3 The Income StatementLearning ObjectivesAfter reading.docx

3 The Income Statement
Learning Objectives
After reading this chapter, you should be able to:
1. Examine the elements of an income statement.
2. Describe the accounts that make up an income statement.
3. Describe the different types of profit shown on an income
statement.
4. Explore the elements of the statement of shareholders’
equity.
5. Examine and create a common-sized income statement.
© Rudyanto Wijaya/iStock/Thinkstock
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Introduction
Pre-Test
1. What is the purpose of an income statement?
a. to determine whether the company earned any revenues
during the period
b. to determine how much the company spent to make revenues

during the
period
c. to determine whether the company made a profit from its
operations during
the period
d. to determine the financial position of the company during
the period
2. What are the four basic groupings on an income statement?
a. Revenues, Cost of Goods Sold, Expenses, Net Profit/Loss
b. Expenses, Revenues, Inventory, Net Profit/Loss
c. Cash, Expenses, Inventory, Net Profit/Loss
d. Sales, Expenses, Inventory, Net Profit/Loss
3. What type of profit is shown on the income statement?
a. gross profit
b. operating profit
c. net profit
d. all of the above
4. Which of the following is/are found in the statement of
shareholders’ equity?
a. treasury stock
b. common stock
c. retained earnings
d. all of the above
5. Which section of the income statement includes information
about advertising
expenses?
a. Cost of Goods Sold
b. Sales and Administrative Expenses
c. Other Expenses

d. Advertising information is not found on the income
statement.
Answers can be found at the end of the chapter.
Introduction
Successful business owners and department managers often look
forward to reading an
income statement (also sometimes called a statement of
earnings, statement of income,
statement of operations, or profit and loss [P&L] statement)
because it tells them just how
much of a profit they have made in any given accounting period.
The statement could be
for a month, a quarter, a year, or some other time period that the
manager deems neces-
sary. Most businesses develop monthly, quarterly, and annual
income statements.
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Section 3.1The Sections of an Income Statement
For business owners or managers who are struggling to meet
sales goals, the income state-
ment is often no cause for celebration—and may even be a
source of dread, if it reveals
that the company is operating at a loss.
Regardless of whether a business is successful or struggling, the
income statement is
always extremely important because it discloses the “bottom
line,” or net profit/loss.
However, the more important parts of the statement are how the

company got to that
number during the period being reported.
In this chapter, we discuss how the numbers are crunched to get
to the bottom line, and
explore the critical rules of accounting that impact when those
numbers can be reported
on the income statement. As in previous chapters, we will be
following Best General Com-
pany throughout this chapter and addressing decisions the
budget committee and man-
agers might make based on the document being discussed.
Before we get to the income statement numbers, let’s review the
key elements of an income
statement, discuss the dates that appear at the top, and explore
possible formats.
3.1 The Sections of an Income Statement
In addition to other information, every income statement
includes the following four key
sections:
1. Sales or Revenues: how much revenue the company brought
in by selling its
products or services.
2. Cost of Goods or Services Sold: how much the company
spent to purchase or
produce the products or services it sold.
3. Expenses: how much the company spent to keep the doors of
the business open.
Essentially, this includes all expenses except those spent
specifically on the cost
of goods or services sold.

4. Net Profit or Loss: the “bottom line” that tells whether the
company made a
profit or operated at a loss.
Let’s use the annual income statement of Best General Company
(Figure 3.1) to explore
how these key sections typically appear. Note that the income
statement in Figure 3.1
shows three periods. This enables the business owner or
manager to quickly see trends
over time.
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Figure 3.1: Best General Company income statement
The income statement presents the “bottom line” showing a
company’s profit or loss.
Best General Company
Income Statement
For the Years Ended December 31, 2013, 2012, and 2011
2013 2012 2011
Revenue
Costs of Goods Sold
Gross Profit

Operating Expenses:
Selling, General, and Administrative Expense
Research and Development Expense
Total Operating Expenses
Operating Profit
Other Income
Other Expenses
Depreciation Expense
Income Tax Expense
Net Pro�t
$ 100,000
73,000
$ 27,000
$ 22,000
500
22,500
$ 4,500
$ 2,500

(900)
(2,400)
(150)
$ 3,550
$ 110,000
78,000
$ 32,000
$ 21,000
500
21,500
$ 10,500
$ 2,500
(900)
(2,400)
(1,500)
$ 8,200
$ 120,000
84,000

$ 36,000
$ 20,000
500
20,500
$ 15,500
$ 2,500
(900)
(2,400)
(1,700)
$ 13,000
In Figure 3.1, the Revenue section is only one line item. An
internal report that a company
manager sees could include more detail in this section. For
example, the first line might be
called Gross Revenues, with additional information provided
about sales discounts and
returns. The manager would therefore have more information
about what was subtracted
to get to the net revenue figure shown as the first line of the
public statements. We discuss
this information in greater detail in the Revenue section below.
The Cost of Goods Sold section is also only one line item.
Again, an internal report that a
Best General Company manager sees could include more detail

about the costs incurred
to purchase or produce the goods sold. We discuss this
information in greater detail in the
Cost of Goods Sold section below.
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For major corporations, the Expenses section is sometimes
divided into Operating
Expenses and Non-Operating Expenses. The simpler example
shown in Figure 3.1 does
not include a distinct non-operating expenses section; it lists the
non-operating income
and expenses as Other Income and Other Expenses.
The Expenses section enables managers to know what expenses
were incurred as part of
the operations of the business and what expenses were incurred
that were not from opera-
tions. We discuss this information in greater detail below.
The Net Profit section in Figure 3.1 is only one line, but many
companies present profits at
various stages, such as earnings before taxes and interest
(EBIT) or earnings before taxes,
interest, depreciation, and amortization (EBITDA). We discuss
why companies view prof-
its in several different ways below.
Our budget committee would be able to discern the following
key trends from the income
statement shown in Figure 3.1, each of which would need to be

further explored:
• Revenue is decreasing. Note how revenues were $120,000 in
2011 but dropped to
$100,000 by 2013. The budget committee would want to find
out why revenue is
on a downward trend. They would need a more detailed internal
report to find out
if there are fewer products being sold, or if a greater number of
discounts are being
offered to sell those products. They may find other reasons for
the decrease as they
get more detail. They would use this information to prepare a
realistic budget pro-
jection for the next year.
• Cost of Goods Sold is also on a downward trend, from $84,000
in 2011 to $73,000
in 2013. That may be good news if the company has found a
way to reduce the
costs of buying its goods, or it could just be that fewer goods
needed to be bought
because products purchased or manufactured in previous years
were sold in the
current year. The budget committee may discover other reasons
as they look at the
details behind the numbers. These details also will be needed to
project the Cost of
Goods Sold for next year’s budget.
• Operating Expenses are on an upward trend, from $20,500 to
$22,500. Increases in
salaries or some other factor could be driving that increase. The
budget committee
would need to see more details from the accounts that make up
that line item to

know why there is an upward trend.
Now we will take a closer look at the key rules for the
presentation of an income state-
ment. We will then explore the various types of profits one
might measure when looking
at an income statement. Finally, we will explore the rules that
accountants must follow
when preparing these financial statements.
Report Timing
Unlike the balance sheet, which is a snapshot in time, the
income statement shows the
performance of a business over a longer period. The “as of”
date on the balance sheet will
be the same as the period ended date on the income statement. If
the company operates
on a calendar year basis, the phrase “Year Ended” will appear in
the heading, at the top
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of the statement; if it operates on another 12-month period, the
phrase will read as “Fiscal
Year Ended.” If the statements are issued monthly or quarterly,
the phrasing will read as
“Month” or “Quarter” Ended. Whatever phrase shown at the top
will be followed by the
ending date of the period.
Remember, when a manager compares results from one year to

the next in the same com-
pany, or compares one company to another, it is important to
examine the same operating
period. For example, if one company’s statement shows “Year
Ended, December 31, 2013”
and another company shows “Fiscal Year Ended, January 31,
2013,” the manager needs to
develop a spreadsheet that will enable him to calculate results
for the same months. He
can do this by getting a copy of the quarterly reports, where
month-by-month data are
usually shown.
Suppose the manager works for a retail company that is highly
dependent on holiday
sales, and he wants to see how well his company did versus a
competitor for the fourth
quarter of the year. His company reports the fourth quarter
using the months of Novem-
ber, December, and January. His competitor reports the fourth
quarter using October,
November, and December. (For many retail companies, October
is a much slower month
than January, because people use holiday gift cards to make
purchases or exchange gifts
after the first of the year). The manager would not be comparing
apples to apples without
adjusting the numbers to be sure he is looking at the results for
the same three months. He
would need to use a report that shows month-by-month results,
if available, so he could
prepare a spreadsheet with the same three months for each
company before doing his
analysis.
It is generally a good idea to do the comparison with a company

that uses the same time
period. Luckily, companies in the same industry often report
using the same time periods.
Format Options
Companies can format information on the income statement in
either a single-step or multi-
step presentation. Both statements provide the same
information, but the multi-step for-
mat uses various summary totals to make it easier to find the
key profit totals, such as
gross profit or operating profit, which we discuss below. Most
companies use the multi-
step format because it is easier to read and analyze.
Single-Step Format
The single-step format groups all data into two categories:
revenues and expenses (see Fig-
ure 3.2). Revenue includes income from sales, interest income,
and gains from sale of
equipment. In addition to income raised from regular
operations, a company will also
include income from one-time transactions, such as the sale of a
building or piece of major
equipment. Other types of revenue may also be possible. This
varies by type of business.
All types of expenses are grouped in the second category. This
can be a very long list. Com-
mon expenses include advertising, salaries, administrative
expenses, insurance expenses,
vehicle expenses, office supplies, and so on. Gains or losses
would also be shown, such as
the loss from the sale of equipment or other assets.

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The benefit of using a single-step format is that it is simpler to
prepare. The limitation of
the single-step format is that it does not indicate whether the
company is actually mak-
ing a profit from its operations; to determine this, we must
reorder the information into a
multi-step format.
Figure 3.2: Single-step format income statement
This singe-step format income statement shows one section for
revenues and one section for expenses.
Income Statement (Single-Step)
For the Year Ended December 31, 2013
Revenues:
Sales
Interest Income
Gain on Sale of Equipment
Total Revenues
Expenses:

Cost of Goods Sold
Advertising Expense
Income Tax Expense
Insurance Expense
Interest Expense
Salaries and Wages Expense
Supplies Expense
Total Expenses
Net Pro�t
$ 10,000
500
5,000
$ 6,000
600
600
700

500
200
1,000
1,000
500
$ 15,500
$ 11,100
$ 4,400
Multi-Step Format
Income statements created using the multi-step format divide
the statement into several
groupings and provide critical subtotals to facilitate analysis of
the information (see Fig-
ure 3.3). Even though they include essentially the same
information, the additional group-
ings of the multi-step format help the reader quickly view the
key profit lines:
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• Gross Profit: This shows the profit made from sales minus the
costs of buying or
manufacturing the products or services sold.
• Operating Profit: This shows the profit from the actual
operations of the company.
• Profit Before Income Tax Expense: This shows the income
before taxes and inter-
est are subtracted.
• Net Profit (or Loss): This shows the bottom line—whether the
company made a
profit or experienced a loss.
Many companies add additional profit lines, such as Earnings
Before Interest, Taxes,
Depreciation, and Amortization (EBITDA).
Figure 3.3: Multi-step format income statement
Compare the groupings of items to the single-step format of
Figure 3.2. The multi-step format provides
the operating income (or operating profit), which is the amount
of profit after costs of goods sold and
operating expenses have been subtracted.
Sales
Cost of Goods Sold
Gross Pro�t
Operating Expenses:
Advertising Expense

Insurance Expense
Research Development Expense
Salaries and Wage Expense
Supplies Expense
Operating Pro�t
Operating Income:
Interest Income
Gain on Sale of Equipment
Other Expenses:
Interest Expense
Pro�t Before Income Tax Expense
Income Tax Expense
Net Pro�t
$ 600
500
1,000
1,000

500
$ 500
5,000
(200)
(600)
$ 10,000
6,000
$ 4,000
$ 3,600
$ 400
$ 5,500
(800)
$ 5,100
(700)
$ 4,400
Income Statement (Multi-Step)

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Section 3.2Building Blocks of the Income Statement
When looking at the bottom line on the single-step format in
Figure 3.2, Best General
Company appeared to be making a profit of $4,400 on $10,000
of sales. But a closer look
with the multi-step format in Figure 3.3 reveals that the
business is not profiting on its
operations. Operating profit was just $400. Using the single-
step format in Figure 3.2 gave
the impression that the business was profitable, but most of the
profits came from a one-
time sale of equipment. It is therefore critical to calculate the
operating income, even if all
you have is a single-step income statement. To do that, remove
from the net profit all items
not included in operations (minus interest income $500; minus
gain on sale of equipment
$5,000; plus depreciation expense $600; plus income tax
expense $700; and plus interest
expense $200) or reformat the single-step income statement into
a multi-step format.
3.2 Building Blocks of the Income Statement
Now we will take a closer look at the numbers on the income
statement and explore how
an income statement is created. We will start with Revenues,
which are not always as
simple as a total of the sales made. Then we will take a closer
look at Cost of Goods or
Services Sold. Finally we will explore the Expenses section of
the income statement.

Revenues
For some types of businesses, such as retail stores or
restaurants, recognizing revenue can
be a relatively simple process. A manager adds up all the
receipts for the day and enters
total revenue earned. However, that’s not the case for many
other types of businesses,
especially when sales and services involve construction,
installation, or training. Sales for
many types of consulting businesses also don’t usually get fully
recognized on the day
the contract is signed. Revenue is only earned when the job is
completed or a contract
deadline is met.
For example, a construction company that contracts to build a
major project may earn its
revenue over a number of years based on various deadlines set
in the contract. A company
like IBM that provides complex systems earns its revenue at
various stages of completion—
after installation, after training is completed, and at the end of a
service period. Note, when
looking at IBM’s income statement in Figure 3.4, its revenue is
split into three line items:
Services, Sales, and Financing.
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Figure 3.4: Top portion of IBM’s 2012 income statement

To help readers navigate their income statement, IBM divides
revenue into three line items: services,
sales, and financing.
Consolidated Statement of Earnings
International Business Machines Corporation and Subsidiary
Companies
Revenue
Services
Sales
Financing
Total revenue
Cost
Services
Sales
Financing
Total cost
Gross profit
($ in millions except per share amounts)
For the year ended December 31: 2012 2011 2010Notes
$ 59,453

43,014
2,040
104,507
39,166
13,956
1,087
54,209
50,298
$ 60,721
44,063
2,132
106,916
40,740
14,973
1,065
56,778
50,138
$ 56,868

40,736
2,267
99,870
38,383
14,374
1,100
53,857
46,014
Source: IBM. (2013). 2012 annual report. Retrieved from
http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_an
nual.pdf
We’ll take a closer look at how IBM actually recognizes these
three different line items,
which can all be part of one contract, when we review the notes
to financial statements
later in the chapter. First, let’s examine the basic rules of
revenue recognition.
Revenue Recognition
As explained in Chapter 2, the first rule in accrual accounting is
that revenue is recognized
when it is earned. Note that this is not true of companies that
use cash-basis accounting, in
which cash revenue is recognized when cash is received.
However, all major companies
that must file financial statements with the Securities and

Exchange Commission (SEC)
use accrual accounting. Most smaller companies use it, too,
even if they do not report to
the SEC, because it more accurately matches revenue earned to
expenses at the time in
which the transactions occur. Thus, in this book, we focus on
the rules of accrual account-
ing. The key question that must be answered before recognizing
revenue, then, is: Has the
money been earned?
The following are some common scenarios in which additional
information, beyond the
sale of a product, might be required in order to determine
revenue recognition:
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nual.pdf
• Price Negotiations: Suppose a company is in the middle of
negotiating the price
for a product and service. It is the end of the month and the
salesperson wants
credit for the sale, but there are still some details to be worked
out before there is a
final price. Revenue cannot be recognized until a final price is
set, the contract has
been signed, and the customer has accepted the product or
service.
• Distribution Issues: Suppose the buyer of the product does not

pay for the mer-
chandise until it is sold to a third party, such as a retailer. This
is common when an
intermediary is involved in the distribution of the product. The
company selling
the product cannot recognize the revenue until the retailer pays
for the product.
Sending out the product to a third-party distributor means the
revenue cannot be
recognized until the product reaches the end customer who will
remit payment.
The determining factor is who actually has title (ownership) of
the product and the
provisions under which the product can be returned to the
manufacturer.
• Service/Installation/Training Issues: Revenue is recognized
when the service,
installation, or training is complete and accepted by the
customer. Sometimes a
company is paid for a product in full before the revenue is
earned. This would be
shown as Prepaid Revenue, which is shown as a liability
account on the balance
sheet. This account may also be called Unearned Revenue or
Deferred Revenue.
For example, IBM not only sells its products, it also installs the
systems, trains its
customers, and services the systems. In some cases, IBM
provides financing so the
customer can buy the system as well. Revenues from a major
sale will not be rec-
ognized until the related terms have been met. For example,
IBM may be paid in
full for the equipment when installation is complete, but it will
not recognize the

revenue for training and servicing until the terms of that part of
the contract are
met. Revenue from financing will be recognized as payments
are made.
• Shipping Issues: Goods are shipped FOB (Free on Board)
destination, whereas other
times they are shipped FOB shipping point.
• When goods are shipped FOB destination, the buyer does not
own and pay
for the shipment until it is received. In this case, the revenue is
not recognized
until the buyer receives it. If the shipment is stolen or lost, the
buyer is not
responsible for paying for the goods.
• On the other hand, if the shipment is sent FOB shipping point,
it is assumed
the buyer takes title on the day they are shipped and revenue
can be recog-
nized upon shipment. In this case, if the shipment is lost or
stolen, the buyer is
responsible for the loss.
• Selling Within the Corporation: Sometimes sales are made
between the parent
company and a subsidiary company. In this case, the sale would
not be recognized
as revenue but instead would be considered a transfer of assets.
• Buyback Agreements: Sometimes a company agrees to buy
back its inventory
at some point in the future. If the buyback covers all costs of
the inventory plus
holding costs, this does not constitute a sale and the revenue is

not recognized.
This type of arrangement can be common in the financial
services industry where
financial products are sold with a promise to buy them back
with interest.
As illustrated in these scenarios, revenue recognition can be a
complex question in certain
types of businesses. A manager for a company with complex
revenue issues may want
to ask her accounting liaison to explain the revenue recognition
rules under which their
company operates.
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Sales Adjustments
The recognition of revenue is not the only factor that comes into
play when calculating
net sales. Sales are adjusted for a number of reasons. In most
cases, a company’s external
financial reports will not show any detail of how much sales
were adjusted. Companies
prefer to keep these details confidential and report them only on
internal reports.
Within a company, managers who are responsible for producing
revenue will get a more
detailed report that shows the accounts used to calculate Net
Revenue shown on the
income statement. Managers will only find details about these
adjustments on these inter-

nal financial reports. These adjustments can have a major
impact on a company’s net
revenue figures and reduce the net revenue reported. Anything
that reduces revenues will
ultimately reduce profits.
New World of Financial Report Oversight
As U.S. regulators try to converge U.S. rules with international
financial reporting rules,
one of the major projects involves improving revenue reporting.
Right now, there are many
different requirements for specific transactions and industries,
such as software, real estate, and
construction contracting. Today there are over 200 specialized
and industry-specific revenue
recognition requirements under U.S. GAAP.
Regulators are expected to issue revenue recognition guidance
in 2014 that will improve the
ability to respond to revenue recognition changes more quickly
and increase comparability
among industries. The goal will be to improve disclosures to
users of financial statements so
they can better compare and contrast the numbers.
Read more about the revenue recognition project spearheaded
by the U.S. Financial Accounting
Standards Board and the international regulators here.
Changes are being contemplated to simplify revenue
recognition, as discussed in “The
New World of Financial Oversight.”
Task Box 3.1: Recognizing Revenue

Analyzing Industry Competitors, Part B
Review the revenue recognition schemes for the two companies
you chose to research in
Chapter 2 (see Task Box 2.9). The information is most likely
located in the first of the Notes
to the Financial Statements, often called “Significant
Accounting Policies” or “Accounting
Methods.” Be prepared to discuss the way revenue is earned and
recognized for each of the
companies, and how it might be different for each.
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http://www.fasb.org/cs/ContentServer?c=FASBContent_C&page
name=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=9
00000011146
Revenue-producing managers want to keep a close watch on the
adjustments to be sure
they are accurate. Also, if any of the revenue adjustments show
an increasing trend, man-
agers want to determine the reason for the increase.
Companies make three common adjustments to their gross sales
or revenue totals:
1. Volume discounts: Companies use this incentive to offer
major retailers a
reduced price if they buy in large numbers. For example, a
company may offer its
widgets at $50 each if fewer than 1,000 units are ordered.
However, it may cut the
price to $45 when 1,001 to 5,000 units are ordered and further

reduce the price
to $40 for orders over 5,000 units. That’s why big box retailers,
such as Walmart
and Target, can often offer lower prices: They can take
advantage of volume dis-
counts. Volume discounts reduce the gross sales for the seller
but likely increase
total sales volume.
2. Returns: Every company that produces tangible goods can
expect that some
items will be returned by buyers. Returns reduce the gross sales
for the company.
Accounting will track returns (usually accompanied by a credit
memo) in a sepa-
rate account and watch the trends for returns. If the trend goes
up sharply, it can
indicate that there is a problem with a product. Management
will use this report
to follow those trends and start an investigation if the numbers
jump dramatically.
3. Allowances: Allowances are liabilities for a company. For
example, a gift card is
an allowance that people pay for up front but take no
merchandise. These allow-
ances must be monitored because at some point, someone will
likely use that
gift card and take some product, which would increase the costs
of goods sold
at a later date. Rebates are another type of allowance that
people may or may
not cash in. Companies will reduce their gross sales to account
for these future
liabilities.

Sales Adjustments at IBM and 3M
A sales manager can find out some information about how
competitors are recognizing
revenue. This research can help the sales manager discover new
revenue opportunities or
new methods for recognizing revenue that she may want to
discuss with her accounting
and finance staff if she believes this will improve the
company’s revenue and profits.
Note 1 in 3M’s Notes to the Financial Statements indicates that
3M reduces income for
distributor incentives that include rebates and free goods,
primarily at the time of sale. It
says in the notes, “These sales incentives are accounted for in
accordance with ASC 605
Revenue Recognition [a GAAP standard]. The estimated
reductions of revenue for rebates
are based on the sales terms, historical experience, trend
analysis and projected market
conditions in the various markets serviced.”
Remember, 3M is a manufacturer that distributes most of its
product through intermedi-
aries, which then sell the products to the retailers, which
ultimately sell the products to the
customer. So its incentives are based primarily on ways to
encourage volume sales. Note
that 3M reduces revenues for rebates. These rebates are offered
to encourage sales, but not
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Now let’s take a closer look at cost of goods or services sold.
Cost of Goods or Services Sold
Every company, even a consulting company that offers only
services, incurs costs for what
it sells. In a service-based company, the costs may include those
related to bidding on
a project. For example, an architectural or engineering firm
likely incurs staff costs and
equipment costs in order to prepare a bid for a specific project.
Those costs would be costs
of services sold. Once the company wins the project, it may hire
staff to work on that
project with no other responsibilities in that company. These
staff costs would be charged
against that project’s gross profit. Essentially, cost of goods or
services sold includes any
expenses that can be directly charged against the production of
that product or service.
all rebates are redeemed. Consumer Reports indicates that 70
percent of consumers actu-
ally send in the request for rebates. Companies do not use
general statistics such as these,
however; instead they develop a percentage of rebates used
based on historical company
data (Consumer Reports Magazine, 2009).
Most of IBM’s sales are directly to the businesses it serves.
Thus, the reductions to revenue
discussed in Note A are very different. IBM indicates it reduces
revenues for client returns,
stock rotation (moving older products to the front so they are
sold first), price protection

(agreements to maintain a set price over a specific period of
time), rebates, and other simi-
lar allowances based on “historical results taking into
consideration the type of client, the
type of transaction and the specifics of each arrangement.”
Neither company provides exact details about how much these
adjustments total in the
Notes to the Financial Statements. Companies usually closely
guard the details about costs
and sales reductions, because they don’t want to give their
competitors information to use
against them. This is why managers with direct responsibility
for the revenue involved
are often the only ones allowed to access this information.
Task Box 3.2: Handling Revenue Reductions
Analyzing Industry Competitors, Part C
Read the Notes to the Financial Statements to find out how the
companies you’ve chosen to
research handle their revenue reductions. Do the two companies
handle them in the same way
or differently? What are the similarities and differences?
eps81356_03_c03_097-132.indd 110 3/26/14 12:54 PM
Advertising, for example, is considered an expense rather than a
cost because it would
be difficult to determine exactly which ad drove a customer to
buy which product. Most
advertising is much broader than one particular product or

service. Tracking and figuring
that out is not worth the staff time involved, so advertising
becomes an expense rather
than a cost and is not included in Cost of Goods Sold.
Another factor that can impact the Cost of Goods Sold line is
the inventory valuation
method used. In Chapter 2, we discussed LIFO vs. FIFO vs.
Average Costing. Below is a
summary of the calculations we completed in that chapter:
LIFO FIFO
Average
costing
Beginning Inventory $400.00 $400.00 $400.00
Cost of Goods Sold $3,250.00 $2,962.50 $3,063.50
Ending Inventory $650.00 $937.50 $835.50
Clearly, the Cost of Goods Sold number usually is the highest
when using the LIFO inven-
tory value method; prices in most industries gradually increase
because of inflation. This
is not true in all industries, and, in some cases, the older
inventory can be more expensive,
as in the computer field, where costs sometimes go down for
products.
When a higher value is used for cost of goods sold, then the
company’s profits will be
reduced. In the example above, company profits would be
$287.50 ($3,250 − 2,962.50) less
using LIFO rather than FIFO. If prices were going down, then
FIFO would likely be the

higher cost of goods sold number. Average costing always evens
out the price differences.
In a manufacturing company like 3M, costs include anything
spent to produce a product.
This includes the purchase of raw materials, the labor costs to
make the product, and the
cost involved in storing raw materials until they are needed. In
addition, the costs of the
machinery and tools for product production are also allocated to
Cost of Goods Sold.
Other types of businesses determine their Costs of Goods or
Services Sold based on the
purchases of products they made in order to sell their products
or services.
Financial report readers can see how complicated it is for a
service company, such as IBM,
to determine its costs of goods sold by reading Note A in IBM’s
Notes to the Financial
Statements. That note states, for example, that “Recurring
operating costs for services con-
tracts, including costs related to bid and proposal activities, are
recognized as incurred.”
IBM tracks its costs on service contracts, including bid and
proposal activities, and rec-
ognizes them when incurred. Since it can take months to
actually win a proposal, IBM
indicates that it reports operating costs periodically throughout
the bidding process. (The
rest of this note can be found in the “World of Business,” which
discusses other difficult
decisions regarding the recognition of costs.)

eps81356_03_c03_097-132.indd 111 3/26/14 12:54 PM
IBM’s Notes to the Financial Statements demonstrate that the
company must analyze a
number of moving parts to determine its costs of goods sold.
• For service contracts: It must calculate operating costs for
service contracts and
costs related to bid and proposal activities.
• For fixed-price design contracts: It must calculate costs of
external hardware and
software based on the percentage of completion. The total
estimated labor costs to
fulfill the contract are calculated; then a percentage of those
costs are allocated each
period to determine Costs of Goods Sold. The company also
calculates transition
World of Business
Recognizing Costs of Goods and Services Sold
Determining when a company should
recognize costs is not always easy. Discover
the complexities to be considered in this
excerpt from IBM’s 2012 Notes to the Financial
Statement, regarding the recognition of costs:
“For fixed-price design and build
contracts, the costs of external hardware
and software accounted for under the
POC [percentage-of-completion] method

are deferred and recognized based on
the labor costs incurred to date, as a
percentage of the total estimated labor
costs to fulfill the contract. Certain
eligible, nonrecurring costs incurred
in the initial phases of outsourcing
contracts are deferred and subsequently
amortized. These costs consist of
transition and setup costs related to
the installation of systems and processes and are amortized on a
straight-line
basis over the expected period of benefit, not to exceed the term
of the contract.
Additionally, fixed assets associated with outsourcing contracts
are capitalized
and depreciated on a straight-line basis over the expected useful
life of the asset.
If an asset is contract specific, then the depreciation period is
the shorter of the
useful life of the asset or the contract term. Amounts paid to
clients in excess of
the fair value of acquired assets used in outsourcing
arrangements are deferred
and amortized on a straight-line basis as a reduction of revenue
over the expected
period of benefit not to exceed the term of the contract. The
company performs
periodic reviews to assess the recoverability of deferred
contract transition and
setup costs. This review is done by comparing the estimated
minimum remaining
undiscounted cash flows of a contract to the unamortized
contract costs. If such
minimum undiscounted cash flows are not sufficient to recover
the unamortized
costs, an impairment loss is recognized.”

Consider This:
1. Does your company have a complex set of rules for
recognizing costs?
2. Must you differentiate costs between services and goods in
your company?
Source: IBM. (2013). 2012 annual report. Retrieved from
http://www.ibm.com/annualreport/2012/bin/assets/2012_
ibm_annual.pdf
Franziska Kraufmann/picture-alliance/dpa/
Associated Press
Companies like IBM must analyze a num-
ber of factors to determine when to recog-
nize costs.
eps81356_03_c03_097-132.indd 112 3/26/14 12:54 PM
nual.pdf
nual.pdf
and setup costs related to the installation of the systems and
processes. Fixed
assets are capitalized and depreciated on a straight-line basis
over the expected
useful life of the asset.
In addition to a section on service costs, IBM includes a section

regarding software costs
and how they are calculated. Research and development
becomes a critical part of cal-
culating these costs. Hardware costs are not discussed in detail
in the note, but these are
either calculated as manufacturing costs (if IBM produces the
product) or purchased costs
(if IBM purchases the product from another company).
Similar to how it separates Revenues, IBM differentiates its
costs by services, sales, and
financing on its income statement, as shown in Figure 3.4.
Gross Profit
The gross profit number is critical for determining how much
profit a company is making
from the actual sale of its goods or services before considering
the operating expenses.
If the company’s gross profit is not high enough to cover
operating expenses, managers
must take actions to fix the problem as soon as it is recognized.
There are essentially four ways managers can fix the problem:
1. Managers can recommend that the company increase its
prices, if the market will
bear it without the company losing too many sales. Sales and
marketing manag-
ers will need to research competitors’ pricing to determine if
this is an option.
If competitors are charging the same or lower prices, this option
will likely
decrease sales.
2. Managers can look for opportunities to expand sales into new

markets. This will
likely mean the company will incur additional sales and
marketing expenses, so
it needs to carefully analyze the impact of this choice. Sales and
marketing man-
agers will need to assess opportunities for expansion and their
costs. They will
then prepare a report for upper management.
3. Financial and purchasing managers can find a way to
decrease costs. They can
do this by finding other suppliers with whom they can negotiate
a lower price.
Another way to reduce costs may be to take advantage of
volume discounts
when ordering materials. Managers in a manufacturing company
may be able to
find other ways to reduce manufacturing costs.
4. Managers can recommend that the company lower its prices
to increase sales.
This may seem counterintuitive, but if the company can reduce
its costs by pur-
chasing or manufacturing at greater volumes, lowering the price
to increase sales
could improve the gross profit.
These are the types of decisions companies must make at least
yearly, and usually more
often, after evaluating periodic financial reports. If managers or
executives see gross profit
trends moving lower, it is an indication that the company needs
to make changes to main-
tain profitability in the long term.
eps81356_03_c03_097-132.indd 113 3/26/14 12:54 PM

Operating Expenses
Recall that companies provide few details about their expenses
on public financial
reports because companies prefer to reveal as little information
as possible on their pub-
lic reports, because they know their competitors will read them.
Now we will take a
closer look at the Expense section of the income statement for
the Best General Company,
as shown in Figure 3.5.
Figure 3.5: Expense section of the income statement for Best
General Company
The operating expenses of a company are shown in the expense
section of the income statement.
Income Statement (Partial)
2013 2012 2011
Expenses:

$ 22,000
500
$ 22,500
$ 21,000
500
$ 21,500
$ 20,000
500
$ 20,500
Selling, General, and Administrative Expenses
The Selling, General, and Administrative Expenses line item
reflects all expenses the com-
pany incurs in selling its products or services (including sales
commissions and advertis-
ing), as well as the expenses it incurs in running all its
administrative and sales offices.
All salaries and wages, insurance costs, professional fees, rents,
office supplies, and other
similar types of expenses are also included in this number.
If the company operates retail stores, it will include the
expenses of running those stores
here as well, such as store rents, inventory warehousing, sales
associates wages, and utili-
ties. However, recall that because a retail store sells many

products, companies cannot
match the expenses of operating a retail store to the costs of one
product sold. Therefore,
retail store operations are considered an expense rather than a
cost of goods sold.
Note in Figure 3.5 that the Best General Company is
experiencing an increase in these
expenses. They have increased by $2,000 over the last three
years. The budget committee
would need to review the accounts that are used to calculate that
number to determine
eps81356_03_c03_097-132.indd 114 3/26/14 12:54 PM
where the increases occurred. They would need to determine if
there is a way to control
these rising expenses by reviewing the accounts where expenses
are increasing and deter-
mining if there is a way to cut some of these expenses in the
next year’s budget.
Research and Development
The Research and Development (R&D) line shows the total
spent on investigating the via-
bility and utility of future products. When comparing two
companies in a similar industry,
this can be a critical number. For example, if one company is
spending a great deal more
on R&D than the other, it might be seeking to develop more
new products or improve the
ones it currently sells. A company that is not spending on R&D,

or is spending very little,
may be too interested in the short-term bottom line and not
investing enough money in
the future growth of the company.
Best General Company incurred the same level of expenses in
each of the three years
shown on the income statement. The budget committee may
determine that R&D needs
to be increased to enable the company to research new products.
They may recommend
that the executives form a committee to review this option and
develop a plan for the
R&D team.
Task Box 3.3: Comparing Research and Development
Spending
Analyzing Industry Competitors, Part D
Calculate the amount spent on R&D at the two companies
you’ve chosen to investigate. Are
they spending roughly equal amounts? If not, why not? Hint:
You may find some discussion of
R&D in the Management’s Discussion and Analysis section of
the annual report.
Other Income and Other Expenses
The Other Income line item is usually a catchall section where a
company includes income
that is not earned from operations. For example, if a company
sells a building, a major
piece of equipment, or some other asset, the income from that
sale is shown here. Gener-
ally, items shown are one-time income.
The same is true for the Other Expenses line item. Generally,

these are one-time rather
than recurring expenses that do not involve the day-to-day
operations of the company.
Figure 3.6 shows the Other Income and Other Expenses section
of the Best General Com-
pany income statement.
eps81356_03_c03_097-132.indd 115 3/26/14 12:54 PM
Figure 3.6: Other income and other expenses section of the
income statement
for Best General Company
Income and expenses that are not directly related to company
operations are shown in the other income
and expenses section of the income statement.
2013 2012 2011
Other Income
Other Expenses
Income Tax Expense

$ 2,500
900
2,400
150
$ 2,500
900
2,400
1,500
$ 2,500
900
2,400
1,700
( )
( )
( ) ( )
( ) ( ) ( )
( ) ( )
Depreciation and Amortization Expenses
In Chapter 2, we discussed the calculation of depreciation and
amortization for the pur-

poses of portioning the cost of buying the asset over the life of
the asset to better match the
expenses with the revenue earned from using those assets. For
example, these long-term
assets can include buildings, equipment, and other assets held
for more than one year.
Each year, the amount of depreciation or amortization to be
added to the accumulated
depreciation line item on the balance sheet is offset by a
depreciation or amortization
expense. This expense line item is included on the income
statement to show the expenses
incurred for that year.
Net Income
As we’ve discussed, net income (loss) is the “bottom line.” This
number allows an
employee to quickly determine whether a company has made a
profit or incurred a loss.
Exploring a little of what is behind the numbers on the income
statement reveals that
there is a great deal to find out about the numbers that lead to
the bottom line. Someone
who looks only at the bottom line misses a lot of crucial
information needed to assess
whether a company is profitable.
Let’s take a closer look at how a manager can determine
whether the business is earning
a profit.
eps81356_03_c03_097-132.indd 116 3/26/14 12:54 PM

Section 3.3Profit Types
3.3 Profit Types
The most important lines on any income statement are the lines
that show whether the
company made a profit. There are three key profit line items
that enable managers to
quickly determine a company’s profitability using the multi-step
income statement for-
mat. These three profit line items are shown in bold on Figure
3.3. Each of these profit line
items provides a different type of information.
1. Gross Profit: Shows whether the company made a profit from
selling its prod-
ucts or services before considering the expenses of operating
the company. The
line is shown in the top section with Revenues minus Cost of
Goods Sold.
2. Operating Profit: Shows whether the company made a profit
after all operating
expenses are subtracted. The line is shown below the Expense
section.
3. Net Profit (Loss): Shows whether the company made a profit
after all operating
and non-operating expenses are subtracted. This is the bottom
line of the income
statement.
Using that information, we can test a company’s profitability
with three ratios:
1. Gross Profit Margin: This indicates how well the company is

doing after taking
into consideration the cost of goods or services sold.
2. Operating Profit Margin: This indicates how well the
company is doing after
taking into consideration the operating expenses.
3. Net Profit Margin: This indicates how well the company is
doing after taking
into consideration all operating and non-operating costs.
We will now demonstrate how to calculate these margins and
what they mean for manag-
ers trying to determine whether their company is profitable.
Gross Profit Margin
First we will calculate the gross profit margin using the
Revenue section of the income
statement for Best General Company, shown in Figure 3.7.
eps81356_03_c03_097-132.indd 117 3/26/14 12:54 PM
Figure 3.7: Gross profit section of the income statement for
The gross profit section shows income after the cost of goods
sold are subtracted.

2013 2012 2011
Revenue
Cost of Goods Sold
Gross Profit
$ 100,000
73,000
$ 27,000
$ 110,000
78,000
$ 32,000
$ 120,000
84,000
$ 36,000
The gross profit margin for each of the three years can be
calculated by dividing the Gross
Profit by the Revenue. The following shows the gross profit
margin for each of the three
years.
Gross Profit Margin 5
Gross Profit

Revenues
2013 2012 2011
Gross Profit Margin
$27,000
$100,000
5 27.0%
$32,000
$120,000
5 29.1%
$36,000
$110,000
5 30.0%
Note that the gross profit margin gives the managers of Best
General Company a way to
quickly see that the company’s profit is dropping on the goods
it is selling. This is a bad
sign for the company. The managers would need to ask
accounting for the details of the
accounts used to calculate the Revenue and Cost of Goods line
items to determine what is
driving this downward trend. Some key accounts to review
would be:
• Revenue: Managers would need to determine whether revenue
was going up or
down.
• Sales Discounts: Did the company offer more discounts in
2011 than it did in

2013? If more discounts are being offered, managers would
need to find out why
this is happening.
• Sales Returns: Are more products being returned? If so,
managers would need to
determine whether a quality control problem exists or if
something else is driving
the returns.
eps81356_03_c03_097-132.indd 118 3/26/14 12:54 PM
• Purchases: Is the company paying more for the products,
which in turn is increas-
ing the Cost of Goods Sold? If this is the case, managers may
seek to find a new
supplier, adjust profit expectations, or consider raising prices to
cover additional
costs. They could consider buying increased volumes to take
advantage of volume
discounts.
In addition, the managers of Best General Company may want
to compare the gross
margin of the company to the gross margin for the industry to
see how well the com-
pany is doing compared to its competitors. If the gross margins
are significantly lower,
more research would be needed to determine what the company
can do to improve its
performance.

The marketing and sales manager would want to compare Best
General’s revenue results
to those of its competitors. The purchasing manager may want
to take a closer look at the
company’s Costs of Goods Sold compared to its competitors.
All managers may want to
review the key competitors’ annual reports to find out how they
are doing and possibly
discover information that could be used to develop
recommendations for improving the
results of the Best General Company. For example, in reading
the details in the annual
reports of one company, the marketing manager may read
information that gives her an
idea for a new product line or new marketing campaign.
Task Box 3.4: Calculating Gross Profit Margin
Analyzing Industry Competitors, Part E
Calculate the gross profit margin for the last five years for the
companies you have chosen to
research. Is gross profit going up or down? Are sales going up
or down? Are costs going up or
down? Determine from these numbers whether the companies
are improving their profitability.
Why did you come to that conclusion?
Operating Profit Margin
The managers would next want to determine whether the
company is still making a profit
after subtracting all its operating expenses. The operating profit
margin indicates how
much profit a company is making after taking all operating
expenses into consideration.
Figure 3.8 shows the Expenses section, followed by the

Operating Profit line, for Best
General Company.
eps81356_03_c03_097-132.indd 119 3/26/14 12:54 PM
Figure 3.8: Expenses and operating profit section of the income
statement for
The operating profit section of the income statement shows
profit after all operating expenses have been
subtracted.
2013 2012 2011
Revenue
Costs of Goods Sold
Gross Profit
Expenses:

Operating Profit
$ 100,000
73,000
$ 27,000
$ 22,000
500
22,500
$ 4,500
$ 110,000
78,000
$ 32,000
$ 21,000
500
21,500
$ 10,500
$ 120,000
84,000

$ 36,000
$ 20,000
500
20,500
$ 15,500
To calculate the operating profit margin, divide the operating
profit by revenues shown in
Figure 3.8. The results are shown in the table below.
Operating Profit Margin 5
Operating Profit
Revenues
2013 2012 2011
Operating Profit Margin
$4,500
$100,000
5 4.5%
$10,500
$110,000
5 9.5%
$15,500
$120,000
5 12.9%

The Best General budget committee members can quickly see
that the downward trend
is even more significant when operating expenses are
considered. The company was
making an operating profit of 12.9% in 2011, and it is now
down by more than half, to
4.5%. The managers would want to take a closer look at
expenses to see which expenses
are increasing and ask for more detail from the accounts that are
used to calculate those
line items. The key line item that shows increasing expenses is
the Selling, General, and
Administrative Expenses line item in Figure 3.8. Many accounts
are used to calculate
that line item, including selling expenses, office expenses,
salaries expense, insurance
expenses, and so on.
eps81356_03_c03_097-132.indd 120 3/26/14 12:54 PM
The Best General budget committee should ask to see a detailed
report of all the accounts
that are used to calculate Selling, General, and Administrative
Expenses and investigate
which ones are contributing to the increase in these expenses.
It is important for a company to maintain a high operating profit
margin. This gives the
company more price flexibility during an economic downturn.
Why? Because with higher
operating profit margins, the company has the option to cut

prices if needed to attract
more business. It therefore has the flexibility needed to be
competitive no matter how bad
an economic downturn may be. Net profit may go down, but the
company will have no
trouble staying in business.
Net Profit Margin
The third key profit test is net profit margin, which looks at
how well the company has
done overall, considering both operating and non-operating
activities. Non-operating
activities can be as simple as interest income or expense, or
they can be much more sig-
nificant, such as the expenses related to the discontinuation of a
product line or the closure
of a plant. Figure 3.9 shows the non-operating expenses and the
net profit for Best General
Company.
Figure 3.9: Non-operating expenses and net profit section of
the income
statement for Best General Company
Expenses not directly related to the company operations are
shown in the non-operating expenses section
of the income statement.
2013 2012 2011

Other Income
Other Expenses
Income Tax Expense
Net Pro�t
$ 2,500
(900)
(2,400)
(150)
$ 3,550
$ 2,500
(900)
(2,400)
(1,500)
$ 8,200
$ 2,500
(900)
(2,400)
(1,700)
$ 13,000
eps81356_03_c03_097-132.indd 121 3/26/14 12:54 PM

To calculate the net profit margin, divide the net profit by
revenues. The results for Best
General Company are shown in the table below.
Net Profit Margin 5
Net Profit
Revenues
2013 2012 2011
Net Profit Margin
$3,550
$100,000
5 3.6%
$8,200
$110,000
5 7.5%
$13,000
$120,000
5 10.8%
The budget committee of Best General Company can see the
company is barely making a
profit of 3.5%. If the Other Income of $2,500 from non-
operating sources were not avail-
able, the net profit would be only $1,050, or just above 1%. Any
drop in revenues could

mean the company would show a net loss rather than a net
profit.
Clearly, Best General Company needs to make some major
changes to improve its profit-
ability. In addition to reviewing the key accounts as discussed
above, the budget com-
mittee members may also want to compare Best General
Company’s results with other
companies in the same industry. They can do this by researching
key industry statistics.
Chapter 6 discusses analyzing financial results in more depth.
Task Box 3.5: Industry Benchmarks
One way to compare a company’s results to industry statistics is
by using the website
BizStats.com. There you can search for industry financial
benchmark reports and get industry
profitability risk data as well as industry statistics. To see how
IBM is doing, for example, you
can use BizStats.com to find industry profit and loss
benchmarks as follows:
1. Select the company structure: Corporation (for IBM)
2. Input annual sales: $104,507,000,000 (no commas when
entering on the website)
3. Pick industry: Professional-Scientific-Technical Services
4. Pick specific industry: Computer systems design and related
services
You will then get industry income-expense statement
benchmarks, as well as industry balance
sheet benchmarks. The gross profit margin benchmark in this
industry category is 72.67%. IBM
is not a perfect match for this industry, since it also

manufactures and sells hardware.
Therefore, you might also want to find the benchmarks for
computer manufacturing. However,
when it comes to the bottom line, IBM is doing much better
than others in this industry. This
industry’s net profit benchmark is 9.21%, whereas IBM’s is
15.9%.
(continued)
eps81356_03_c03_097-132.indd 122 3/26/14 12:54 PM
Section 3.4The Elements of a Statement of Shareholders’ Equity
3.4 The Elements of a Statement of Shareholders’ Equity
At the bottom of the income statement or on another page, a
statement of Shareholders’
equity is shown. This statement indicates how shareholders
were affected by the com-
pany’s results for the year. It also indicates other changes that
might impact claims own-
ers have against the company, such as the issuance of new stock
or the buyback of stock
already on the market. The first line is always the balance in
each of the accounts that
make up Shareholders’ equity:
• Common Stock and Additional Paid-in Capital,
• Retained Earnings,
• Treasury Stock,
• Accumulated Other Comprehensive Income (Loss), and
• Non-controlling Interests.

The bottom line of this statement is Total Equity. Figure 3.10
shows the statement of Share-
holders’ equity for Best General Company.
Note that the net earnings from the income statement match the
retained earnings on the
statement of Shareholders’ equity. Net earnings not paid out in
dividends to the share-
holders are held as retained earnings. The retained earnings
total is an historical account
that tracks all money reinvested into the business over the
years.
You can also examine IBM’s results on the manufacturing side
using BizStats.com:
1. Select the company structure: Corporation (for IBM)
2. Input annual sales: $104,507,000,000
3. Pick industry: Manufacturing
4. Pick specific industry: Computer and electronic product
manufacturing
5. Pick specific industry once more: Computers and peripheral
equipment
In the manufacturing industry segment, the gross profit margin
is much lower than in the
services industry. The gross profit margin is 38.91%. Remember
that Cost of Goods Sold will
always be much higher for a company that is manufacturing its
products than for a service
industry that has much lower cost of services sold. The net
profit for the manufacturing sector is
just 8.98%. IBM far exceeds the net profit here, as well.
Practice using Bizstats.com by finding the benchmarks for your
company or a company in

which you are interested. How do those companies compare to
others in their industry sectors?
Task Box 3.5: Industry Benchmarks (continued)
eps81356_03_c03_097-132.indd 123 3/26/14 12:54 PM
Figure 3.10: Best General Company statement of shareholders’
equity
Details of the claims owners have against the assets of the
company are shown in the statement of
Shareholders’ equity.
Statement of Shareholders’ Equity
Common
Stock and
Paid-in Capital
Number of
Common Stock
Issued
Retained
Earnings
Total

Shareholders’
Equity
Balance as of
December 31, 2012
Net Earnings
2,000 shares $20,000
2,000 shares $20,000
$3,900
3,550
0
$7,450
$23,900
3,550
0
$27,450
Cash Dividends
Balance as of
December 31, 2013
The statement of shareholders' equity for Best General Company
is relatively simple. On

a major corporation's, however, there will be line items not
shown here. Let's review the
line items that can appear on a statement of shareholders' equity
and what they show.
Common Stock and Additional Paid-In Capital
Public and private corporations divide the ownership of the
company using shares of
stock. Most of these shares are called common stock. Common
shareholders can participate
in the election of a board of directors and can vote on company
policy. Most common
shareholders in a major corporation own such a small share in
the company that their vote
holds little weight. The common shareholders of a small
company often own a significant
portion of the common stock of the company, often have a role
on the Board of Directors,
and possibly hold a position in upper management.
eps81356_03_c03_097-132.indd 124 3/26/14 12:54 PM
When common stock is first set up, a share value called “par
value” is established. When
the stock is first sold to investors, any money collected above
the par value is listed as
“additional paid-in capital.” So if a stock has a par value of $10
and 100 shares are sold for
$20 each, the value of the common stock shown on the
statement of Shareholders’ equity
would be $1,000 and the value of paid-in capital would be

$1,000.
Best General Company, when formed, set its par value at $10
per share for a total of
$20,000 in common stock. Since it is a small company, it was
not sold on the stock market.
Its shareholders are the partners who started the company. Their
proportion of owner-
ship is based on the number of shares each partner owns. For
example, if Partner A owns
500 shares, it means he invested $5,000 (500 x $10 per share) in
the company to buy those
shares.
This section of a statement of Shareholders’ equity can get very
complex for a large corpo-
ration, especially if it issues stock at different prices. Another
line item may show stock-
based compensation. This reflects stock that was awarded to
employees as part of their
compensation plan.
Other Line Items
Some companies will have additional line items. For example, if
there is preferred stock
issued, there will be a line item detailing the value of the
preferred stock, similar to the line
item for common stock. We discussed preferred stock in
Chapter 2.
We also discussed treasury stock in Chapter 2. Any transactions
involving the buying
back of stock or reissuing of stock will be detailed in a line
item on this statement.

Non-Controlling Interests
Sometimes there is a line item called Non-Controlling Interests.
This line item shows own-
ership held in companies in which the holding company has no
controlling interest. A
company generally must hold between 5% and 10% of another
company before it can
push for a seat on the board and obtain some control.
Let’s now turn our attention to how we can use the information
on the income statement
to analyze some basic trends for a company using a common-
sized income statement.
eps81356_03_c03_097-132.indd 125 3/26/14 12:54 PM
Section 3.5Creating a Common-Sized Income Statement
Figure 3.11 shows a common-sized income statement for Best
General Company prepared
using the downloadable multi-step template. To use the
template, we separated expenses
and other income. We also moved interest expenses to the Other
Expenses category.
Task Box 3.6: Preparing a Common-Sized Income Statement
To prepare a common-sized income statement, start an Excel
worksheet. Copy the information
from the income statement into the Excel worksheet. Then
develop a formula to divide each line
item by Net Sales or Net Revenue. To make things easier,
download our template that uses the

multi-step format with the formulas already developed for the
percentage columns.
3.5 Creating a Common-Sized Income Statement
The common-sized income statement enables users to analyze
the key line items that lead
to profit or loss from a different perspective by calculating each
number on the income
statement as a percentage. It allows for an easier comparison
between two or more com-
panies of varying sizes in the same industry. It is also useful for
managers to quickly iden-
tify trends from year to year.
The common-sized income statement may be presented with
both dollar figures and per-
centages for each line item, or, when it displays a number of
years on one page, it may
be presented with just percentages. The percentages allow for a
quick assessment of the
trends of each line item when looking at several years on one
report. All items are shown as
a percentage of Net Revenue or Net Sales. Note that because
this statement is not required
by the government, it does not need to be prepared according to
a particular set of rules.
eps81356_03_c03_097-132.indd 126 3/26/14 12:54 PM
Section 3.5Creating a Common-Sized Income Statement
Figure 3.11: A common-sized income statement for Best
General Company

With each line item shown as a percentage, a common-sized
income statement allows readers to easily
identify trends within a company and also to compare large and
small companies.
Common-Sized Income Statement
2013 2012 2011 2013 2012 2011
Revenue
Costs of Goods Sold
Gross Profit
Operating Expenses:
Selling, General,
and Administrative
Research and Development
Operating Profit
Other Income
Other Expenses

Profit Before Income
Tax Expense
Income Tax Expense
Net Pro�t
$100,000
73,000
$ 27,000
$ 22,000
500
22,500
$ 4,500
$ 2,500
900
2,400
$ 3,700
150
$ 3,550
$110,000

78,000
$ 32,000
$ 21,000
500
21,500
$ 10,500
$ 2,500
900
2,400
$ 9,700
1,500
$ 8,200
$120,000
84,000
$ 36,000
$ 20,000
500
20,500

$ 15,500
$ 2,500
900
2,400
$ 14,700
1,700
$ 13,000
100.0%
73.0%
27.0%
22.0%
0.5%
22.5%
4.5%
2.5%
0.9%
2.4%
3.7%

0.2%
3.6%
100.0%
70.9%
29.1%
19.1%
0.5%
19.5%
9.5%
2.3%
0.8%
2.2%
8.8%
1.4%
7.5%
100.0%
70.0%
30.0%

16.7%
0.4%
17.1%
12.9%
2.1%
0.8%
2.0%
12.3%
1.4%
10.8%
eps81356_03_c03_097-132.indd 127 3/26/14 12:54 PM
Summary and Resources
Figure 3.11 clearly illustrates that Best General Company is
showing a downward trend in
profitability. The three key factors include:
1. A downward trend in Revenues.
2. An upward trend in Cost of Goods Sold.
3. An upward trend in Selling, General, and Administrative
Expenses.

Review the discussion in each of the profit analysis sections
above to consider the tasks
that managers may engage in when confronted with these trends.
Task Box 3.7: Calculating a Common-Sized Income Statement
Analyzing Industry Competitors, Part F
Use the downloadable template to calculate the common-sized
income statement for the
companies you have chosen. What trends do you notice after
creating a common-sized income
statement for your companies?
Chapter Summary
In this chapter, we illuminated the numbers on the income
statement to take a closer
look at how companies develop this statement.
• We reviewed the rules related to statement timing and
formatting and how these
rules impact the way the statement is presented.
• We examined the key sections of an income statement and
explored how the
numbers are developed for the income statement. This included
rules related
to how revenue is recognized and how costs or expenses are
determined. Some
companies, such as retail companies and restaurants, simply
recognize revenue
at the time the good or service is sold. Other companies must
determine when
the revenue is actually earned. We explored the costs of
producing or purchasing

products or services to be sold and looked at the expenses
incurred to operate a
business and how those differ from costs incurred to sell
products.
• Next we discussed the three key profit line items that enable
managers to quickly
determine how well the company is doing. We also discussed
key details manag-
ers may want to review if they see problems in the numbers to
determine where
the problems are in the company’s operations.
• We briefly reviewed the statement of shareholders’ equity,
where the ownership
of the company is detailed.
• We then explored a tool that makes it easier to analyze an
income statement
called the common-sized income statement. This tool helps
managers to spot
trends in the income statement by comparing results period to
period. It also
eps81356_03_c03_097-132.indd 128 3/26/14 12:54 PM
gives managers a way to compare the company results to those
of competitors,
even if the competitors are a different size.
Takeaways for Chapter 3
• Managers must review the trends of the various line items in

an income state-
ment from period to period to determine how well the company
is doing and
to identify areas where the company is doing well, as well as
find areas where
improvement is needed.
• Managers should compare their company results to those of
their competitors
to test how well the company is doing. Companies do not
operate in a vacuum.
Using the common-sized income statement a manager can
compare his company
to a company of any size.
• Managers should be aware of the accounts that are used to
calculate the line
items on the income statement, so if they see a problematic
trend they know what
detail to request from accounting in order to fix a problem. Also
this detail can
help managers spot a positive trend upon which they may want
to build.
Post-Test
1. The income statement shows:
a. the profit/loss results as of a particular day in time
b. the profit/loss results over a particular period of time
c. the profits from money collected
d. the profits from the company’s operations
2. Which statement shows a company’s profits at various points
on the statement?
a. the income statement in a multi-step format
b. the income statement in a single-step format

c. the balance sheet in a report format
d. the balance sheet in a number format
3. Which account would not be found on an income statement?
a. Advertising
b. Office Supplies
c. Prepaid Expenses
d. Administrative Expenses
4. How do you determine the expenses of long-term assets
shown on the income
statement?
a. look for Depreciation Expenses
b. look for Amortization Expenses
c. look for Equipment Expenses
d. both (a) and (b)
5. What does the Gross Profit line item show the financial
report reader?
a. how much profit the company made
b. how much profit the company made after accounting for the
costs of goods or
services sold
c. how much profit the company made after expenses
d. how much profit the company made after taxes
eps81356_03_c03_097-132.indd 129 3/26/14 12:54 PM
6. Why is it important to monitor operating profit?
a. You must know whether the company is profitable from its

operations prior to
any one-time income or expense items.
b. You must know whether the company covers all expenses
from the core
operations of the business.
c. You must know whether the company can stay in business.
d. both (a) and (b)
7. What account would not be found on a statement of
shareholders’ equity?
a. Treasury Stock
b. Common Stock
c. Marketable Securities
d. Retained Earnings
8. What does the retained earnings line show on the statement
of shareholders’
equity?
a. earnings kept in the business until next year
b. an account that tracks the historical reinvestment of profits
c. earnings not paid out in dividends
d. profits turned into earnings
9. What are the key benefits of preparing a common-sized
income statement?
a. It provides a tool for analyzing trends related to
profitability.
b. It provides a tool to compare large companies to small
companies.
c. It provides a tool for comparing the company to industry
benchmarks.
d. all of the above

10. Which of the following trends can be spotted when reading a
common-sized
income statement?
a. a downward or upward trend in Revenues
b. a downward or upward trend in Cost of Goods Sold
c. a downward or upward trend in Selling, General, and
Administrative Expenses
d. all of the above
Answers: 1 (b), 2 (a), 3 (c), 4 (d), 5 (b), 6 (d), 7 (c), 8 (b), 9 (d),
10 (d)
Answers and Rejoinders to Chapter Pre-Test
1. c. Although you will find out information about the revenues
earned and
money spent during the period, the purpose of an income
statement is to find
out whether the company made a profit or incurred a loss.
2. a. These are the parts of an income statement. Inventory is
always found on a
balance sheet. The cost of buying the inventory is found in the
Cost of Goods
Sold line item on an income statement.
3. d. All three are different types of profits you will find on a
multi-step income
statement.
4. d. The statement of shareholders’ equity shows ownership
information from the
balance sheet, which includes common stock and treasury stock.
It also includes
information for changes in retained earnings from the income

statement.
5. b. Advertising expenses are usually included in Sales and
Administrative
Expenses. Some companies do report advertising expenses on an
individual
line as part of the expense section of the income statement.
eps81356_03_c03_097-132.indd 130 3/26/14 12:54 PM
Rejoinders to Chapter Post-Test
1. The income statement shows the financial results over a
particular period of time.
2. The multi-step income statement shows profits after cost of
goods sold, which is
called gross profit. Then it shows profits after operating
expenses, which is called
operating profit. Then it shows profit after non-operating
expenses, which rep-
resents the bottom line, called net profit. Some income
statements include other
profit lines as well.
3. Prepaid Expenses are an asset account that is used when an
item is paid for in
advance, such as an insurance policy. The policy is then
expensed on a monthly
basis as insurance expenses, which would be found on the
income statement.
4. Long-term assets are expensed using both depreciation (for

tangible assets) and
amortization (for intangible assets). If there is a line item on the
income statement
showing equipment expenses, that line item indicates costs of
equipment not
used over the long term.
5. Gross Profit shows the profit made from sales minus the costs
of buying or
manufacturing the products or services sold.
6. When monitoring operating profit, managers want to be sure
a company can
cover all its expenses for its operations of the core business. If
the company can-
not earn the revenue it needs for its core operations, then in a
year when a one-
time income opportunity is not available, the company may lose
money. Other
factors may be involved when trying to determine whether a
company can stay
in business, such as a company’s ability to get financing to
cover operations in a
downturn.
7. Marketable Securities is an asset that would be found on the
balance sheet.
8. While both earnings kept in the business until the next year
and earnings not
paid out in dividends do add to retained earnings, the line item
on the statement
of shareholders’ equity reflects the historical reinvestment of
profits.
9. All of the above. The common-sized income statement

provides a tool for analyz-
ing trends, comparing large and small companies and comparing
the company to
industry benchmarks.
10. All of the above. Downward or upward trend in revenues,
costs, and expenses
can be seen when reading a common-sized income statement.
Discussion Questions
1. What are the key factors a manager should consider when
reviewing gross profit
trends?
reviewing operating
profit trends?
reviewing net profit
trends?
4. Why is it important to compare a company’s results period to
period?
5. Why do you think it is important to use a common-sized
income statement to
compare competitive companies?
eps81356_03_c03_097-132.indd 131 3/26/14 12:54 PM
Further Reading/Resources

BizStats.com
3M 2012 Annual Report
IBM 2012 Annual Report
InvestorWords.com
Yahoo Finance Industry List
Key Terms
allowances An account used to track a
discount or rebate given to the customer.
common-sized income statement Docu-
ment that enables users to analyze the key
line items that lead to profit or loss from a
different perspective by calculating each
number on the income statement as a
percentage.
cost of goods or services sold The costs
directly associated to produce the prod-
ucts or services to be sold by the business.
EBITDA A profit line seen on some
companies’ income statements that shows
earnings before interest, taxes, deprecia-
tion, and amortization.
expenses The money spent on operating
the business.
gross profit Profit after the cost of goods
sold is subtracted.

gross profit margin Percentage of profit
after the cost of goods sold is subtracted.
Profit Before Income Tax Expensed
Income before taxes and interest are
subtracted.
net profit margin The percentage of net
profit.
net profit (or loss) The bottom line of an
income statement that shows whether the
business experienced a gain or a loss.
operating profit Profit from the opera-
tions of the company.
operating profit margin The percent-
age of profit after subtracting operating
expenses.
returns Products returned by purchasers.
revenue The total income from the sales
of products or services.
sales The revenue earned from selling
products or services.
volume discounts Discounts offered
when a significant volume of merchandise
is purchased at the same time or over a
promised period of time. The volume is
negotiated between buyer and seller.
eps81356_03_c03_097-132.indd 132 3/26/14 12:54 PM

http://www.bizstats.com
http://media.corporate-
ir.net/media_files/irol/80/80574/Annual_Report_2012.pdf
nual.pdf
http://www.investorwords.com
http://biz.yahoo.com/p/sum_conameu.html

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