The Income Statement

Learning Objectives
By the end of this chapter, you should be able
to:
• Identify income and expense accounts.
• Identify the various income statement for-
mats.
• Prepare the single-step income statement.
• List the five types of revenue and expense ad-
justments.

INTRODUCTION
The income statement serves three key functions. First, it is a summary of the
revenues and expenses of an entity for a specified period of time. Second, it
summarizes the company’s operational activity. Finally, the income statement
account balances reflect the cumulative activity in the revenue and expense
accounts for the period being reported. This statement is also referred to as
the statement of income, the operating statement, the statement of operations, or the profit
and loss statement.

INCOME STATEMENT FORMAT

An income statement may take one of several forms. The single-step income state-
ment has no provision for intermediate income measurement. It merely deducts
the total of all costs and expenses from the total of all revenues to arrive at a
net income figure. No recognition is given to gross profit or nonoperating in-
come and expenses. Exhibit 5–1 shows an example of the single-step format.

71
72 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS

5–1
Example of a Single-Step Income Statement

ABC Corporation
Income Statement
For Year Ended December 31, 20X2

Revenues:
Net Sales $708,000
Interest Income 3,600
Total Revenues $711,600

Expenses:
Cost of Merchandise Sold $525,000
Selling Expenses 75,000
General Expenses 35,000
Interest Expense 2,400
Total Expenses 637,400
Net Income $ 74,200

The multi-step income statement provides for intermediate income meas-

urement of such items as gross profit, net operating income, and net income.
A distinction is made between operating and nonoperating revenues and ex-
penses. For example, if the company earns revenues from an extraordinary
event, such as the sale of a subsidiary, the revenue is shown separately from
the operating income. The amount of income before taxes reflects pre-tax
earnings and emphasizes the special nature of the income tax levy. The multi-
step income statement is more likely to be found in the more detailed financial
statements prepared for use by management, bankers, and other creditors. Ex-
hibit 5–2 is an example of the multi-step income statement.

Answers appear at the end of this chapter.

1. On a separate peice of paper use the following account balances to prepare a single-step in-
come statement for the XYZ Company. Use the format shown in Exhibit 5–1 as a guide.
(CAUTION: There may be one or two figures that you do not need to prepare the single-step
statement.)

“Think About It” continues on next page.

 THE INCOME STATEMENT 73

Think About It continued from previous page.

Cost of Merchandise Sold $500,000

Net Sales $850,000
Selling Expenses $70,000
Interest Income $3,000
General Expenses $30,000
Gross Profit $350,000

Components of an Income Statement

Whatever the format, every income statement details the activity of four types
of economic variables. These variables are:
1. Revenues
2. Expenses
3. Gains
4. Losses
Revenues
Revenues are earned from providing services and selling goods. Under the
accrual basis of accounting, revenues are recorded at the time of providing
the service or delivering the goods, even if cash is not received at the point of
purchase. Examples of revenue accounts include sales, service revenues, fees
earned, and interest earned. The nature of the business operation dictates the
main revenue sources of the entity. Typical revenues of a law firm are from
fees earned; for Walmart, they are from sales (merchandise); for Bank of
America, they are from interest paid on loans made to its customers. A key
quality of revenue is that it is the result of activities that constitute the entity’s
ongoing major or central operations.

Expenses
Expenses are outflows (or other using-up of assets) or incurrences of liabilities (or
both) during a period from delivering or producing goods, rendering serv- ices,
or carrying out other activities that constitute the entity’s ongoing major or
central operations. Expenses are often categorized as cost of goods sold (the cost
of the merchandise or product sold) and operating expenses. Operating
expenses are incurred in carrying out an organization’s day-to-day activities
and include payroll, sales commissions, employee benefits and pension con-
tributions, transportation and travel, rent, amortization and depreciation, re-
pairs, and various types of taxes. Operating expenses are usually subdivided
into selling expenses and administrative and general expenses.
74 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS

xhibit 5–2
Example of a Multi-Step Income Statement

ABC Corporation
Income Statement
For Year Ended December 31, 20X2

Revenues from Sales:

Sales $720,000
Less: Sales Returns and Allowances $ 6,100
Sales Discounts 5,900 12,000
Net Sales $708,000

Cost of Merchandise Sold:

Merchandise Inventory,
January 1, 20X2 $ 60,000
Purchases $520,000
Less:
Purchase Returns and Allowances $ 9,100
Purchase Discounts 2,500 11,600
Net Purchases $508,400
Add in Transportation 17,400
Cost of Merchandise Purchased 525,800
Merchandise Available for Sale $585,800
Less: Merchandise Inventory,
December 31, 20X2 60,800
Cost of Merchandise Sold 525,000
Gross Profit $183,000

Operating Expenses:
Selling Expenses:
Sales Salaries Expense $ 60,000
Advertising Expense 11,000
Depreciation Expense 3,100
Miscellaneous Selling Expense 600
Total Selling Expenses $ 74,700

General Expenses:
Office Salaries Expense $ 21,000
Rent Expense 8,100
Depreciation Expense 2,500
Insurance Expense 1,900
Office Supplies Expense 600
Merchandise General Expense 700
Total General Expenses 34,800

Total Operating Expenses 109,500

Income from Operations $ 73,500
Other Income: Interest Income $ 3,600
Other Expense: Interest Expense 2,900 700
Net Income $ 74,200
 THE INCOME STATEMENT 75

Gains
Gains are increases in equity (net assets) from peripheral or incidental trans-
actions of an entity and from all other transactions and other events and cir-
cumstances, except those resulting from revenues or investments by owners,
affecting the entity during a period. For example, if a manufacturing company
owns a vacant lot at a cost of $100,000 and sells it for $150,000, it will have a
$50,000 gain (ignoring taxes). That gain is a peripheral or incidental event
with regard to its normal operating activities (manufacturing and selling prod-
ucts) and is therefore not classified as a revenue item, as it is not from normal
(day-to-day) operations.

Losses
Losses are decreases in equity (net assets) from peripheral or incidental trans-
actions on an entity and from all other transactions and other events and cir-
cumstances, except those that result from expenses or distributions to owners,
affecting the entity during a period.
Gains and losses can be widely varied, but the key is that they are of a
non-normal type of transaction, i.e., sale of investments, theft, sale or closing
of a plant, etc. If the gain or loss is of an unusual and infrequent nature, it is
usually classified as an extraordinary item and is presented below the income
from operations. The purpose is to separate nonrecurring items from normal
operations in order to make the components of income clear to the reader.
To summarize: Revenues and expenses are the recording of transactions
that are the normally occurring types of business in which an enterprise is
engaged. The result of these transactions represents the income or loss from
operations. Gains and losses are the result of transactions that are outside the
normal realm of operations; for example, the closing of a plant is usually pre-
sented as an extraordinary item.

Comprehensive Income
Comprehensive income is a company’s change in total stockholders’ equity
from all sources other than the owners’ of the firm. It is calculated as follows:
Net income (or net loss) plus unrealized gains (losses) on available-for-sale invest-
ments and foreign-currency translation adjustments
Net income, not comprehensive income, is used to calculate the earnings
per share of a company. Exhibit 5–3 shows an example of a statement of com-
prehensive income.
76 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS

Answers appear at the end of this chapter.

2. Match the revenue or expense described with the type of company.

Type of Revenue or Expense Type of Company

1. Legal fees earned A. Landscaping company

2. Interest income B. Insurance company
3. Premiums
C. Bank
4. Sales of merchandise
D. Law firm
5. Interest expense on time deposit
accounts E. Retailer
6. Cost of materials, labor, and
overhead of products sold F. Manufacturer
7. Depreciation expense on trucks
and lawn mowers

5–3
Example of a Statement of Comprehensive Income

Statement of Comprehensive Income

For the year ended December 31, 20X1
Amounts are in thousands (000s)

Net Sales $15,000

Cost of goods sold 9,000
Gross profit $6,000
Operating expenses 4,000
Operating income $2,000
Interest income 15
Income before taxes $2,015
Income taxes 800
Net income $1,215
Other comprehensive income:
Unrealized gains on available-for-sale investments 500
Loss on foreign currency translation 100
Comprehensive income $1,615
 THE INCOME STATEMENT 77

CASH VERSUS ACCRUAL BASIS OF

ACCOUNTING
The analyst must be aware of the accounting basis, cash or accrual, used by
the company whose statements he or she is examining. The cash basis is gen-
erally used by small businesses in which inventories, receivables, and payables
are not a material factor.

Cash Basis
A rule for the cash basis of accounting for revenues and expenses is:
1. Revenue is recorded as earned when it is received or collected.
2. Expense is recorded as incurred when it is paid.
Objections to the cash basis are numerous. The primary objection con-
cerns the difficulty of matching current costs with current revenues. The time
elapsed between the production of revenue and its ultimate recognition affects
the financial and managerial position of a company. If expenses are prepaid
(for example, prepaid rent), they are taken entirely as an expense at the time
of a payment and will produce a calculated income. The calculated income
will be understated in the period of payment and overstated in the subsequent
period or periods that received the benefit of the expenditure.

Accrual Basis
The accrual basis of accounting is used by larger firms and is an acceptable
method for reporting revenue. On the accrual basis, revenue is allocated to
the period or periods it is earned, regardless of when it is collected. Expenses
are applied to the period in which they are incurred rather than the period of
their payment or satisfaction. The summarizing rule for the accrual basis of
accounting is:
1. Revenue is recorded as such in the period it is earned, regardless of when
it is received.
2. Expense is recorded as such in the period it is incurred, regardless of when
it is paid.

Since an important goal of the accrual basis of accounting is to match

costs and revenues for a particular period, adjustment of account balances is
necessary at year’s end.

APPORTIONMENT OF REVENUES AND

EXPENSES
In its operations during an accounting period, a company is affected by accrued
and deferred expenses and revenues. Transactions that were recorded in ac-
counts affecting the balance sheet and income statement during one period
may influence other accounting periods. Therefore, end-of-period adjustments
78 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS

are necessary. Financial transactions or events that have not been recorded as
of year’s end will have to be recorded in order to bring all accounts to their
proper balances as of the statement date.
The diversity of year-end adjustments fits into five categories:
1. Prepaid expenses requiring apportionment
2. Unearned and recorded revenues requiring apportionment
3. Unrecorded accrued revenues
4. Unrecorded accrued expenses
5. Valuation of accounts receivable and investments

Prepaid Expenses Requiring Apportionment

Outlays that contribute to revenues of a particular period are called expenses.
For example, prepaid or unexpired insurance for a three-year coverage is an
asset at the time of the cash outlay. However, this cost eventually expires and
requires an entry that would move the expired portion of insurance from an
asset account to an expense account. This periodic matching of the use of an
asset with the period in which it is used is an excellent example of the concept of
matching of revenue and expense.

Unearned and Recorded Revenues Requiring Apportionment

Suppose $24,000 was received in advance for the 24-month rental of a ware-
house unused by the company. Revenue income, if recorded as $24,000, would
produce an overstated figure, with the resulting income and income tax over-
stated. The later period or periods would receive the benefit of the rent pre-
payment but would not be charged with any of the expense. Matching of costs
and revenues would not occur. In this case, a liability for the unearned portion
would be set up and the revenue account credited for the amount earned. The
liability account of unearned revenue may need to be split between a current
and noncurrent liability, depending on how many months are unearned and
the fiscal year of the company. For example, if 18 months were unearned, 12
months would be current and 6 months would be noncurrent as of that balance
sheet date.

Unrecorded Accrued Revenues

Accrued revenues occur when revenue is earned but not yet collected. At the
end of an accounting period, some accrued revenues may need to be recorded.
Examples of unrecorded revenues are interest revenue owed to the company
for completed services or delivered goods that, for a variety of reasons, have
not been billed (invoiced) to the customer. For example, assume a bank’s cus-
tomer owes 12% interest on a three-year, $10,000 note (loan) receivable but
has not yet made a payment; still, one month of interest has accrued. That
would mean that $100 ($10,000 x .12/12 months) of accrued interest would
need to be recorded. Another example: A service worth $1,000 was performed
for a customer on the last day of the year but the customer won’t pay until
next month and an invoice has not yet been mailed out. Under accrual ac-
counting rules, the revenue is earned when the service has been provided or
 THE INCOME STATEMENT 79

the goods have been delivered and so the $1,000 should be recognized as ac-
crued revenue.

Unrecorded Accrued Expenses

Accrued salaries serve as an illustration here. If payroll accrued at a daily rate
of $20,000 and was not recorded for three days at year’s end, the expense for
payroll would be understated, income overstated, and income tax computed
thereon too high. The accounting period that followed would be affected con-
versely. To correct this balance, a current liability would be recorded and the
correct expense accounts would be charged for $60,000. This reasoning is the
same for any other expense incurred but not paid during the accounting pe-
riod.

Valuation of Accounts Receivable and Investments

Whenever a business makes sales on account, some accounts receivable prove
wholly or partially uncollectible. In order to effect a proper matching of costs
and revenues, the estimated loss arising from a credit sale should be recog-
nized in the period the sale was made. This requires an evaluation of the re-
ceivables to determine the approximate amount of the loss. Once the estimate
is established, it should be reflected on the accounts receivable balance at
year’s end. An account for bad debts expense (also often called the allowance
for doubtful accounts) contains the total of the periodic expense to be used in
the income statement; a contra-valuation account follows the accounts re-
ceivable account to the balance sheet. Income is reduced by the bad debts es-
timate, and accounts receivable is reduced by the contra account. The balance
sheet equation will be in balance. Here is an example. Management estimates
that 2 percent of its credit sales will be uncollectible. Sales for the past year
were $1,000,000, and $600,000 of that amount was on credit. Therefore, the
estimate for bad debts is $12,000. If the company has $50,000 of accounts re-
ceivable at the end of the year, the net book value of the accounts receivable
reported on the balance sheet as of the end of the year would be $38,000
($50,000 less $12,000).

Valuation of Marketable Securities

The valuation accounts for adjusting marketable securities for changes in mar-
ket values (also called fair market value) are covered in Chapter 3.

Answers appear at the end of this chapter.

3. Match the description of an apportionment of a revenue or expense with one of the four appor-
tionment descriptions.

“Think About It” continues on next page.

80 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS

Think About It continued from previous page.

A. During the year 20X1, a civic center sells a three-concert ticket package for a price of
$60 to 10,000 customers. By year end 20X1, two of the concerts had been performed.
Therefore, two-thirds of the $600,000 revenue ($400,000) was recognized as revenue
for 20X1, and $200,000 (the remaining unearned revenue) is shown on the 20X1 year-
end balance sheet as an unearned revenue (liability).
B. A company rents a warehouse. The company makes a rental payment covering the next
24 months on April 1, 20X1. At year end, the remaining unexpired rent, which represents
15 months, is shown on the balance sheet as an asset.
C. At the end of the year, the balance of accounts receivable is $150,000. However, it is
estimated that $20,000 of the receivables will not be collected. The book value of the
receivables is adjusted to show $130,000 as the amount of net receivables.
Apportionment Descriptions
1. Prepaid expenses requiring apportionment
2. Unearned and recorded revenues requiring apportionment
3. Unrecorded accrued expenses
4. Valuation of accounts receivable and investments

The income statement is a summary of the revenues and ex-

penses of an entity for a specific period of time. It shows the
calculation of net income (revenues less expenses). Two for-
mats are used to present the income statement: the single step
and multi-step formats.
When accountants prepare an income statement using
accrual accounting principles, adjusting entries are necessary to
assure that revenues and expenses are properly reflected.
There are five categories of adjustments: prepaid expenses requiring appor-
tionment, unearned and recorded revenues requiring apportionment, un-
recorded accrued revenues, unrecorded accrued expenses, and valuation of
accounts receivable and investments. Adjustments are performed at end of
the accounting period, just before the financial statements are prepared.
 THE INCOME STATEMENT 81

Questions

1. The multi-step income statement provides for intermediate income 1. (d)

measurement of such items as , net operating income, and
net income.
(a) cost of goods sold
(b) earnings before interest
(c) depreciation
(d) gross profit

2. A manufacturing company owns a truck with a net book value of 2. (a)

$14,000. It sells the truck for $10,000 and therefore incurs a $4,000 loss.
Which of the following best describes how the loss will be reported on
the company’s income statement?
(a) It will be shown as a loss, separated from expenses since it is not
incurred in the normal course of operating activities.
(b) The $4,000 loss will be shown as depreciation expense (for the truck)
for the period in which the sale occurs.
(c) It will not be shown separately as it is a type of revenue ($10,000)
because the truck was sold.
(d) It will be part of cost of goods sold reported for the same period of the
sale.

3. A company purchases supplies for $5,000 on January 2, 20X1 and 3. (b)

initially records the purchase as an asset. During the year, another
$2,000 of supplies are purchased and are also added to the supplies
account. On December 31, 20X1 in anticipation of preparing a balance
sheet and income statement, the staff takes a count of the supplies that
remain on hand. The count reveals that $2,500 of supplies have not yet
been used. Which of the following best describes the adjusting entry
that is needed?
(a) No adjusting entry is needed because the company still owns some of
the supplies and therefore won’t need to write them off until they are
used.
(b) The supplies account needs to be reduced by $4,500 and the supplies
expense account needs to be increased by $4,500 to recognize the use
of the asset during the year.
(c) The cash account needs to be reduced by $7,000 for the cost of the
supplies.
(d) The cash account needs to be reduced by $7,000 and increased by
$2,500 by the end of the year.
82 HOW TO READ AND INTERPRET FINANCIAL STATEMENTS

4. If a professional sports team sells season tickets during the

summer 4. (b)
months (games will be played in the time period of September
through February), what will the team most likely need to do at
the end of the
fiscal year (December 31)?
(a) Increase cash for the sale of the tickets and recognize
revenue for all the tickets sold.
(b) Determine what percentage of all games for the season
have been played by year end and recognize a
proportional amount as revenue and reduce its related
liability (unearned revenue) for the same amount.
(c) Determine what percentage of all games for the season has
been played by year end and increase cash by a
proportional amount.
(d) Adjust (reduce) operating expenses for the year by a
proportion equal to the number of games played by
December 31 divided by the total number of games on
the schedule.

5. Management estimates that 4% of its credit sales will be uncollectible. 5. (c)

Sales for the past year were $2,000,000 and $1,600,000 of that amount
was on credit. The end of year balance for accounts receivable is
$120,000. Which of the following is correct?
(a) There are about $80,000 of bad debts that most
likely exist as of year end.
(b) The net receivables are $40,000 as of year end.
(c) The net receivables are $56,000 as of year end.
(d) The bad debt expense for the year will be $56,000.

ANSWERS TO “THINK ABOUT

IT...” QUESTIONS FROM THIS
CHAPTER
1. Revenues:
Net Sales $850,000
Interest Income $3,000
Total Revenues $853,000
Expenses:
Cost of Merchandise $500,000
Selling Expenses $70,000
General Expenses $30,000
Total Expenses $600,000
 THE INCOME STATEMENT 83

Net Income $253,000

2. 1. D, 2. C, 3. B, 4. E, 5. C, 6. F, 7. A
3. A. 2
B. 1
C. 4