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CHAPTER 2

Income Statement
I/ Key Things to Know

Revenues: Provide goods or services to customers in return for an asset (cash)

The revenue principle: 4 criteria that must be met for revenue to be recognized

1) Delivery of goods has occurred or a service has been rendered

2) Persuasive evidence of arrangement for customer payment
3) The price is fixed and determinable
4) Collection is reasonably assured

Revenue is NOT recognized when cash is received.

Expenses: Use an asset to generate revenues, “incurred” when

1) an asset is used up
2) a service is provided to the company that must be paid for

Expenses are recognized when incurred, NOT when they are paid

(Recognize means to record and report in the financial statements)

The Matching Principle: Expenses incurred to generate revenues must be

recognized in the same period as the revenue

examples: Wages and salary expense is recorded for the period the
employees work to produce revenues
Depreciation expense is recorded for the period the long term
asset is used to produce revenues
Interest expense is recorded for the period the money is used
to produce revenues
Utility expense is recorded for the period the utilities are used
to produce revenues
Bad debt expense is recorded in the period the sale occurred

Revenues are recorded when earned and expenses are recorded when incurred
to produce the revenues.

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Accrual Basis of Accounting:

Revenues are recorded when earned and expenses are recorded when incurred.
When the cash is received or paid DOES NOT Matter

Format of the Single Step Income Statement: For a period of time

List all revenues and subtotal, list all expenses and subtotal:

Sales
Interest income
Rent income
Total revenues

Cost of Goods sold

Selling expenses
Administrative expenses
Interest expense
Rent expense
- Total expenses

= Net Income

Format of the Multi-Step Income Statement: For a period of time

Sales
- Cost of Goods Sold
= Gross Profit
- Operating Expenses:
General and Administrative
Selling
Research & Development
Restructuring
= Operating Income
+ - Other Revenues & Expenses:
Interest Income or Expense
Rent Income
Unusual Gains and Losses
Realized/Unrealized Gains/Losses on Investments
Gain/loss on Sale of an Asset

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= Income Before Taxes:

- Tax Expense
= Income from Continuing Operations
+ - Discontinued Operations:
+ - Extraordinary Items

= Net Income

Terms related to the income statement:

Gross Profit: Sales price less the cost to buy or manufacture the goods sold
This is the profit made from selling inventory only.
This profit is used to pay operating expenses

Operating Expenses: Directly related to day to day business operations

Related to:
1) Selling – sales employees, marketing, advertising
2) Administrative – expenses to run the organization
3) Research & Development – to develop new products
4) Restructuring of operations – to reduce future expenses

Operating Income: Sales less Cost of Goods Sold less Operating expenses

This is what is earned from day to day business that is expected to

continue in the future as the business continues

Other Revenues/Expenses: the result of a transaction that is not part of your

primary day to day business
Examples:
Interest expense: a cost of borrowing money
Gains/Losses: resulting from selling assets you no longer use
or disposal or destruction of an asset
Rent Income: earn from leasing excess space, not your primary business
Interest income: earn from excess cash, not your primary business
Dividend income: earn from investing excess cash when investing is not
your primary business

Tax Expense: Reported separately. Not an expense that management

can control since it is government mandated.

Income from Continuing Operations: An indication of income that can be earned

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in future years – used for trend analysis

Discontinued Operations: Selling or disposing of a major part of the business

- product line -geographic area

Extraordinary Item: “Unusual and Infrequent” – not expected to happen again

Net Income: Total earnings of the company for this period

Cash Basis vs. Accrual Basis

Cash Basis:

Revenues: record when cash is received for providing goods or services

Expenses: record when cash is paid for something provided to the company
- can be an asset or a service

Accrual Basis:

Revenues: recorded when earned, the goods or services are provided

Expenses: recorded when incurred; use up an asset or a service was

provided to the company

GAAP, IFRS requires the accrual basis of accounting in order

to follow the matching principle

When cash is paid or received does not matter

Revenues are recorded when earned
Expenses are recorded when incurred

Practice as You Learn :You should memorize the formats of the single step and the
multi-step income statements

Practice Problem 1 – Income Statement - Reporting revenues and

expenses

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Prepaid Legal, Inc. had the following transactions occur during the month of January:

1) Customers paid the company $480,000 for one year of legal service
to be earned equally over the year.
2) Employees worked and the company incurred $14,000 in salaries for
the month of January.
3) The company paid $12,000 for salaries to employees during January.
4) The December utility bill of $1,200 was paid in January
5) The January utility bill of $2,500 was received but not paid.
6) The company purchased office furniture for $32,000 in January that is
expected to be used for the next 8 years.
7) The company incurred $800 of interest expense in January that won’t
be paid until March.
8) Liability insurance in the amount of $3,600 to cover the next six months
was paid for in January
9) Rent for the first three months of the year was paid in January in the
amount of $6,000.
10) Supplies costing $2,000 were purchased in January and supplies costing
$275 were used up in January.

required:

a./ Double entry transactions occur during the month of January in Prepaid Legal, Inc.

b./ Prepare a single step and the multi-step income statement for the month of January
using the accrual basis.

Practice Problem 2 – Prepare a Multi-Step Income Statement

The following items were taken from the company’s accounting records for the year
ended December 31st.

Sales 5,400,000 General & Admin 850,000

expense
Cost of Goods Sold 3,200,000 Selling expense 400,000
Interest Expense 70,000 Income tax expense 40%
Rent Income 80,000 Loss from selling a 75,000
major prod line (net
tax)

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Loss on sale of 15,000 Accumulated 27,000

building Depreciation
Unusual Loss 130,000 Dividends Paid 100,000
Research and 125,000 Restructuring 180,000
Develop Expenses
Gain - Infrequent & 200,000 Accrued expenses 32,000
Unusual(net tax)
Prepaid Expenses 30,000 Salaries Payable 49,000

Prepare a a single step and multi-step income statement in proper format.

Q3. Indicate which section of the classified income statement the account will be
reported under:
S Sales
CGS Cost of Goods Sold
OE Operating Expense
ORE Other Revenue and Expense
N Not reported on the income statement
_____a. rent expense
_____b. depreciation expense on administrative furniture
_____c. insurance expense
_____d. selling investments at a loss
_____e. collections from customers
_____f. restructuring expense
_____g. loss from a fire
_____h. the cost of inventory provided to customers
_____ i. executive salaries
_____ j. advertising expense
_____k. owe for employee bonuses
_____l. supplies on hand

Q4. For each of the following items :

a./ Determine the financial statement the following accounts are reported on:
b./ state whether it is an asset (A), liability (L), Owner’s equity (O), revenue (R), or expense
(E)

1. accounts receivable
2. interest revenue
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3. notes payable
4. dividends paid
5. rent expense
6. taxes payable
7. accumulated depreciation
8. Owe on account
9. Accrued expenses
10. Retained earnings
11. Trademarks
12. Cost of goods sold
13. Providing goods to customers
14. Salaries to employees

Q5. A company has the following accounts at the end of the year. Prepare a multi-
step income statement for the period ended December 31st.
Insurance expense
Loss from a flood
Salesman salary expense
Rent income
Sales revenue
Inventory
Accumulated depreciation
Loss from selling part of the business
Interest expense
Cost of goods sold
Dividends paid
Rent expense

Q6.Global Legal, Inc. had the following transactions occur during the month of
July:

1) Customers paid the company $480,000 for one year of legal service
to be earned equally over the year.

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2) Employees worked and the company incurred $14,000 in salaries for

the month of January.
3) The company incurred $12,000 for salaries to employees during July.
4) The July utility bill of $1,200 was paid in July
5) The January utility bill of $2,500 was received but not paid.
6) The company purchased office furniture for $48,000 in January that is
expected to be used for the next 6 years.
7) The company incurred $800 of interest expense in June that won’t
be paid until December.
8) Liability insurance in the amount of $3,600 to cover the next six months
was paid for in July
9) Rent for the first three months of the year was paid in July in the
amount of $6,000.
10) supplies costing $275 were used up in July.

required:

a./ Double entry transactions occur during the month of January in Prepaid Legal, Inc.

b./ Prepare a single step and the multi-step income statement for the month of January
using the accrual basis.

Q7. A company had the following transactions during the first month of the
year. Prepare a multi-step income statement for the month ended January 31st.
a. paid $16,000 in salaries and wages incurred during the month
b. sold $100,000 of goods that cost $48,000
c. collected $69,000 from customers
d. paid $900 for rent for this month and the next two months
e. received $100 for interest earned last month
f. recorded depreciation expense of $500 for this month
g. received a bill for utilities for this month for $1,100

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h. paid the utility bill for last month for $950.

i. the company’s tax rate is 30%

Q8. In 2013, Burghoff, Inc. (a hardware retail company) sold 10,000 units of its
product at an average price of $400 per unit. The company reported estimated Returns and
allowances in 2013 of $200,000. Burghoff actually purchased 11,000 units of its product
from its manufacturer in 2013 at an average cost of $300 per unit. Burghoff began 2013
with 900 units of its product in inventory (carried at an average cost of $300 per unit).
Operating expenses (excluding depreciation) for Burghoff, Inc. in 2013 were $400,000 and
depreciation expense was $100,000. Burghoff had $2,000,000 in debt outstanding
throughout all of 2013. This debt carried an average interest rate of 10 percent. Finally,
Burghoff’s tax rate was 40 percent. Burghoff’s fiscal year runs from January 1 through
December 31. Given this information:
+ What was Burghoff’s 2013 ending inventory balance (in both units and in dollars)?
+ construct Burghoff’s 2013 multi-step income statement.

Q9. Prepare a single step and the multi-step income statement using the following
information:

1) The cost of inventory sold to customer $220,000

2) Advertising expenses $ 25,000

3) Administrative salary expenses $ 80,000

4) Issued common stock $ 75,000

5) Interest income $ 10,000

6) Insurance expense $ 4,000

7) Research and development costs $ 22,000

8) Dividends paid $ 15,000

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9) Tax expense 35%

10) Rent expense $ 12,000

11) Loss from closing 1 out of 6 shops $ 8,000

12) Accrued expenses $ 11,000

13) Sales price of goods provided to customers $450,000

14) Loss on the sale of a building $ 26,000

15) Gain that is both unusual and infrequent $ 90,000

Q10. Match the following categories with the descriptions provided below:

A. Included in Gross Profit

B. Included in Operating expenses
C. Included in Other Revenues and Expenses
D. Included in Discontinued Operations
E. Included in Extraordinary Items
F. Included in Effect of an Accounting Change
G. Is not reported on the Income Statement

______ 1. Rent revenue collected in advance

______ 2. Reorganizing the company’s operations
______ 3. Loss from selling a major product line
______ 4. Interest income
______ 5. Provide goods to customers
______ 6. Changing a depreciation method
______ 7. Loss from a hurricane in Florida ( happened every year)
______ 8. Research and development expenses
______ 9. Marketing expenses
______ 10. Executive salaries
______ 11. Depreciation on manufacturing equipment
______ 12. Rent income
______ 13. The cost of inventory sold to customers
______ 14. Loss on the sale of an investment
______ 15. Loss from a flood in the California desert

Q11. The following income statement was prepared by the marketing manager
using the company’s cash records and inventory records:

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Sales $650,000
Other revenues $ 26,000
Total Revenues: $676,000

Cost of Goods Sold: $234,000

Gross Profit: $442,000

Selling Expenses: $102,000

Administrative Expenses $144,000
Other Expenses $ 86,152

Net Earnings: $109,848

After examining transactions, you discovered the following:

Included in other expenses

1) Tax expense was at 36% of income before taxes
2) The company incurred a loss of $2,800 from selling equipment
3) Rent expense of $12,000
Included in other revenues:
1) Interest income of $13,000
2) Rent income $6,000
Included in selling expenses:
1) Loss from selling a major part of the business $17,000
2) Depreciation expense on manufacturing equipment $22,000

a./ Prepare a corrected multi-step income statement for the Company

b./ Prepare a single step income statement

c./ Cal PROFITABLITY ANALYSIS

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Q12: Financial statements for Longman Company follow:

Longman Company
Income Statements
for the Years Ended December 31
Unit: $ 2012 2013
Revenues
Net sales 315,000 259,000
Expenses
Cost of goods sold 189,000 154,000
General, selling, and administrative
expenses 54,000 46000
Interest expense 4,000 4500
Income before taxes 68,000 54,500
Income tax expense (40%) 27,200 21,800
Net income 40,800 32,700

Required:
a./ Analysis vertical common and comment
b./ Prepare a trend analysis and comment.
c./ Cal PROFITABLITY ANALYSIS

Q13: Financial statements for Longman Company follow:

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Required:
a./ Analysis vertical common and comment
b./ Prepare a trend analysis and comment.
c./ Cal PROFITABLITY ANALYSIS

Quick Study Sheet

Revenues: 4 criteria that must be met for revenue to be recognized
1) Delivery of goods or service 2) evidence of arrangement for customer payment
3) The price is fixed and determinable 4) Collection is reasonably assured
Revenue is recognized when earned - NOT when cash is received.

Expenses: 1) use up an asset 2) service provided to the company that must be

paid for
Expenses are recognized when incurred - NOT when they are paid

The Matching Principle: Expenses incurred to generate revenues must be

recognized in the same period as the revenue

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Accrual Basis of Accounting:

Revenues are recorded when earned and expenses are recorded when incurred.
When cash is received or paid DOES NOT Matter

Format of the Single Step Income Statement: For a period of time

Total revenues – list them out and total them
Total expenses – list them out and total them
Total revenues less total expenses = net income

Format of the Multi-step income statement: For a period of time

Sales
- Cost of Goods Sold
=Gross Profit
- Operating Expenses:
General and Administrative Selling
Research & Development Restructuring
= Operating Income
+ - Other Revenues & Expenses: (gains/losses/interest/rent income)
= Income Before Taxes:
- Tax Expense
= Income from Continuing Operations
+ - Discontinued Operations:
+ - Extraordinary Items

= Net Income

Operating income: earned from primary day to day operations

Income from continuing operations: earnings from all activities expected to
continue
Discontinued Operations: Selling or disposing of a major part of the business
Extraordinary Item: Both “Unusual and Infrequent” – not expected to happen again
Net Income: Total earnings of the company for this period

Accrual Basis – required by GAAP

Revenues: record when earned; the goods or services are provided
Expenses: record when incurred; use up an asset or a service was provided to the
company

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