Introduction to Accounting:

The Language of Business

Lesson 2: General Purpose Financial Statements
Supplemental Textbook

Business Learning Software, Inc

 Financial statements of business organizations
Business entities may have many objectives and goals. For example, one of your objectives in owning a physical
fitness center may be to improve your physical fitness. However, the two primary objectives of every business are
profitability and solvency. Profitability is the ability to generate income. Solvency is the ability to pay debts as
they become due. Unless a business can produce satisfactory income and pay its debts as they become due, the
business cannot survive to realize its other objectives.

There are four basic financial statements. Together they present the profitability and strength of a company. The
financial statement that reflects a company’s profitability is the income statement. The statement of retained
earnings shows the change in retained earnings between the beginning and end of a period (e.g. a month or a
year). The balance sheet reflects a company’s solvency and financial position. The statement of cash flows
shows the cash inflows and outflows for a company over a period of time. The headings and elements of each
statement are similar from company to company. You can see this similarity in the financial statements of actual
companies in the appendix of this textbook.

The income statement, sometimes called an earnings statement, reports the profitability of a business
organization for a stated period of time. In accounting, we measure profitability for a period, such as a month or
year, by comparing the revenues earned with the expenses incurred to produce these revenues. Revenues are the
inflows of assets (such as cash) resulting from the sale of products or the rendering of services to customers. We
measure revenues by the prices agreed on in the exchanges in which a business delivers goods or renders services.
Expenses are the costs incurred to produce revenues. Expenses are measured by the assets surrendered or
consumed in serving customers. If the revenues of a period exceed the expenses of the same period, net income
results. Thus,

Net income = Revenues – Expenses

Net income is often called the earnings of the company. When expenses exceed revenues, the business has a net
loss, and it has operated unprofitably.

In Exhibit 1, Part A shows the income statement of Metro Courier, Inc., for July 2010. This corporation performs
courier delivery services of documents and packages in San Diego in the state of California, USA.

Metro’s income statement for the month ended 2010 July 31, shows that the revenues (or delivery fees)
generated by serving customers for July totaled USD 5,700. Expenses for the month amounted to USD 3,600. As a
result of these business activities, Metro’s net income for July was USD 2,100. To determine its net income, the
company subtracts its expenses of USD 3,600 from its revenues of USD 5,700. Even though corporations are
taxable entities, we ignore corporate income taxes at this point.

One purpose of the statement of retained earnings is to connect the income statement and the balance sheet.
The statement of retained earnings explains the changes in retained earnings between two balance sheet dates.
These changes usually consist of the addition of net income (or deduction of net loss) and the deduction of
dividends.

Dividends are the means by which a corporation rewards its stockholders (owners) for providing it with
investment funds. A dividend is a payment (usually of cash) to the owners of the business; it is a distribution of

Introduction to Accounting : The Language of Business – Supplemental Textbook 1

income to owners rather than an expense of doing business. Corporations are not required to pay dividends and,
because dividends are not an expense, they do not appear on the income statement.

The effect of a dividend is to reduce cash and retained earnings by the amount paid out. Then, the company no
longer retains a portion of the income earned but passes it on to the stockholders. Receiving dividends is, of course,
one of the primary reasons people invest in corporations.

The statement of retained earnings for Metro Courier, Inc., for July 2010 is relatively simple (see Part B of
Exhibit 1). Organized on June 1, Metro did not earn any revenues or incur any expenses during June. So Metro’s
beginning retained earnings balance on July 1 is zero. Metro then adds its USD 2,100 net income for July. Since
Metro paid no dividends in July, the USD 2,100 would be the ending balance of retained earnings. See below.
A. Income Statement
METRO COURIIER INC
Income Statement For the Month Ended
2010 July 31
Revenues:
Service
$ 5,700
revenue
Expenses:
Salaries
$ 2,600
expense
Rent expense 400
Gas and oil
600
expense
Total
3,600
expenses
Net income $ 2,100 (A)

B. Statement of Retained
Earnings

METRO COURIER , INC.

Statement of Retained
Earnings
For the Month Ended 2010
July 31

Retained
-0-
earnings, July 1
Add: Net
(A)2,100
income for July
Retained $ 2,100
earnings, July 31 (B)

C. Balance Sheet

METRO COURIER, INC.

Balance Sheet
2010 July 31

Assets Liabilities and Stockholder's Equity

Cash $ 15,500 Liabilities:
Account receivables 700 Accounts payable $ 600
Trucks 20,000 Notes payable 6,000
Office equipment 2,500 Total liabilities $ 6,600
Stockholders equity:

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 Capital stock $ 30,000
Retained earnings (B)2,100
Total stockholders' equity $ 32,100
Total assets $ 38,700 Total liabilities and stockholders' equity $ 38,700

Exhibit 1:

Next, Metro carries this USD 2,100 ending balance in retained earnings to the balance sheet (Part C). If there
had been a net loss, it would have deducted the loss from the beginning balance on the statement of retained
earnings. For instance, if during the next month (August) there is a net loss of USD 500, the loss would be deducted
from the beginning balance in retained earnings of USD 2,100. The retained earnings balance at the end of August
would be USD 1,600.

Dividends could also have affected the Retained Earnings balance. To give a more realistic illustration, assume
that (1) Metro Courier, Inc.’s net income for August was actually USD 1,500 (revenues of USD 5,600 less expenses
of USD 4,100) and (2) the company declared and paid dividends of USD 1,000. Then, Metro’s statement of retained
earnings for August would be:
METRO COURIER, INC.
Statement of Retained Earnings
For the Month Ended 2010 August 31
Retained earnings, August 1.......................... $2,100
Add: Net income for August..................... 1,500
Total.......................................... $3,600
Less: Dividends................................... 1,000
Retained earnings, August 31........................ $2,600

The balance sheet, sometimes called the statement of financial position, lists the company’s assets, liabilities,
and stockholders’ equity (including dollar amounts) as of a specific moment in time. That specific moment is the
close of business on the date of the balance sheet. Notice how the heading of the balance sheet differs from the
headings on the income statement and statement of retained earnings. A balance sheet is like a photograph; it
captures the financial position of a company at a particular point in time. The other two statements are for a period
of time. As you study about the assets, liabilities, and stockholders’ equity contained in a balance sheet, you will
understand why this financial statement provides information about the solvency of the business.

Assets are things of value owned by the business. They are also called the resources of the business. Examples
include cash, machines, and buildings. Assets have value because a business can use or exchange them to produce
the services or products of the business. In Part C of Exhibit 1 the assets of Metro Courier, Inc., amount to USD
38,700. Metro’s assets consist of cash, accounts receivable (amounts due from customers for services previously
rendered), trucks, and office equipment.

Liabilities are the debts owed by a business. Typically, a business must pay its debts by certain dates. A
business incurs many of its liabilities by purchasing items on credit. Metro’s liabilities consist of accounts
payable (amounts owed to suppliers for previous purchases) and notes payable (written promises to pay a
specific sum of money) totaling USD 6,600.1

Metro Courier, Inc., is a corporation. The owners’ interest in a corporation is referred to as stockholders’
equity. Metro’s stockholders’ equity consists of (1) USD 30,000 paid for shares of capital stock and (2) retained

1 Most notes bear interest, but in this chapter we assume that all notes bear no interest. Interest is an amount
paid by the borrower to the lender (in addition to the amount of the loan) for use of the money over time.

Introduction to Accounting : The Language of Business – Supplemental Textbook 3

earnings of USD 2,100. Capital stock shows the amount of the owners’ investment in the corporation. Retained
earnings generally consists of the accumulated net income of the corporation minus dividends distributed to
stockholders. We discuss these items later in the text. At this point, simply note that the balance sheet heading
includes the name of the organization and the title and date of the statement. Notice also that the dollar amount of
the total assets is equal to the claims on (or interest in) those assets. The balance sheet shows these claims under
the heading “Liabilities and Stockholders’ Equity”.

Management is interested in the cash inflows to the company and the cash outflows from the company because
these determine the company’s cash it has available to pay its bills when due. The statement of cash flows shows
the cash inflows and cash outflows from operating, investing, and financing activities. Operating activities
generally include the cash effects of transactions and other events that enter into the determination of net income.
Investing activities generally include business transactions involving the acquisition or disposal of long-term assets
such as land, buildings, and equipment. Financing activities generally include the cash effects of transactions
and other events involving creditors and owners (stockholders).

The income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows of
Metro Courier, Inc., show the results of management’s past decisions. They are the end products of the accounting
process, which we explain in the next section. These financial statements give a picture of the solvency and
profitability of the company. The accounting process details how this picture was made. Management and other
interested parties use these statements to make future decisions. Management is the first to know the financial
results; then, it publishes the financial statements to inform other users. The most recent financial statements for
most companies can be found on their websites under “Investor Relations” or some similar heading.

The financial accounting process

In this section, we explain the accounting equation—the framework for the entire accounting process. Then, we
show you how to recognize a business transaction and describe underlying assumptions that accountants use to
record business transactions. Next you learn how to analyze and record business transactions.

In the balance sheet presented in Exhibit 1 (Part C), the total assets of Metro Courier, Inc., were equal to its total
liabilities and stockholders’ equity. This equality shows that the assets of a business are equal to its equities; that is,

Assets = Equities

Assets were defined earlier as the things of value owned by the business, or the economic resources of the
business. Equities are all claims to, or interests in, assets. For example, assume that you purchased a new
company automobile for USD 15,000 by investing USD 10,000 in your own corporation and borrowing USD 5,000
in the name of the corporation from a bank. Your equity in the automobile is USD 10,000, and the bank’s equity is
USD 5,000. You can further describe the USD 5,000 as a liability because you owe the bank USD 5,000. If you are a
corporation, you can describe your USD 10,000 equity as stockholders’ equity or interest in the asset. Since the
owners in a corporation are stockholders, the basic accounting equation becomes:

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 Assets ! A"= Liabilities!L"$Stockholders ’ equity!SE "

From Metro’s balance sheet in Exhibit 1 (Part C), we can enter in the amount of its assets, liabilities, and
stockholders’ equity:

A = L + SE

USD 38,700 = USD 6,600 + USD 32,100

Remember that someone must provide assets or resources—either a creditor or a stockholder. Therefore, this
equation must always be in balance.

You can also look at the right side of this equation in another manner. The liabilities and stockholders’ equity
show the sources of an existing group of assets. Thus, liabilities are not only claims against assets but also sources
of assets.

Together, creditors and owners provide all the assets in a corporation. The higher the proportion of assets
provided by owners, the more solvent the company. However, companies can sometimes improve their profitability
by borrowing from creditors and using the funds effectively. As a business engages in economic activity, the dollar
amounts and composition of its assets, liabilities, and stockholders’ equity change. However, the equality of the
basic accounting equation always holds.

A classified balance sheet

The balance sheets we presented so far have been unclassified balance sheets. Unclassified balance sheet
has three major categories: assets, liabilities, and stockholders' equity. A classified balance sheet contains the
same three major categories and subdivides them to provide useful information for interpretation and analysis by
users of financial statements.

Exhibit 2, shows a slightly revised classified balance sheet for The Home Depot, Inc., and subsidiaries.2 Note
that The Home Depot classified balance sheet is in a vertical format (assets appearing above liabilities and
stockholders' equity) rather than the horizontal format (assets on the left and liabilities and stockholders' equity on
the right). The two formats are equally acceptable.

The Home Depot classified balance sheet subdivides two of its three major categories. The Home Depot
subdivides its assets into current assets, property and equipment, long-term investments, long-term notes
receivable, intangible assets (cost in excess of the fair value of net assets acquired), and other assets. The company
subdivides its liabilities into current liabilities and long-term liabilities (including deferred income taxes). A later
chapter describes minority interest. Stockholders' equity is the same in a classified balance sheet as in an
unclassified balance sheet. Later chapters describe further subdivisions of the stockholders' equity section.

2 Founded in 1978, The Home Depot is America's largest home improvement retailer and ranks among the
nation's 30 largest retailers. The company has more than 1,000 full-service warehouse stores. Their primary
customers are do-it-yourselfers.

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 We discuss the individual items in the classified balance sheet later in the text. Our only purpose here is to
briefly describe the items that can be listed under each category. Some of these items are not in The Home Depot's
balance sheet.

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 THE HOME DEPOT, INC. AND SUBSIDIARIES
Consolidated Balance Sheet
2001 January 28
(amounts in millions, except share data)
January 28,
2001
Assets
Current Assets:
Cash and Cash Equivalents $ 167
Short-Term Investments, including current maturities of long-term investments 10
Receivables, net 835
Merchandise Inventories 6,556
Other Current Assets 209
Total Current Assets $ 7,777
Property and Equipment, at cost:
Land $ 4,230
Buildings 6,167
Furniture, Fixtures and Equipment 2,877
Leasehold Improvements 665
Construction in Progress 1,032
Capital Leases 261
$ 15,232
Less: Accumulated Depreciation and Amortization 2,164
Net Property and Equipment $ 13,068
Long-Term Investments 15
Notes Receivable 77
Cost in Excess of Fair Value of Net Assets Acquired, net of accumulated amortization
of $41 at January 25, 2001 and $33 at January 30, 2000 314
Other 134 13,608
Total assets $ 21,385
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts Payable $ 1,976
Accrued Salaries and Related Expenses 627
Sales Taxes Payable 298
Other Accrued Expenses 1,402
Income Taxes Payable 78
Current Installments of Long-Term Debt 4
Total Current Liabilities $4,385
Long-Term Debt, excluding current installments $ 1,545
Other Long-Term Liabilities 245
Deferred Income Taxes 195 1,985
Minority Interest 11
Stockholders' equity:
Common Stock, par value $0.05. Authorized: 10,000,000,000 shares; issued and
outstanding-
2,323,747,000 shares at 2001 January 28 and 2,304,317,000 shares at 2000 January 30 116
Paid-In Capital 4,810
Retained Earnings 10,151

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Accumulated Other Comprehensive Income (67)
15,010
Less: Shares Purchased for Compensation Plans 6
Total Stockholders' Equity 15,004
Total Liabilities and Stockholders' Equity $ 21,385

Exhibit 2: A classified balance sheet

Current assets are cash and other assets that a business can convert to cash or uses up in a relatively short
period—one year or one operating cycle, whichever is longer. An operating cycle is the time it takes to start with
cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or finished goods), sell
services or goods, and receive cash by collecting the resulting receivables. Companies in service industries and
merchandising industries generally have operating cycles shorter than one year. Companies in some manufacturing
industries, such as distilling and lumber, have operating cycles longer than one year. However, since most operating
cycles are shorter than one year, the one-year period is usually used in identifying current assets and current
liabilities. Common current assets in a service business include cash, marketable securities, accounts receivable,
notes receivable, interest receivable, and prepaid expenses. Note that on a balance sheet, current assets are in order
of how easily they are convertible to cash, from most liquid to least liquid.

Cash includes deposits in banks available for current operations at the balance sheet date plus cash on hand
consisting of currency, undeposited checks, drafts, and money orders. Cash is the first current asset to appear on a
balance sheet. The term cash normally includes cash equivalents.

Cash equivalents are highly liquid, short-term investments acquired with temporarily idle cash and easily
convertible into a known cash amount. Examples are Treasury bills, short-term notes maturing within 90 days,
certificates of deposit, and money market funds.

Marketable securities are temporary investments such as short-term ownership of stocks and bonds of other
companies. Such investments do not qualify as cash equivalents. These investments earn additional money on cash
that the business does not need at present but will probably need within one year.

Accounts receivable (also called trade accounts receivable) are amounts owed to a business by customers. An
account receivable arises when a company performs a service or sells merchandise on credit. Customers normally
provide no written evidence of indebtedness on sales invoices or delivery tickets except their signatures. Notice the
term net in the balance sheet of The Home Depot (Exhibit 2). This term indicates the possibility that the company
may not collect some of its accounts receivable. In the balance sheet, the accounts receivable amount is the sum of
the individual accounts receivable from customers shown in a subsidiary ledger or file.

Merchandise inventories are goods held for sale.

A note is an unconditional written promise to pay another party the amount owed either when demanded or at
a certain specified date, usually with interest (a charge made for use of the money) at a specified rate. A note
receivable appears on the balance sheet of the company to which the note is given. A note receivable arises (1) when
a company makes a sale and receives a note from the customer, (2) when a customer gives a note for an amount due
on an account receivable, or (3) when a company loans money and receives a note in return.

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 Other current assets might include interest receivable and prepaid expenses. Interest receivable arises when
a company has earned but not collected interest by the balance sheet date. Usually, the amount is not due until
later. Prepaid expenses include rent, insurance, and supplies that have been paid for but all the benefits have not
yet been realized (or consumed) from these expenses. If prepaid expenses had not been paid for in advance, they
would require the future disbursement of cash. Furthermore, prepaid expenses are considered assets because they
have service potential.

Long-term assets are assets that a business has on hand or uses for a relatively long time. Examples include
property, plant, and equipment; long-term investments; and intangible assets.

Property, plant, and equipment are assets with useful lives of more than one year; a company acquires
them for use in the business rather than for resale. (These assets are called property and equipment in The Home
Depot's balance sheet.) The terms plant assets or fixed assets are also used for property, plant, and equipment. To
agree with the order in the heading, balance sheets generally list property first, plant next, and equipment last.
These items are fixed assets because the company uses them for long-term purposes. We describe several types of
property, plant, and equipment next.

Land is ground the company uses for business operations; this includes ground on which the company locates
its business buildings and that is used for outside storage space or parking. Land owned for investment is not a
plant asset because it is a long-term investment.

Buildings are structures the company uses to carry on its business. Again, the buildings that a company owns
as investments are not plant assets.

Office furniture includes file cabinets, desks, chairs, and shelves.

Office equipment includes computers, copiers, FAX machines, and phone answering machines.

Leasehold improvements are any physical alterations made by the lessee to the leased property when these
benefits are expected to last beyond the current accounting period. An example is when the lessee builds room
partitions in a leased building. (The lessee is the one obtaining the rights to possess and use the property.)

Construction in progress represents the partially completed stores or other buildings that a company such
as The Home Depot plans to occupy when completed.

Accumulated depreciation is a contra asset account to depreciable assets such as buildings, machinery, and
equipment. This account shows the total depreciation taken for the depreciable assets. On the balance sheet,
companies deduct the accumulated depreciation (as a contra asset) from its related asset.

Long-term investments A long-term investment usually consists of securities of another company held
with the intention of (1) obtaining control of another company, (2) securing a permanent source of income for the
investor, or (3) establishing friendly business relations. The long-term investment classification in the balance sheet
does not include those securities purchased for short-term purposes. For most businesses, long-term investments
may be stocks or bonds of other corporations. Occasionally, long-term investments include funds accumulated for
specific purposes, rental properties, and plant sites for future use.

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 Intangible assets Intangible assets consist of the noncurrent, nonmonetary, nonphysical assets of a
business. Companies must charge the costs of intangible assets to expense over the period benefited. Among the
intangible assets are rights granted by governmental bodies, such as patents and copyrights. Other intangible assets
include leaseholds and goodwill.

A patent is a right granted by the federal government; it gives the owner of an invention the authority to
manufacture a product or to use a process for a specified time.

A copyright granted by the federal government gives the owner the exclusive privilege of publishing written
material for a specified time.

Leaseholds are rights to use rented properties, usually for several years.

Goodwill is an intangible value attached to a business, evidenced by the ability to earn larger net income per
dollar of investment than that earned by competitors in the same industry. The ability to produce superior profits is
a valuable resource of a business. Normally, companies record goodwill only at the time of purchase and then only
at the price paid for it. The Home Depot has labeled its goodwill "cost in excess of the fair value of net assets
acquired".

Accumulated amortization is a contra asset account to intangible assets. This account shows the total
amortization taken on the intangible assets.

Current liabilities are debts due within one year or one operating cycle, whichever is longer. The payment of
current liabilities normally requires the use of current assets. Balance sheets list current liabilities in the order they
must be paid; the sooner a liability must be paid, the earlier it is listed. Examples of current liabilities follow.

Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accounts payable
are generally due in 30 or 60 days and do not bear interest. In the balance sheet, the accounts payable amount is
the sum of the individual accounts payable to suppliers shown in a subsidiary ledger or file.

Notes payable are unconditional written promises by the company to pay a specific sum of money at a certain
future date. The notes may arise from borrowing money from a bank, from the purchase of assets, or from the
giving of a note in settlement of an account payable. Generally, only notes payable due in one year or less are
included as current liabilities.

Salaries payable are amounts owed to employees for services rendered. The company has not paid these
salaries by the balance sheet date because they are not due until later.

Sales taxes payable are the taxes a company has collected from customers but not yet remitted to the taxing
authority, usually the state.

Other accrued expenses might include taxes withheld from employees, income taxes payable, and interest
payable. Taxes withheld from employees include federal income taxes, state income taxes, and social security
taxes withheld from employees' paychecks. The company plans to pay these amounts to the proper governmental
agencies within a short period. Income taxes payable are the taxes paid to the state and federal governments by
a corporation on its income. Interest payable is interest that the company has accumulated on notes or bonds but
has not paid by the balance sheet date because it is not due until later.

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 Dividends payable, or amounts the company has declared payable to stockholders, represent a distribution of
income. Since the corporation has not paid these declared dividends by the balance sheet date, they are a liability.

Unearned revenues (revenues received in advance) result when a company receives payment for goods or
services before earning the revenue, such as payments for subscriptions to a magazine. These unearned revenues
represent a liability to perform the agreed services or other contractual requirements or to return the assets
received.

Companies report any current installment on long-term debt due within one year under current liabilities. The
remaining portion continues to be reported as a long-term liability.

Long-term liabilities are debts such as a mortgage payable and bonds payable that are not due for more than
one year. Companies should show maturity dates in the balance sheet for all long-term liabilities. Normally, the
liabilities with the earliest due dates are listed first.

Notes payable with maturity dates at least one year beyond the balance sheet date are long-term liabilities.

Bonds payable are long-term liabilities and are evidenced by formal printed certificates sometimes secured by
liens (claims) on property, such as mortgages. Maturity dates should appear on the balance sheet for all major long-
term liabilities.

The deferred income taxes on The Home Depot's balance sheet result from a difference between income tax
expense in the accounting records and the income tax payable on the company's tax return.

Stockholders' equity shows the owners' interest in the business. This interest is equal to the amount
contributed plus the income left in the business.

The items under stockholders' equity in The Home Depot's balance sheet are paid-in capital (including common
stock) and retained earnings. Paid-in capital shows the capital paid into the company as the owners' investment.
Retained earnings shows the cumulative income of the company less the amounts distributed to the owners in
the form of dividends. Cumulative translation adjustments result from translating foreign currencies into US
dollars (a topic discussed in advanced accounting courses).

The next section shows how two categories on the classified balance sheet relate to each other. Together they
help reveal a company's short-term debt-paying ability.

Classified income statement

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 8, we present a classified income statement for Hanlon Retail Food Store. This statement uses the
previously presented data on sales (Exhibit 4) and cost of goods sold (Exhibit 7), together with additional assumed

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data on operating expenses and other expenses and revenues. Note in Exhibit 8 that a classified income statement
has the following four major sections:

% Operating revenues.

% Cost of goods sold.

% Operating expenses.

% Nonoperating revenues and expenses (other revenues and other expenses).

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.

An accounting perspective:

Business insight

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.

HANLON RETAIL FOOD STORE

Income Statement

For the Year Ended 2010 December 31

Operating revenues:

Gross sales $282,000

Less: Sales discounts $ 5,000

Sales return and allowances 15,000 20,000

Net sales $262,000

Cost of goods sold:

Merchandise inventory, 2010 January 1 $24,000

Purchases $167,000

Less: Purchase discount $3,000

Purchase returns and allowances 8,000 11,000

Net purchases $156,000

Add: Transportation-in 10,000

Net cost of purchases 166,000

Cost of goods available for sale $190,000

Less: Merchandise inventory, 2010 December 31 31,000

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Cost of goods sold 159,000

Gross Margin $103,000

Operating expenses:

Selling expenses:

Salaries and commissions expense $ 26,000

Salespersons' travel expense 3,000

Delivery expense 2,000

Advertising expense 4,000

Rent expense—store building 2,500

Supplies expense 1,000

Utilities expense 1,800

Depreciation expense—store equipment 700

Other selling expense 400 $41,400

Administrative expenses:

Salaries expense, executive $29,000

Rent expense—administrative building 1,600

Insurance expense 1,500

Supplies expense 800

Depreciation expense—office equipment 1,100

Other administrative expenses 300 34,300

Total operating expenses 75,700

Income from operations $ 27,300

Nonoperating revenues and expenses:

Nonoperating revenues:

Interest revenue 1,400

$ 28,700
Nonoperating expenses:

Interest expense 600

Net income $ 28,100

Exhibit 3: Classified income statement for a merchandising company

Next, we explain the major headings of the classified income statement in Exhibit 8. 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.

% Operating revenues are the revenues generated by the major activities of the business—usually the sale of
products or services or both.

% Cost of goods sold is the major expense in merchandising companies. Note the cost of goods sold section of
the classified income statement in Exhibit 8. This chapter has already discussed the items used in calculating
cost of goods sold. Merchandisers usually highlight the amount by which sales revenues exceed the cost of
goods sold in the top part of the income statement. The excess of net sales over cost of goods sold is the gross
margin or gross profit. To express gross margin as a percentage rate, we divide gross margin by net sales. In
Exhibit 8, the gross margin rate is approximately 39.3 per cent (USD 103,000/USD 262,000). The gross
margin rate indicates that out of each sales dollar, approximately 39 cents is available to cover other expenses
and produce income. Business owners watch the gross margin rate closely since a small percentage fluctuation
can cause a large dollar change in net income. Also, a downward trend in the gross margin rate may indicate a

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 problem, such as theft of merchandise. For instance, one Southeastern sporting goods company, SportsTown,
Inc., suffered significant gross margin deterioration from increased shoplifting and employee theft.

% 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.

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.

% Nonoperating revenues (other revenues) and nonoperating expenses (other expenses) are revenues
and expenses not related to the sale of products or services regularly offered for sale by a business. An example
of a nonoperating revenue is interest that a business earns on notes receivable. An example of a nonoperating
expense is interest incurred on money borrowed by the company.

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

% Net sales = Gross sales - (Sales discounts + Sales returns and allowances).

% Net purchases = Purchases - (Purchase discounts + Purchase returns and allowances).

% Net cost of purchases = Net purchases + Transportation-in.

% Cost of goods sold = Beginning inventory + Net cost of purchases - Ending inventory.

% Gross margin = Net sales - Cost of goods sold.

% Income from operations = Gross margin - Operating (selling and administrative) expenses.

% Net income = Income from operations + Nonoperating revenues - Nonoperating 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 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).

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 An ethical perspective:
World auto parts corporation
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?

Introduction to Accounting : The Language of Business – Supplemental Textbook 15

This textbook is part of the the Global Text Project. The textbook has been modified by Business Learning Software,
Inc. and Brigham Young University under the creative commons license
(http://creativecommons.org/licenses/by/3.0/). For more information please see: http://globaltext.terry.uga.edu

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