net profit/loss.
However, the more important parts of the statement are how the company got to that
number during the period being reported.

In this chapter, we discuss how the numbers are crunched to get to the bottom line, and
explore the critical rules of accounting that impact when those numbers can be reported
on the income statement. As in previous chapters, we will be following Best General Com-
pany throughout this chapter and addressing decisions the budget committee and man-
agers might make based on the document being discussed.

Before we get to the income statement numbers, let’s review the key elements of an income
statement, discuss the dates that appear at the top, and explore possible formats.

3.1 The Sections of an Income Statement
In addition to other information, every income statement includes the following four key
sections:

1. Sales or Revenues: how much revenue the company brought in by selling its
products or services.

2. Cost of Goods or Services Sold: how much the company spent to purchase or
produce the products or services it sold.

3. Expenses: how much the company spent to keep the doors of the business open.
Essentially, this includes all expenses except those spent specifically on the cost
of goods or services sold.

4. Net Profit or Loss: the “bottom line” that tells whether the company made a
profit or operated at a loss.

Let’s use the annual income statement of Best General Company (Figure 3.1) to explore
how these key sections typically appear. Note that the income statement in Figure 3.1
shows three periods. This enables the business owner or manager to quickly see trends
over time.

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Section 3.1The Sections of an Income Statement

Figure 3.1: Best General Company income statement

The income statement presents the “bottom line” showing a company’s profit or loss.

Best General Company

Income Statement

For the Years Ended December 31, 2013, 2012, and 2011

2013 2012 2011

Revenue

Costs of Goods Sold

Gross Profit

Operating

Expenses:

Selling, General, and Administrative Expense

Research and Development Expense

Total

Operating Expenses

Operating Profit

Other Income

Other Expenses

Depreciation Expense

Income

Tax Expense

Net Pro�t

$ 100,000

73,000

$ 27,000

$ 22,000

500

22,500

$ 4,500

$ 2,500

(900)

(2,400)

(150)

$ 3,550

$ 110,000

78,000

$ 32,000

$ 2

1,000

500

21,500

$ 10,500

$ 2,500
(900)
(2,400)

(1,500)

$ 8,200

$ 120,000

84,000

$ 3

6,000

$ 20,000

500

20,500

$ 15,500

$ 2,500
(900)
(2,400)

(1,700)

$ 13,000

In Figure 3.1, the Revenue section is only one line item. An internal report that a company
manager sees could include more detail in this section. For example, the first line might be
called Gross Revenues, with additional information provided about sales discounts and
returns. The manager would therefore have more information about what was subtracted
to get to the net revenue figure shown as the first line of the public statements. We discuss
this information in greater detail in the Revenue section below.

The Cost of Goods Sold section is also only one line item. Again, an internal report that a
Best General Company manager sees could include more detail about the costs incurred
to purchase or produce the goods sold. We discuss this information in greater detail in the
Cost of Goods Sold section below.

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Section 3.1The Sections of an Income Statement

For major corporations, the Expenses section is sometimes divided into Operating
Expenses and Non-Operating Expenses. The simpler example shown in Figure 3.1 does
not include a distinct non-operating expenses section; it lists the non-operating income
and expenses as Other Income and Other Expenses.

The Expenses section enables managers to know what expenses were incurred as part of
the operations of the business and what expenses were incurred that were not from opera-
tions. We discuss this information in greater detail below.

The Net Profit section in Figure 3.1 is only one line, but many companies present profits at
various stages, such as earnings before taxes and interest (EBIT) or earnings before taxes,
interest, depreciation, and amortization (EBITDA). We discuss why companies view prof-
its in several different ways below.

Our budget committee would be able to discern the following key trends from the income
statement shown in Figure 3.1, each of which would need to be further explored:

• Revenue is decreasing. Note how revenues were $120,000 in 2011 but dropped to
$100,000 by 2013. The budget committee would want to find out why revenue is
on a downward trend. They would need a more detailed internal report to find out
if there are fewer products being sold, or if a greater number of discounts are being
offered to sell those products. They may find other reasons for the decrease as they
get more detail. They would use this information to prepare a realistic budget pro-
jection for the next year.

• Cost of Goods Sold is also on a downward trend, from $84,000 in 2011 to $73,000
in 2013. That may be good news if the company has found a way to reduce the
costs of buying its goods, or it could just be that fewer goods needed to be bought
because products purchased or manufactured in previous years were sold in the
current year. The budget committee may discover other reasons as they look at the
details behind the numbers. These details also will be needed to project the Cost of
Goods Sold for next year’s budget.

• Operating Expenses are on an upward trend, from $20,500 to $22,500. Increases in
salaries or some other factor could be driving that increase. The budget committee
would need to see more details from the accounts that make up that line item to
know why there is an upward trend.

Now we will take a closer look at the key rules for the presentation of an income state-
ment. We will then explore the various types of profits one might measure when looking
at an income statement. Finally, we will explore the rules that accountants must follow
when preparing these financial statements.

Report Timing

Unlike the balance sheet, which is a snapshot in time, the income statement shows the
performance of a business over a longer period. The “as of” date on the balance sheet will
be the same as the period ended date on the income statement. If the company operates
on a calendar year basis, the phrase “Year Ended” will appear in the heading, at the top

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Section 3.1The Sections of an Income Statement

of the statement; if it operates on another 12-month period, the phrase will read as “Fiscal
Year Ended.” If the statements are issued monthly or quarterly, the phrasing will read as
“Month” or “Quarter” Ended. Whatever phrase shown at the top will be followed by the
ending date of the period.

Remember, when a manager compares results from one year to the next in the same com-
pany, or compares one company to another, it is important to examine the same operating
period. For example, if one company’s statement shows “Year Ended, December 31, 2013”
and another company shows “Fiscal Year Ended, January 31, 2013,” the manager needs to
develop a spreadsheet that will enable him to calculate results for the same months. He
can do this by getting a copy of the quarterly reports, where month-by-month data are
usually shown.

Suppose the manager works for a retail company that is highly dependent on holiday
sales, and he wants to see how well his company did versus a competitor for the fourth
quarter of the year. His company reports the fourth quarter using the months of Novem-
ber, December, and January. His competitor reports the fourth quarter using October,
November, and December. (For many retail companies, October is a much slower month
than January, because people use holiday gift cards to make purchases or exchange gifts
after the first of the year). The manager would not be comparing apples to apples without
adjusting the numbers to be sure he is looking at the results for the same three months. He
would need to use a report that shows month-by-month results, if available, so he could
prepare a spreadsheet with the same three months for each company before doing his
analysis.

It is generally a good idea to do the comparison with a company that uses the same time
period. Luckily, companies in the same industry often report using the same time periods.

Format Options

Companies can format information on the income statement in either a single-step or multi-
step presentation. Both statements provide the same information, but the multi-step for-
mat uses various summary totals to make it easier to find the key profit totals, such as
gross profit or operating profit, which we discuss below. Most companies use the multi-
step format because it is easier to read and analyze.

Single-Step Format
The single-step format groups all data into two categories: revenues and expenses (see Fig-
ure 3.2). Revenue includes income from sales, interest income, and gains from sale of
equipment. In addition to income raised from regular operations, a company will also
include income from one-time transactions, such as the sale of a building or piece of major
equipment. Other types of revenue may also be possible. This varies by type of business.

All types of expenses are grouped in the second category. This can be a very long list. Com-
mon expenses include advertising, salaries, administrative expenses, insurance expenses,
vehicle expenses, office supplies, and so on. Gains or losses would also be shown, such as
the loss from the sale of equipment or other assets.

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Section 3.1The Sections of an Income Statement

The benefit of using a single-step format is that it is simpler to prepare. The limitation of
the single-step format is that it does not indicate whether the company is actually mak-
ing a profit from its operations; to determine this, we must reorder the information into a
multi-step format.

Figure 3.2: Single-step format income statement

This singe-step format income statement shows one section for revenues and one section for expenses.

Best General Company
Income Statement (Single-Step)

For the Year Ended December 31, 2013

Revenues:

Sales

Interest Income

Gain on Sale of Equipment

Total

Revenues

Expenses:

Cost of Goods Sold

Advertising Expense

Depreciation Expense

Income Tax Expense

Insurance Expense

Interest Expense

Research and Development Expense

Salaries and Wages Expense

Supplies Expense

Total Expenses

Net Pro�t

$ 10,00

500

5,000

$ 6,000

600

700

500

200

1,000

1,000
500

$ 15,500

$ 1

1,100

$ 4,400

Multi-Step Format
Income statements created using the multi-step format divide the statement into several
groupings and provide critical subtotals to facilitate analysis of the information (see Fig-
ure 3.3). Even though they include essentially the same information, the additional group-
ings of the multi-step format help the reader quickly view the key profit lines:

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Section 3.1The Sections of an Income Statement

• Gross Profit: This shows the profit made from sales minus the costs of buying or
manufacturing the products or services sold.

• Operating Profit: This shows the profit from the actual operations of the company.
• Profit Before Income Tax Expense: This shows the income before taxes and inter-

est are subtracted.
• Net Profit (or Loss): This shows the bottom line—whether the company made a

profit or experienced a loss.

Many companies add additional profit lines, such as Earnings Before Interest, Taxes,
Depreciation, and Amortization (EBITDA).

Figure 3.3: Multi-step format income statement

Compare the groupings of items to the single-step format of Figure 3.2. The multi-step format provides
the operating income (or operating profit), which is the amount of profit after costs of goods sold and
operating expenses have been subtracted.

Sales
Cost of Goods Sold

Gross Pro�t

Operating Expenses:

Advertising Expense

Insurance Expense

Research Development Expense

Salaries and Wage Expense

Supplies Expense

Total Operating Expenses

Operating Pro�t

Operating Income:
Interest Income

Gain on Sale of Equipment

Other Expenses:
Interest Expense

Depreciation Expense

Pro�t Before Income Tax Expense
Income Tax Expense

Net Pro�t

$ 600

500

1,000

1,000
500

$ 500

5,000

(200)

(600)

$ 10,000

6,000

$ 4,000

$ 3,600

$ 400

$ 5,500

(800)

$ 5,100

(700)

$ 4,400

Best General Company
Income Statement (Multi-Step)

For the Year Ended December 31, 2013

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Section 3.2Building Blocks of the Income Statement

When looking at the bottom line on the single-step format in Figure 3.2, Best General
Company appeared to be making a profit of $4,400 on $10,000 of sales. But a closer look
with the multi-step format in Figure 3.3 reveals that the business is not profiting on its
operations. Operating profit was just $400. Using the single-step format in Figure 3.2 gave
the impression that the business was profitable, but most of the profits came from a one-
time sale of equipment. It is therefore critical to calculate the operating income, even if all
you have is a single-step income statement. To do that, remove from the net profit all items
not included in operations (minus interest income $500; minus gain on sale of equipment
$5,000; plus depreciation expense $600; plus income tax expense $700; and plus interest
expense $200) or reformat the single-step income statement into a multi-step format.

3.2 Building Blocks of the Income Statement
Now we will take a closer look at the numbers on the income statement and explore how
an income statement is created. We will start with Revenues, which are not always as
simple as a total of the sales made. Then we will take a closer look at Cost of Goods or
Services Sold. Finally we will explore the Expenses section of the income statement.

Revenues

For some types of businesses, such as retail stores or restaurants, recognizing revenue can
be a relatively simple process. A manager adds up all the receipts for the day and enters
total revenue earned. However, that’s not the case for many other types of businesses,
especially when sales and services involve construction, installation, or training. Sales for
many types of consulting businesses also don’t usually get fully recognized on the day
the contract is signed. Revenue is only earned when the job is completed or a contract
deadline is met.

For example, a construction company that contracts to build a major project may earn its
revenue over a number of years based on various deadlines set in the contract. A company
like IBM that provides complex systems earns its revenue at various stages of completion—
after installation, after training is completed, and at the end of a service period. Note, when
looking at IBM’s income statement in Figure 3.4, its revenue is split into three line items:
Services, Sales, and Financing.

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Section 3.2Building Blocks of the Income Statement

Figure 3.4: Top portion of IBM’s 2012 income statement

To help readers navigate their income statement, IBM divides revenue into three line items: services,
sales, and financing.

Consolidated Statement of Earnings
International Business Machines Corporation and Subsidiary Companies

Revenue

Services

Sales

Financing

Total revenue

Cost

Services
Sales
Financing

Total cost

Gross profit

($ in millions except per share amounts)

For the year ended December 31: 2012 2011 2010Notes

$ 59,453

43,014

2,040

104,507

39,166

13,956

1,087

54,209

50,298

$ 60,721

44,063

2,132

106,916

40,740

14,973

1,065

56,778

50,138

$ 56,868

40,736

2,267

99,870

38,383

14,374

1,100

53,857

46,014

Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual

We’ll take a closer look at how IBM actually recognizes these three different line items,
which can all be part of one contract, when we review the notes to financial statements
later in the chapter. First, let’s examine the basic rules of revenue recognition.

Revenue Recognition
As explained in Chapter 2, the first rule in accrual accounting is that revenue is recognized
when it is earned. Note that this is not true of companies that use cash-basis accounting, in
which cash revenue is recognized when cash is received. However, all major companies
that must file financial statements with the Securities and Exchange Commission (SEC)
use accrual accounting. Most smaller companies use it, too, even if they do not report to
the SEC, because it more accurately matches revenue earned to expenses at the time in
which the transactions occur. Thus, in this book, we focus on the rules of accrual account-
ing. The key question that must be answered before recognizing revenue, then, is: Has the
money been earned?

The following are some common scenarios in which additional information, beyond the
sale of a product, might be required in order to determine revenue recognition:

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http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual

Section 3.2Building Blocks of the Income Statement

• Price Negotiations: Suppose a company is in the middle of negotiating the price
for a product and service. It is the end of the month and the salesperson wants
credit for the sale, but there are still some details to be worked out before there is a
final price. Revenue cannot be recognized until a final price is set, the contract has
been signed, and the customer has accepted the product or service.

• Distribution Issues: Suppose the buyer of the product does not pay for the mer-
chandise until it is sold to a third party, such as a retailer. This is common when an
intermediary is involved in the distribution of the product. The company selling
the product cannot recognize the revenue until the retailer pays for the product.
Sending out the product to a third-party distributor means the revenue cannot be
recognized until the product reaches the end customer who will remit payment.
The determining factor is who actually has title (ownership) of the product and the
provisions under which the product can be returned to the manufacturer.

• Service/Installation/Training Issues: Revenue is recognized when the service,
installation, or training is complete and accepted by the customer. Sometimes a
company is paid for a product in full before the revenue is earned. This would be
shown as Prepaid Revenue, which is shown as a liability account on the balance
sheet. This account may also be called Unearned Revenue or Deferred Revenue.
For example, IBM not only sells its products, it also installs the systems, trains its
customers, and services the systems. In some cases, IBM provides financing so the
customer can buy the system as well. Revenues from a major sale will not be rec-
ognized until the related terms have been met. For example, IBM may be paid in
full for the equipment when installation is complete, but it will not recognize the
revenue for training and servicing until the terms of that part of the contract are
met. Revenue from financing will be recognized as payments are made.

• Shipping Issues: Goods are shipped FOB (Free on Board) destination, whereas other
times they are shipped FOB shipping point.
• When goods are shipped FOB destination, the buyer does not own and pay

for the shipment until it is received. In this case, the revenue is not recognized
until the buyer receives it. If the shipment is stolen or lost, the buyer is not
responsible for paying for the goods.

• On the other hand, if the shipment is sent FOB shipping point, it is assumed
the buyer takes title on the day they are shipped and revenue can be recog-
nized upon shipment. In this case, if the shipment is lost or stolen, the buyer is
responsible for the loss.

• Selling Within the Corporation: Sometimes sales are made between the parent
company and a subsidiary company. In this case, the sale would not be recognized
as revenue but instead would be considered a transfer of assets.

• Buyback Agreements: Sometimes a company agrees to buy back its inventory
at some point in the future. If the buyback covers all costs of the inventory plus
holding costs, this does not constitute a sale and the revenue is not recognized.
This type of arrangement can be common in the financial services industry where
financial products are sold with a promise to buy them back with interest.

As illustrated in these scenarios, revenue recognition can be a complex question in certain
types of businesses. A manager for a company with complex revenue issues may want
to ask her accounting liaison to explain the revenue recognition rules under which their
company operates.

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Section 3.2Building Blocks of the Income Statement

Sales Adjustments
The recognition of revenue is not the only factor that comes into play when calculating
net sales. Sales are adjusted for a number of reasons. In most cases, a company’s external
financial reports will not show any detail of how much sales were adjusted. Companies
prefer to keep these details confidential and report them only on internal reports.

Within a company, managers who are responsible for producing revenue will get a more
detailed report that shows the accounts used to calculate Net Revenue shown on the
income statement. Managers will only find details about these adjustments on these inter-
nal financial reports. These adjustments can have a major impact on a company’s net
revenue figures and reduce the net revenue reported. Anything that reduces revenues will
ultimately reduce profits.

New World of Financial Report Oversight

As U.S. regulators try to converge U.S. rules with international financial reporting rules,
one of the major projects involves improving revenue reporting. Right now, there are many
different requirements for specific transactions and industries, such as software, real estate, and
construction contracting. Today there are over 200 specialized and industry-specific revenue
recognition requirements under U.S. GAAP.

Regulators are expected to issue revenue recognition guidance in 2014 that will improve the
ability to respond to revenue recognition changes more quickly and increase comparability
among industries. The goal will be to improve disclosures to users of financial statements so
they can better compare and contrast the numbers.

Read more about the revenue recognition project spearheaded by the U.S. Financial Accounting
Standards Board and the international regulators here.

Changes are being contemplated to simplify revenue recognition, as discussed in “The
New World of Financial Oversight.”

Task Box 3.1: Recognizing Revenue

Analyzing Industry Competitors, Part B
Review the revenue recognition schemes for the two companies you chose to research in
Chapter 2 (see Task Box 2.9). The information is most likely located in the first of the Notes
to the Financial Statements, often called “Significant Accounting Policies” or “Accounting
Methods.” Be prepared to discuss the way revenue is earned and recognized for each of the
companies, and how it might be different for each.

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http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=900000011146

Section 3.2Building Blocks of the Income Statement

Revenue-producing managers want to keep a close watch on the adjustments to be sure
they are accurate. Also, if any of the revenue adjustments show an increasing trend, man-
agers want to determine the reason for the increase.

Companies make three common adjustments to their gross sales or revenue totals:

1. Volume discounts: Companies use this incentive to offer major retailers a
reduced price if they buy in large numbers. For example, a company may offer its
widgets at $50 each if fewer than 1,000 units are ordered. However, it may cut the
price to $45 when 1,001 to 5,000 units are ordered and further reduce the price
to $40 for orders over 5,000 units. That’s why big box retailers, such as Walmart
and Target, can often offer lower prices: They can take advantage of volume dis-
counts. Volume discounts reduce the gross sales for the seller but likely increase
total sales volume.

2. Returns: Every company that produces tangible goods can expect that some
items will be returned by buyers. Returns reduce the gross sales for the company.
Accounting will track returns (usually accompanied by a credit memo) in a sepa-
rate account and watch the trends for returns. If the trend goes up sharply, it can
indicate that there is a problem with a product. Management will use this report
to follow those trends and start an investigation if the numbers jump dramatically.

3. Allowances: Allowances are liabilities for a company. For example, a gift card is
an allowance that people pay for up front but take no merchandise. These allow-
ances must be monitored because at some point, someone will likely use that
gift card and take some product, which would increase the costs of goods sold
at a later date. Rebates are another type of allowance that people may or may
not cash in. Companies will reduce their gross sales to account for these future
liabilities.

Sales Adjustments at IBM and 3M
A sales manager can find out some information about how competitors are recognizing
revenue. This research can help the sales manager discover new revenue opportunities or
new methods for recognizing revenue that she may want to discuss with her accounting
and finance staff if she believes this will improve the company’s revenue and profits.

Note 1 in 3M’s Notes to the Financial Statements indicates that 3M reduces income for
distributor incentives that include rebates and free goods, primarily at the time of sale. It
says in the notes, “These sales incentives are accounted for in accordance with ASC 605
Revenue Recognition [a GAAP standard]. The estimated reductions of revenue for rebates
are based on the sales terms, historical experience, trend analysis and projected market
conditions in the various markets serviced.”

Remember, 3M is a manufacturer that distributes most of its product through intermedi-
aries, which then sell the products to the retailers, which ultimately sell the products to the
customer. So its incentives are based primarily on ways to encourage volume sales. Note
that 3M reduces revenues for rebates. These rebates are offered to encourage sales, but not

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Section 3.2Building Blocks of the Income Statement

Now let’s take a closer look at cost of goods or services sold.

Cost of Goods or Services Sold

Every company, even a consulting company that offers only services, incurs costs for what
it sells. In a service-based company, the costs may include those related to bidding on
a project. For example, an architectural or engineering firm likely incurs staff costs and
equipment costs in order to prepare a bid for a specific project. Those costs would be costs
of services sold. Once the company wins the project, it may hire staff to work on that
project with no other responsibilities in that company. These staff costs would be charged
against that project’s gross profit. Essentially, cost of goods or services sold includes any
expenses that can be directly charged against the production of that product or service.

all rebates are redeemed. Consumer Reports indicates that 70 percent of consumers actu-
ally send in the request for rebates. Companies do not use general statistics such as these,
however; instead they develop a percentage of rebates used based on historical company
data (Consumer Reports Magazine, 2009).

Most of IBM’s sales are directly to the businesses it serves. Thus, the reductions to revenue
discussed in Note A are very different. IBM indicates it reduces revenues for client returns,
stock rotation (moving older products to the front so they are sold first), price protection
(agreements to maintain a set price over a specific period of time), rebates, and other simi-
lar allowances based on “historical results taking into consideration the type of client, the
type of transaction and the specifics of each arrangement.”

Neither company provides exact details about how much these adjustments total in the
Notes to the Financial Statements. Companies usually closely guard the details about costs
and sales reductions, because they don’t want to give their competitors information to use
against them. This is why managers with direct responsibility for the revenue involved
are often the only ones allowed to access this information.

Task Box 3.2: Handling Revenue Reductions

Analyzing Industry Competitors, Part C
Read the Notes to the Financial Statements to find out how the companies you’ve chosen to
research handle their revenue reductions. Do the two companies handle them in the same way
or differently? What are the similarities and differences?

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Section 3.2Building Blocks of the Income Statement

Advertising, for example, is considered an expense rather than a cost because it would
be difficult to determine exactly which ad drove a customer to buy which product. Most
advertising is much broader than one particular product or service. Tracking and figuring
that out is not worth the staff time involved, so advertising becomes an expense rather
than a cost and is not included in Cost of Goods Sold.

Another factor that can impact the Cost of Goods Sold line is the inventory valuation
method used. In Chapter 2, we discussed LIFO vs. FIFO vs. Average Costing. Below is a
summary of the calculations we completed in that chapter:

LIFO FIFO
Average
costing

Beginning Inventory $400.00 $400.00 $400.00

Cost of Goods Sold $3,250.00 $2,962.50 $3,063.50

Ending Inventory $650.00 $937.50 $835.50

Clearly, the Cost of Goods Sold number usually is the highest when using the LIFO inven-
tory value method; prices in most industries gradually increase because of inflation. This
is not true in all industries, and, in some cases, the older inventory can be more expensive,
as in the computer field, where costs sometimes go down for products.

When a higher value is used for cost of goods sold, then the company’s profits will be
reduced. In the example above, company profits would be $287.50 ($3,250 − 2,962.50) less
using LIFO rather than FIFO. If prices were going down, then FIFO would likely be the
higher cost of goods sold number. Average costing always evens out the price differences.

In a manufacturing company like 3M, costs include anything spent to produce a product.
This includes the purchase of raw materials, the labor costs to make the product, and the
cost involved in storing raw materials until they are needed. In addition, the costs of the
machinery and tools for product production are also allocated to Cost of Goods Sold.

Other types of businesses determine their Costs of Goods or Services Sold based on the
purchases of products they made in order to sell their products or services.

Financial report readers can see how complicated it is for a service company, such as IBM,
to determine its costs of goods sold by reading Note A in IBM’s Notes to the Financial
Statements. That note states, for example, that “Recurring operating costs for services con-
tracts, including costs related to bid and proposal activities, are recognized as incurred.”

IBM tracks its costs on service contracts, including bid and proposal activities, and rec-
ognizes them when incurred. Since it can take months to actually win a proposal, IBM
indicates that it reports operating costs periodically throughout the bidding process. (The
rest of this note can be found in the “World of Business,” which discusses other difficult
decisions regarding the recognition of costs.)

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Section 3.2Building Blocks of the Income Statement

IBM’s Notes to the Financial Statements demonstrate that the company must analyze a
number of moving parts to determine its costs of goods sold.

• For service contracts: It must calculate operating costs for service contracts and
costs related to bid and proposal activities.

• For fixed-price design contracts: It must calculate costs of external hardware and
software based on the percentage of completion. The total estimated labor costs to
fulfill the contract are calculated; then a percentage of those costs are allocated each
period to determine Costs of Goods Sold. The company also calculates transition

World of Business

Recognizing Costs of Goods and Services Sold
Determining when a company should
recognize costs is not always easy. Discover
the complexities to be considered in this
excerpt from IBM’s 2012 Notes to the Financial
Statement, regarding the recognition of costs:

“For fixed-price design and build
contracts, the costs of external hardware
and software accounted for under the
POC [percentage-of-completion] method
are deferred and recognized based on
the labor costs incurred to date, as a
percentage of the total estimated labor
costs to fulfill the contract. Certain
eligible, nonrecurring costs incurred
in the initial phases of outsourcing
contracts are deferred and subsequently
amortized. These costs consist of
transition and setup costs related to
the installation of systems and processes and are amortized on a straight-line
basis over the expected period of benefit, not to exceed the term of the contract.
Additionally, fixed assets associated with outsourcing contracts are capitalized
and depreciated on a straight-line basis over the expected useful life of the asset.
If an asset is contract specific, then the depreciation period is the shorter of the
useful life of the asset or the contract term. Amounts paid to clients in excess of
the fair value of acquired assets used in outsourcing arrangements are deferred
and amortized on a straight-line basis as a reduction of revenue over the expected
period of benefit not to exceed the term of the contract. The company performs
periodic reviews to assess the recoverability of deferred contract transition and
setup costs. This review is done by comparing the estimated minimum remaining
undiscounted cash flows of a contract to the unamortized contract costs. If such
minimum undiscounted cash flows are not sufficient to recover the unamortized
costs, an impairment loss is recognized.”

Consider This:

1. Does your company have a complex set of rules for recognizing costs?
2. Must you differentiate costs between services and goods in your company?

Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_
ibm_annual

Franziska Kraufmann/picture-alliance/dpa/
Associated Press

Companies like IBM must analyze a num-
ber of factors to determine when to recog-
nize costs.

eps81356_03_c03_097-132.indd 112 3/26/14 12:54 PM

http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual

Section 3.2Building Blocks of the Income Statement

and setup costs related to the installation of the systems and processes. Fixed
assets are capitalized and depreciated on a straight-line basis over the expected
useful life of the asset.

In addition to a section on service costs, IBM includes a section regarding software costs
and how they are calculated. Research and development becomes a critical part of cal-
culating these costs. Hardware costs are not discussed in detail in the note, but these are
either calculated as manufacturing costs (if IBM produces the product) or purchased costs
(if IBM purchases the product from another company).

Similar to how it separates Revenues, IBM differentiates its costs by services, sales, and
financing on its income statement, as shown in Figure 3.4.

Gross Profit

The gross profit number is critical for determining how much profit a company is making
from the actual sale of its goods or services before considering the operating expenses.
If the company’s gross profit is not high enough to cover operating expenses, managers
must take actions to fix the problem as soon as it is recognized.

There are essentially four ways managers can fix the problem:

1. Managers can recommend that the company increase its prices, if the market will
bear it without the company losing too many sales. Sales and marketing manag-
ers will need to research competitors’ pricing to determine if this is an option.
If competitors are charging the same or lower prices, this option will likely
decrease sales.

2. Managers can look for opportunities to expand sales into new markets. This will
likely mean the company will incur additional sales and marketing expenses, so
it needs to carefully analyze the impact of this choice. Sales and marketing man-
agers will need to assess opportunities for expansion and their costs. They will
then prepare a report for upper management.

3. Financial and purchasing managers can find a way to decrease costs. They can
do this by finding other suppliers with whom they can negotiate a lower price.
Another way to reduce costs may be to take advantage of volume discounts
when ordering materials. Managers in a manufacturing company may be able to
find other ways to reduce manufacturing costs.

4. Managers can recommend that the company lower its prices to increase sales.
This may seem counterintuitive, but if the company can reduce its costs by pur-
chasing or manufacturing at greater volumes, lowering the price to increase sales
could improve the gross profit.

These are the types of decisions companies must make at least yearly, and usually more
often, after evaluating periodic financial reports. If managers or executives see gross profit
trends moving lower, it is an indication that the company needs to make changes to main-
tain profitability in the long term.

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Section 3.2Building Blocks of the Income Statement
Operating Expenses

Recall that companies provide few details about their expenses on public financial
reports because companies prefer to reveal as little information as possible on their pub-
lic reports, because they know their competitors will read them. Now we will take a
closer look at the Expense section of the income statement for the Best General Company,
as shown in Figure 3.5.

Figure 3.5: Expense section of the income

statement for Best General Company

The operating expenses of a company are shown in the expense section of the income statement.

Best General Company
Income Statement (Partial)

For the Years Ended December 31, 2013, 2012, and 2011
2013 2012 2011
Expenses:
Selling, General, and Administrative Expense
Research and Development Expense
Total Operating Expenses

$ 22,000

500

22,500

$ 21,000

500

$ 2

1,500

$ 20,000

500

20,500

Selling, General, and Administrative Expenses
The Selling, General, and Administrative Expenses line item reflects all expenses the com-
pany incurs in selling its products or services (including sales commissions and advertis-
ing), as well as the expenses it incurs in running all its administrative and sales offices.
All salaries and wages, insurance costs, professional fees, rents, office supplies, and other
similar types of expenses are also included in this number.

If the company operates retail stores, it will include the expenses of running those stores
here as well, such as store rents, inventory warehousing, sales associates wages, and utili-
ties. However, recall that because a retail store sells many products, companies cannot
match the expenses of operating a retail store to the costs of one product sold. Therefore,
retail store operations are considered an expense rather than a cost of goods sold.

Note in Figure 3.5 that the Best General Company is experiencing an increase in these
expenses. They have increased by $2,000 over the last three years. The budget committee
would need to review the accounts that are used to calculate that number to determine

eps81356_03_c03_097-132.indd 114 3/26/14 12:54 PM

Section 3.2Building Blocks of the Income Statement

where the increases occurred. They would need to determine if there is a way to control
these rising expenses by reviewing the accounts where expenses are increasing and deter-
mining if there is a way to cut some of these expenses in the next year’s budget.

Research and Development
The Research and Development (R&D) line shows the total spent on investigating the via-
bility and utility of future products. When comparing two companies in a similar industry,
this can be a critical number. For example, if one company is spending a great deal more
on R&D than the other, it might be seeking to develop more new products or improve the
ones it currently sells. A company that is not spending on R&D, or is spending very little,
may be too interested in the short-term bottom line and not investing enough money in
the future growth of the company.

Best General Company incurred the same level of expenses in each of the three years
shown on the income statement. The budget committee may determine that R&D needs
to be increased to enable the company to research new products. They may recommend
that the executives form a committee to review this option and develop a plan for the
R&D team.

Task Box 3.3: Comparing Research and Development
Spending

Analyzing Industry Competitors, Part D
Calculate the amount spent on R&D at the two companies you’ve chosen to investigate. Are
they spending roughly equal amounts? If not, why not? Hint: You may find some discussion of
R&D in the Management’s Discussion and Analysis section of the annual report.

Other Income and Other Expenses
The Other Income line item is usually a catchall section where a company includes income
that is not earned from operations. For example, if a company sells a building, a major
piece of equipment, or some other asset, the income from that sale is shown here. Gener-
ally, items shown are one-time income.

The same is true for the Other Expenses line item. Generally, these are one-time rather
than recurring expenses that do not involve the day-to-day operations of the company.
Figure 3.6 shows the Other Income and Other Expenses section of the Best General Com-
pany income statement.

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Section 3.2Building Blocks of the Income Statement

Figure 3.6: Other income and other expenses section of the income statement
for Best General Company

Income and expenses that are not directly related to company operations are shown in the other income
and expenses section of the income statement.

Best General Company
Income Statement (Partial)
For the Years Ended December 31, 2013, 2012, and 2011
2013 2012 2011
Other Income
Other Expenses
Depreciation Expense
Income Tax Expense

$ 2,500

900

2,400

150

$ 2,500
900
2,400
1,500
$ 2,500
900
2,400

1,700

( )

( ) ( )
( )

( ) ( )

Depreciation and Amortization Expenses
In Chapter 2, we discussed the calculation of depreciation and amortization for the pur-
poses of portioning the cost of buying the asset over the life of the asset to better match the
expenses with the revenue earned from using those assets. For example, these long-term
assets can include buildings, equipment, and other assets held for more than one year.
Each year, the amount of depreciation or amortization to be added to the accumulated
depreciation line item on the balance sheet is offset by a depreciation or amortization
expense. This expense line item is included on the income statement to show the expenses
incurred for that year.

Net Income

As we’ve discussed, net income (loss) is the “bottom line.” This number allows an
employee to quickly determine whether a company has made a profit or incurred a loss.

Exploring a little of what is behind the numbers on the income statement reveals that
there is a great deal to find out about the numbers that lead to the bottom line. Someone
who looks only at the bottom line misses a lot of crucial information needed to assess
whether a company is profitable.

Let’s take a closer look at how a manager can determine whether the business is earning
a profit.

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Section 3.3Profit Types

3.3 Profit Types
The most important lines on any income statement are the lines that show whether the
company made a profit. There are three key profit line items that enable managers to
quickly determine a company’s profitability using the multi-step income statement for-
mat. These three profit line items are shown in bold on Figure 3.3. Each of these profit line
items provides a different type of information.

1. Gross Profit: Shows whether the company made a profit from selling its prod-
ucts or services before considering the expenses of operating the company. The
line is shown in the top section with Revenues minus Cost of Goods Sold.

2. Operating Profit: Shows whether the company made a profit after all operating
expenses are subtracted. The line is shown below the Expense section.

3. Net Profit (Loss): Shows whether the company made a profit after all operating
and non-operating expenses are subtracted. This is the bottom line of the income
statement.

Using that information, we can test a company’s profitability with three ratios:

1. Gross Profit Margin: This indicates how well the company is doing after taking
into consideration the cost of goods or services sold.

2. Operating Profit Margin: This indicates how well the company is doing after
taking into consideration the operating expenses.

3. Net Profit Margin: This indicates how well the company is doing after taking
into consideration all operating and non-operating costs.

We will now demonstrate how to calculate these margins and what they mean for manag-
ers trying to determine whether their company is profitable.

Gross Profit Margin

First we will calculate the gross profit margin using the Revenue section of the income
statement for Best General Company, shown in Figure 3.7.

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Section 3.3Profit Types

Figure 3.7: Gross profit section of the income statement for
Best General Company

The gross profit section shows income after the cost of goods sold are subtracted.

Best General Company
Income Statement (Partial)
For the Years Ended December 31, 2013, 2012, and 2011
2013 2012 2011
Revenue
Cost of Goods Sold
Gross Profit

$ 100,000

73,000

$ 27,000

$ 110,000

78,000

$ 32,000

$ 120,000

84,000

$ 36,000

The gross profit margin for each of the three years can be calculated by dividing the Gross
Profit by the Revenue. The following shows the gross profit margin for each of the three
years.

Gross Profit Margin 5
Gross Profit

Revenues
2013 2012 2011

Gross Profit Margin
$27,000

$100,000

27.0%

$32,000

$120,000

29.1%

$36,000

$110,000

30.0%

Note that the gross profit margin gives the managers of Best General Company a way to
quickly see that the company’s profit is dropping on the goods it is selling. This is a bad
sign for the company. The managers would need to ask accounting for the details of the
accounts used to calculate the Revenue and Cost of Goods line items to determine what is
driving this downward trend. Some key accounts to review would be:

• Revenue: Managers would need to determine whether revenue was going up or
down.

• Sales Discounts: Did the company offer more discounts in 2011 than it did in
2013? If more discounts are being offered, managers would need to find out why
this is happening.

• Sales Returns: Are more products being returned? If so, managers would need to
determine whether a quality control problem exists or if something else is driving
the returns.

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Section 3.3Profit Types

• Purchases: Is the company paying more for the products, which in turn is increas-
ing the Cost of Goods Sold? If this is the case, managers may seek to find a new
supplier, adjust profit expectations, or consider raising prices to cover additional
costs. They could consider buying increased volumes to take advantage of volume
discounts.

In addition, the managers of Best General Company may want to compare the gross
margin of the company to the gross margin for the industry to see how well the com-
pany is doing compared to its competitors. If the gross margins are significantly lower,
more research would be needed to determine what the company can do to improve its
performance.

The marketing and sales manager would want to compare Best General’s revenue results
to those of its competitors. The purchasing manager may want to take a closer look at the
company’s Costs of Goods Sold compared to its competitors. All managers may want to
review the key competitors’ annual reports to find out how they are doing and possibly
discover information that could be used to develop recommendations for improving the
results of the Best General Company. For example, in reading the details in the annual
reports of one company, the marketing manager may read information that gives her an
idea for a new product line or new marketing campaign.

Task Box 3.4: Calculating Gross Profit Margin

Analyzing Industry Competitors, Part E
Calculate the gross profit margin for the last five years for the companies you have chosen to
research. Is gross profit going up or down? Are sales going up or down? Are costs going up or
down? Determine from these numbers whether the companies are improving their profitability.
Why did you come to that conclusion?

Operating Profit Margin

The managers would next want to determine whether the company is still making a profit
after subtracting all its operating expenses. The operating profit margin indicates how
much profit a company is making after taking all operating expenses into consideration.
Figure 3.8 shows the Expenses section, followed by the Operating Profit line, for Best
General Company.

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Section 3.3Profit Types

Figure 3.8: Expenses and operating profit section of the income statement for

Best General Company

The operating profit section of the income statement shows profit after all operating expenses have been
subtracted.

Best General Company
Income Statement (Partial)
For the Years Ended December 31, 2013, 2012, and 2011
2013 2012 2011
Revenue
Costs of Goods Sold
Gross Profit
Expenses:
Selling, General, and Administrative Expense
Research and Development Expense
Total Operating Expenses
Operating Profit
$ 100,000
73,000
$ 27,000
$ 22,000
500
22,500

$ 4,500

$ 110,000
78,000
$ 32,000
$ 21,000
500

21,500

$ 10,500

$ 120,000
84,000
$ 36,000
$ 20,000
500
20,500

$ 15,500

To calculate the operating profit margin, divide the operating profit by revenues shown in
Figure 3.8. The results are shown in the table below.

Operating Profit Margin 5
Operating Profit

Revenues
2013 2012 2011

Operating Profit Margin
$4,500

$100,000
5

4.5%

$10,500
$110,000

9.5%

$15,500
$120,000

12.9%

The Best General budget committee members can quickly see that the downward trend
is even more significant when operating expenses are considered. The company was
making an operating profit of 12.9% in 2011, and it is now down by more than half, to
4.5%. The managers would want to take a closer look at expenses to see which expenses
are increasing and ask for more detail from the accounts that are used to calculate those
line items. The key line item that shows increasing expenses is the Selling, General, and
Administrative Expenses line item in Figure 3.8. Many accounts are used to calculate
that line item, including selling expenses, office expenses, salaries expense, insurance
expenses, and so on.

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Section 3.3Profit Types

The Best General budget committee should ask to see a detailed report of all the accounts
that are used to calculate Selling, General, and Administrative Expenses and investigate
which ones are contributing to the increase in these expenses.

It is important for a company to maintain a high operating profit margin. This gives the
company more price flexibility during an economic downturn. Why? Because with higher
operating profit margins, the company has the option to cut prices if needed to attract
more business. It therefore has the flexibility needed to be competitive no matter how bad
an economic downturn may be. Net profit may go down, but the company will have no
trouble staying in business.

Net Profit Margin

The third key profit test is net profit margin, which looks at how well the company has
done overall, considering both operating and non-operating activities. Non-operating
activities can be as simple as interest income or expense, or they can be much more sig-
nificant, such as the expenses related to the discontinuation of a product line or the closure
of a plant. Figure 3.9 shows the non-operating expenses and the net profit for Best General
Company.

Figure 3.9: Non-operating expenses and net profit section of the income

statement for Best General Company

Expenses not directly related to the company operations are shown in the non-operating expenses section
of the income statement.

Best General Company
Income Statement (Partial)
For the Years Ended December 31, 2013, 2012, and 2011
2013 2012 2011
Other Income
Other Expenses
Depreciation Expense
Income Tax Expense
Net Pro�t

$ 2,500

(900)
(2,400)
(150)

$ 3,550

$ 2,500

(900)
(2,400)
(1,500)

$ 8,200

$ 2,500

(900)
(2,400)
(1,700)

$ 13,000

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Section 3.3Profit Types

To calculate the net profit margin, divide the net profit by revenues. The results for Best
General Company are shown in the table below.

Net Profit Margin 5
Net Profit
Revenues

2013 2012 2011

Net Profit Margin
$

3,550

$100,000
5

3.6%

$8,200
$110,000

7.5%

$13,000
$120,000

5 1

0.8%

The budget committee of Best General Company can see the company is barely making a
profit of 3.5%. If the Other Income of $2,500 from non-operating sources were not avail-
able, the net profit would be only $1,050, or just above 1%. Any drop in revenues could
mean the company would show a net loss rather than a net profit.

Clearly, Best General Company needs to make some major changes to improve its profit-
ability. In addition to reviewing the key accounts as discussed above, the budget com-
mittee members may also want to compare Best General Company’s results with other
companies in the same industry. They can do this by researching key industry statistics.
Chapter 6 discusses analyzing financial results in more depth.

Task Box 3.5: Industry Benchmarks

One way to compare a company’s results to industry statistics is by using the website
BizStats.com. There you can search for industry financial benchmark reports and get industry
profitability risk data as well as industry statistics. To see how IBM is doing, for example, you
can use BizStats.com to find industry profit and loss benchmarks as follows:

1. Select the company structure: Corporation (for IBM)
2. Input annual sales: $104,507,000,000 (no commas when entering on the website)
3. Pick industry: Professional-Scientific-Technical Services
4. Pick specific industry: Computer systems design and related services

You will then get industry income-expense statement benchmarks, as well as industry balance
sheet benchmarks. The gross profit margin benchmark in this industry category is 72.67%. IBM
is not a perfect match for this industry, since it also manufactures and sells hardware.

Therefore, you might also want to find the benchmarks for computer manufacturing. However,
when it comes to the bottom line, IBM is doing much better than others in this industry. This
industry’s net profit benchmark is 9.21%, whereas IBM’s is 15.9%.

(continued)

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Section 3.4The Elements of a Statement of Shareholders’

Equity

3.4 The Elements of a Statement of Shareholders’ Equity
At the bottom of the income statement or on another page, a statement of Shareholders’
equity is shown. This statement indicates how shareholders were affected by the com-
pany’s results for the year. It also indicates other changes that might impact claims own-
ers have against the company, such as the issuance of new stock or the buyback of stock
already on the market. The first line is always the balance in each of the accounts that
make up Shareholders’ equity:

• Common Stock and Additional Paid-in Capital,
• Retained Earnings,
• Treasury Stock,
• Accumulated Other Comprehensive Income (Loss), and
• Non-controlling Interests.

The bottom line of this statement is Total Equity. Figure 3.10 shows the statement of Share-
holders’ equity for Best General Company.

Note that the net earnings from the income statement match the retained earnings on the
statement of Shareholders’ equity. Net earnings not paid out in dividends to the share-
holders are held as retained earnings. The retained earnings total is an historical account
that tracks all money reinvested into the business over the years.

You can also examine IBM’s results on the manufacturing side using BizStats.com:

1. Select the company structure: Corporation (for IBM)
2. Input annual sales: $104,507,000,000
3. Pick industry: Manufacturing
4. Pick specific industry: Computer and electronic product manufacturing
5. Pick specific industry once more: Computers and peripheral equipment

In the manufacturing industry segment, the gross profit margin is much lower than in the
services industry. The gross profit margin is 38.91%. Remember that Cost of Goods Sold will
always be much higher for a company that is manufacturing its products than for a service
industry that has much lower cost of services sold. The net profit for the manufacturing sector is
just 8.98%. IBM far exceeds the net profit here, as well.

Practice using Bizstats.com by finding the benchmarks for your company or a company in
which you are interested. How do those companies compare to others in their industry sectors?

Task Box 3.5: Industry Benchmarks (continued)

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Section 3.4The Elements of a Statement of Shareholders’ Equity

Figure 3.10: Best General Company statement of shareholders’ equity

Details of the claims owners have against the assets of the company are shown in the statement of
Shareholders’ equity.

Best General Company
Statement of Shareholders’ Equity

For the Year Ended December 31, 2013

Common
Stock and

Paid-in Capital

Number of
Common Stock

Issued
Retained
Earnings

Total
Shareholders’

Equity

Balance as of
December 31, 2012

Net Earnings

2,000 shares $20,000

$3,900

3,550
0

$7,450

$23,900

3,550
0

$27,450

Cash Dividends

Balance as of
December 31, 2013

The statement of shareholders’ equity for Best General Company is relatively simple. On
a major corporation’s, however, there will be line items not shown here. Let’s review the
line items that can appear on a statement of shareholders’ equity and what they show.

Common Stock and Additional Paid-In Capital

Public and private corporations divide the ownership of the company using shares of
stock. Most of these shares are called common stock. Common shareholders can participate
in the election of a board of directors and can vote on company policy. Most common
shareholders in a major corporation own such a small share in the company that their vote
holds little weight. The common shareholders of a small company often own a significant
portion of the common stock of the company, often have a role on the Board of Directors,
and possibly hold a position in upper management.

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Section 3.4The Elements of a Statement of Shareholders’ Equity

When common stock is first set up, a share value called “par value” is established. When
the stock is first sold to investors, any money collected above the par value is listed as
“additional paid-in capital.” So if a stock has a par value of $10 and 100 shares are sold for
$20 each, the value of the common stock shown on the statement of Shareholders’ equity
would be $1,000 and the value of paid-in capital would be $1,000.

Best General Company, when formed, set its par value at $10 per share for a total of
$20,000 in common stock. Since it is a small company, it was not sold on the stock market.
Its shareholders are the partners who started the company. Their proportion of owner-
ship is based on the number of shares each partner owns. For example, if Partner A owns
500 shares, it means he invested $5,000 (500 x $10 per share) in the company to buy those
shares.

This section of a statement of Shareholders’ equity can get very complex for a large corpo-
ration, especially if it issues stock at different prices. Another line item may show stock-
based compensation. This reflects stock that was awarded to employees as part of their
compensation plan.

Other Line Items

Some companies will have additional line items. For example, if there is preferred stock
issued, there will be a line item detailing the value of the preferred stock, similar to the line
item for common stock. We discussed preferred stock in Chapter 2.

We also discussed treasury stock in Chapter 2. Any transactions involving the buying
back of stock or reissuing of stock will be detailed in a line item on this statement.

Non-Controlling Interests

Sometimes there is a line item called Non-Controlling Interests. This line item shows own-
ership held in companies in which the holding company has no controlling interest. A
company generally must hold between 5% and 10% of another company before it can
push for a seat on the board and obtain some control.

Let’s now turn our attention to how we can use the information on the income statement
to analyze some basic trends for a company using a common-sized income statement.

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Section 3.5Creating a Common-Sized Income Statement

Figure 3.11 shows a common-sized income statement for Best General Company prepared
using the downloadable multi-step template. To use the template, we separated expenses
and other income. We also moved interest expenses to the Other Expenses category.

Task Box 3.6: Preparing a Common-Sized Income Statement

To prepare a common-sized income statement, start an Excel worksheet. Copy the information
from the income statement into the Excel worksheet. Then develop a formula to divide each line
item by Net Sales or Net Revenue. To make things easier, download our template that uses the
multi-step format with the formulas already developed for the percentage columns.

3.5 Creating a Common-Sized Income Statement
The common-sized income statement enables users to analyze the key line items that lead
to profit or loss from a different perspective by calculating each number on the income
statement as a percentage. It allows for an easier comparison between two or more com-
panies of varying sizes in the same industry. It is also useful for managers to quickly iden-
tify trends from year to year.

The common-sized income statement may be presented with both dollar figures and per-
centages for each line item, or, when it displays a number of years on one page, it may
be presented with just percentages. The percentages allow for a quick assessment of the
trends of each line item when looking at several years on one report. All items are shown as
a percentage of Net Revenue or Net Sales. Note that because this statement is not required
by the government, it does not need to be prepared according to a particular set of rules.

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Section 3.5Creating a Common-Sized Income Statement

Figure 3.11: A common-sized income statement for Best General Company

With each line item shown as a percentage, a common-sized income statement allows readers to easily
identify trends within a company and also to compare large and small companies.

Best General Company
Common-Sized Income Statement

For the Years Ended December 31, 2013, 2012, and 2011

2013 2012 2011 2013 2012 2011

Revenue
Costs of Goods Sold
Gross Profit
Operating Expenses:

Selling, General,

and Administrative

Research and Development

Total Operating Expenses
Operating Profit

Other Income

Other Expenses
Depreciation Expense

Profit Before Income

Tax Expense
Income Tax Expense

Net Pro�t
$100,000
73,000

$ 27,000

$ 22,000

500
22,500

$ 4,500

$ 2,500

900
2,400

$ 3,700

150

$ 3,550

$110,000
78,000

$ 32,000

$ 21,000

500
21,500

$ 10,500

$ 2,500
900
2,400

$ 9,700

1,500

$ 8,200

$120,000
84,000

$ 36,000

$ 20,000

500
20,500

$ 15,500

$ 2,500
900
2,400

$ 14,700

1,700

$ 13,000

100.0%

73.0%

27.0%

2.0%

0.5%

2.5%

4.5%
2.5%

0.9%

2.4%

3.7%

0.2%

3.6%
100.0%

70.9%

29.1%

19.1%

0.5%

19.5%

9.5%

2.3%

0.8%

2.2%

8.8%

1.4%

7.5%
100.0%

70.0%

30.0%

16.7%

0.4%

17.1%

12.9%

2.1%

0.8%
2.0%

12.3%

1.4%

10.8%

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Summary and Resources

Figure 3.11 clearly illustrates that Best General Company is showing a downward trend in
profitability. The three key factors include:

1. A downward trend in Revenues.
2. An upward trend in Cost of Goods Sold.
3. An upward trend in Selling, General, and Administrative Expenses.

Review the discussion in each of the profit analysis sections above to consider the tasks
that managers may engage in when confronted with these trends.

Task Box 3.7: Calculating a Common-Sized Income Statement

Analyzing Industry Competitors, Part F
Use the downloadable template to calculate the common-sized income statement for the
companies you have chosen. What trends do you notice after creating a common-sized income
statement for your companies?

Summary and Resources

Chapter Summary
In this chapter, we illuminated the numbers on the income statement to take a closer
look at how companies develop this statement.

• We reviewed the rules related to statement timing and formatting and how these
rules impact the way the statement is presented.

• We examined the key sections of an income statement and explored how the
numbers are developed for the income statement. This included rules related
to how revenue is recognized and how costs or expenses are determined. Some
companies, such as retail companies and restaurants, simply recognize revenue
at the time the good or service is sold. Other companies must determine when
the revenue is actually earned. We explored the costs of producing or purchasing
products or services to be sold and looked at the expenses incurred to operate a
business and how those differ from costs incurred to sell products.

• Next we discussed the three key profit line items that enable managers to quickly
determine how well the company is doing. We also discussed key details manag-
ers may want to review if they see problems in the numbers to determine where
the problems are in the company’s operations.

• We briefly reviewed the statement of shareholders’ equity, where the ownership
of the company is detailed.

• We then explored a tool that makes it easier to analyze an income statement
called the common-sized income statement. This tool helps managers to spot
trends in the income statement by comparing results period to period. It also

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Summary and Resources

gives managers a way to compare the company results to those of competitors,
even if the competitors are a different size.

Takeaways for Chapter 3
• Managers must review the trends of the various line items in an income state-

ment from period to period to determine how well the company is doing and
to identify areas where the company is doing well, as well as find areas where
improvement is needed.

• Managers should compare their company results to those of their competitors
to test how well the company is doing. Companies do not operate in a vacuum.
Using the common-sized income statement a manager can compare his company
to a company of any size.

• Managers should be aware of the accounts that are used to calculate the line
items on the income statement, so if they see a problematic trend they know what
detail to request from accounting in order to fix a problem. Also this detail can
help managers spot a positive trend upon which they may want to build.

Post-Test
1. The income statement shows:
a. the profit/loss results as of a particular day in time
b. the profit/loss results over a particular period of time
c. the profits from money collected
d. the profits from the company’s operations

2. Which statement shows a company’s profits at various points on the statement?
a. the income statement in a multi-step format
b. the income statement in a single-step format
c. the balance sheet in a report format
d. the balance sheet in a number format

3. Which account would not be found on an income statement?
a. Advertising
b. Office Supplies
c. Prepaid Expenses
d. Administrative Expenses

4. How do you determine the expenses of long-term assets shown on the income
statement?

a. look for Depreciation Expenses
b. look for Amortization Expenses
c. look for Equipment Expenses
d. both (a) and (b)

5. What does the Gross Profit line item show the financial report reader?
a. how much profit the company made
b. how much profit the company made after accounting for the costs of goods or

services sold
c. how much profit the company made after expenses
d. how much profit the company made after taxes

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Summary and Resources

6. Why is it important to monitor operating profit?
a. You must know whether the company is profitable from its operations prior to

any one-time income or expense items.
b. You must know whether the company covers all expenses from the core

operations of the business.
c. You must know whether the company can stay in business.
d. both (a) and (b)

7. What account would not be found on a statement of shareholders’ equity?
a. Treasury Stock
b. Common Stock
c. Marketable Securities
d. Retained Earnings

8. What does the retained earnings line show on the statement of shareholders’
equity?

a. earnings kept in the business until next year
b. an account that tracks the historical reinvestment of profits
c. earnings not paid out in dividends
d. profits turned into earnings

9. What are the key benefits of preparing a common-sized income statement?
a. It provides a tool for analyzing trends related to profitability.
b. It provides a tool to compare large companies to small companies.
c. It provides a tool for comparing the company to industry benchmarks.
d. all of the above

10. Which of the following trends can be spotted when reading a common-sized
income statement?

a. a downward or upward trend in Revenues
b. a downward or upward trend in Cost of Goods Sold
c. a downward or upward trend in Selling, General, and Administrative Expenses
d. all of the above

Answers: 1 (b), 2 (a), 3 (c), 4 (d), 5 (b), 6 (d), 7 (c), 8 (b), 9 (d), 10 (d)

Answers and Rejoinders to Chapter Pre-Test
1. c. Although you will find out information about the revenues earned and

money spent during the period, the purpose of an income statement is to find
out whether the company made a profit or incurred a loss.

2. a. These are the parts of an income statement. Inventory is always found on a
balance sheet. The cost of buying the inventory is found in the Cost of Goods
Sold line item on an income statement.

3. d. All three are different types of profits you will find on a multi-step income
statement.

4. d. The statement of shareholders’ equity shows ownership information from the
balance sheet, which includes common stock and treasury stock. It also includes
information for changes in retained earnings from the income statement.

5. b. Advertising expenses are usually included in Sales and Administrative
Expenses. Some companies do report advertising expenses on an individual
line as part of the expense section of the income statement.

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Summary and Resources

Rejoinders to Chapter Post-Test
1. The income statement shows the financial results over a particular period of time.
2. The multi-step income statement shows profits after cost of goods sold, which is

called gross profit. Then it shows profits after operating expenses, which is called
operating profit. Then it shows profit after non-operating expenses, which rep-
resents the bottom line, called net profit. Some income statements include other
profit lines as well.

3. Prepaid Expenses are an asset account that is used when an item is paid for in
advance, such as an insurance policy. The policy is then expensed on a monthly
basis as insurance expenses, which would be found on the income statement.

4. Long-term assets are expensed using both depreciation (for tangible assets) and
amortization (for intangible assets). If there is a line item on the income statement
showing equipment expenses, that line item indicates costs of equipment not
used over the long term.

5. Gross Profit shows the profit made from sales minus the costs of buying or
manufacturing the products or services sold.

6. When monitoring operating profit, managers want to be sure a company can
cover all its expenses for its operations of the core business. If the company can-
not earn the revenue it needs for its core operations, then in a year when a one-
time income opportunity is not available, the company may lose money. Other
factors may be involved when trying to determine whether a company can stay
in business, such as a company’s ability to get financing to cover operations in a
downturn.

7. Marketable Securities is an asset that would be found on the balance sheet.
8. While both earnings kept in the business until the next year and earnings not

paid out in dividends do add to retained earnings, the line item on the statement
of shareholders’ equity reflects the historical reinvestment of profits.

9. All of the above. The common-sized income statement provides a tool for analyz-
ing trends, comparing large and small companies and comparing the company to
industry benchmarks.

10. All of the above. Downward or upward trend in revenues, costs, and expenses
can be seen when reading a common-sized income statement.

Discussion Questions
1. What are the key factors a manager should consider when reviewing gross profit

trends?
2. What are the key factors a manager should consider when reviewing operating

profit trends?
3. What are the key factors a manager should consider when reviewing net profit

trends?
4. Why is it important to compare a company’s results period to period?
5. Why do you think it is important to use a common-sized income statement to

compare competitive companies?

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Summary and Resources