In preceding chapters, we illustrated the income statement with only two categories—revenues and expenses. In contrast, a multi-step income statement divides both revenues and expenses into operating and nonoperating (other) items. The statement also separates operating expenses into selling and administrative expenses. A multi-step income statement is also called a classified income statement.

The multi-step income statement shows important relationships that help in analyzing how well the company is performing. For example, by deducting cost of goods sold from operating revenues, you can determine by what amount sales revenues exceed the cost of items being sold. If this margin, called gross margin, is lower than desired, a company may need to increase its selling prices and/or decrease its cost of goods sold. The classified income statement subdivides operating expenses into selling and administrative expenses. Thus, statement users can see how much expense is incurred in selling the product and how much in administering the business. Statement users can also make comparisons with other years’ data for the same business and with other businesses. Nonoperating revenues and expenses appear at the bottom of the income statement because they are less significant in assessing the profitability of the business.

• Net Sales are the revenues generated by the major activities of the business—usually the sale of products or services or both less any sales discounts and sales returns and allowances.
• Cost of goods sold is the major expense in merchandising companies and represents what the seller paid for the inventory it has sold.
• Gross margin or gross profit is the net sales – cost of goods sold and represents the amount we charge customers above what we paid for the items.  This is also referred to as a company’s markup.
• Operating expenses for a merchandising company are those expenses, other than cost of goods sold, incurred in the normal business functions of a company. Usually, operating expenses are either selling expenses or administrative expenses. Selling expenses are expenses a company incurs in selling and marketing efforts. Examples include salaries and commissions of salespersons, expenses for salespersons’ travel, delivery, advertising, rent (or depreciation, if owned) and utilities on a sales building, sales supplies used, and depreciation on delivery trucks used in sales. Administrative expenses are expenses a company incurs in the overall management of a business. Examples include administrative salaries, rent (or depreciation, if owned) and utilities on an administrative building, insurance expense, administrative supplies used, and depreciation on office equipment.
• Income from Operations is Gross profit (or margin) – operating expenses and represents the amount of income directly earned by business operations.
• Other revenues and expenses are revenues and expenses not related to the sale of products or services regularly offered for sale by a business.   This typically includes interest earned (interest revenue) and interest owed (interest expense).
• Net Income is the income earned after other revenues are added and other expenses are subtracted.

Look at these selected accounts from Hanlon’s adjusted trial balance:

We can prepare Hanlon’s Multi-step Income statement as:

Reporting Cost of Goods Sold

Cost of goods sold can be reported two ways:  as a single line item or as detailed section showing net purchases and calculating cost of goods sold.  When using the perpetual inventory method, cost of goods sold is reported as a single line item (as illustrated in video and example above).

Under the periodic method, you can use a single line item in the multi-step income statement with a separate schedule of cost of goods sold OR you can report the cost of goods sold within the income statement itself.  The following video reviews the periodic method entries and shows how to complete the cost of goods sold section with in the multi-step income statement.

To illustrate a cost of goods sold statement, Hanlon Food Store had the following unadjusted trial balance amounts:

Remember, the merchandise inventory on the unadjusted trial balance is the beginning balance (or ending balance from the previous period.  A physical count of inventory on December 31 showed inventory of $31,000 unsold.  The Cost of Goods Sold Statement would appear as:

 Other financial statements

After the income statement is complete, we would use the net income to calculate ending retained earnings on the statement of retained earnings.  We would use ending retained earnings in preparing the balance sheet.  Finally, we would prepare the statement of cash flows.  These financial statements are prepared the same way under either the perpetual or periodic inventory methods.

Summary

To summarize the important relationships in the income statement of a merchandising firm in equation form:

• Net sales = Sales revenue – Sales discounts – Sales returns and allowances.
• Gross margin = Net sales – Cost of goods sold.
• Total Operating Expenses = Selling expenses + Administrative expenses.
• Income from operations = Gross margin – Operating (selling and administrative) expenses.
• Total other revenues (expenses) = Other Revenues – Other Expenses
• Net income = Income from operations + Other revenues – Other expenses.

Each of these relationships is important because of the way it relates to an overall measure of business profitability. For example, a company may produce a high gross margin on sales. However, because of large sales commissions and delivery expenses, the owner may realize only a very small amount of the gross margin as profit.