Read this chapter and pay attention to the comparison of the two income statements. This chapter reviews the difference in reporting and financial presentation of information for service and merchandising operations and compares recording inventories for two separate types of businesses.
In preceding chapters, we illustrated the unclassified (or single-step) income statement. An unclassified income statement has only two categories - revenues and expenses. In contrast, a classified income statement divides both revenues and expenses into operating and nonoperating items. The statement also separates operating expenses into selling and administrative expenses. A classified income statement is also called a multiple-step income statement.
In Exhibit 39, we present a classified income statement for Hanlon Retail Food Store. This statement uses the previously presented data on sales (Exhibit 35) and cost of goods sold (Exhibit 38), together with additional assumed data on operating expenses and other expenses and revenues. Note in Exhibit 39 that a classified income statement has the following four major sections:
The classified 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.
Management chooses whether to use a classified or unclassified income statement to present a company's financial data. This choice may be based either on how their competitors present their data or on the costs associated with assembling the data.
Less: Sales discounts
Sales return and allowances
Cost of goods sold:
Merchandise inventory, 2010 January 1
Less: Purchase discount
Purchase returns and allowances
Net cost of purchases
Cost of goods available for sale
Less: Merchandise inventory, 2010 December 31
Cost of goods sold
Salaries and commissions expense
Salespersons' travel expense
Rent expense - store building
Depreciation expense - store equipment
Other selling expense
Salaries expense, executive
Rent expense - administrative building
Depreciation expense - office equipment
Other administrative expenses
Total operating expenses
Income from operations
Nonoperating revenues and expenses:
Exhibit 39: Classified income statement for a merchandising company
Next, we explain the major headings of the classified income statement in Exhibit 39. The terms in some of these headings are already familiar to you. Although future illustrations of classified income statements may vary somewhat in form, we retain the basic organization.
Certain operating expenses may be shared by the selling and administrative functions. For example, a company might incur rent, taxes, and insurance on a building for both sales and administrative purposes. Expenses covering both the selling and administrative functions must be analyzed and prorated between the two functions on the income statement. For instance, if USD 1,000 of depreciation expense relates 60 per cent to selling and 40 per cent to administrative based on the square footage or number of employees, the income statement would show USD 600 as a selling expense and USD 400 as an administrative expense.
To summarize the more important relationships in the income statement of a merchandising firm in equation form:
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 percentage of the gross margin as profit. The classifications in the income statement allow a user to focus on the whole picture as well as on how net income was derived (statement relationships).
John Bentley is the chief financial officer for World Auto Parts Corporation. The company buys approximately USD 500 million of auto parts each year from small suppliers all over the world and resells them to auto repair shops in the United States. Most of the suppliers have cash discount terms of 2/10, n/30. John has instructed his personnel to pay invoices on the 30th day after the invoice date but to take the 2 per cent discount even though they are not entitled to do so. Whenever a supplier complains, John instructs his purchasing agent to find another supplier who will go along with this practice. When some of his own employees questioned the practice, John responded as follows:
This practice really does no harm. These small suppliers are much better off to go along and have our business than to not go along and lose it. For most of them, we are their largest customer. Besides, if they are willing to sell to others at a 2 per cent discount, why should they not be willing to sell to us at that same discount even though we pay a little later? The benefit to our company is very significant. Last year our profits were USD 100 million. A total of USD 10 million of the profits was attributable to this practice. Do you really want me to change this practice and give up USD 10 million of our profits?