2

The income statement, often called a statement of

operations or a profit and loss statement (P&L),
describes the performance of the company over a
period of time, usually a month, a quarter, or a year

The income statement is summarized

as follows:

Revenue - Expenses = Profit

3
24. Revenue, $4,160,000

This is the dollar amount of

products and services that the
company provided to its customers
during the year.

Revenue is the value of products or

services that is delivered to a
satisfied customer. The customer
either pays cash or promises to pay
in the future; in the latter case, the
amount is recorded as an accounts
receivable.

For example, a customer may make a

down payment or deposit or may pay in
advance for a magazine subscription.
More commonly, however, businesses
receive cash after the revenue is
earned, resulting in accounts receivable
4
25. Cost of Goods Sold, $2,759,000
 The cost of producing or
purchasing the goods that are
delivered to customers.
Cost of goods sold is the cost of
producing or purchasing the goods
that are delivered to customers. This
amount is subtracted from revenue in
order to determine gross profit or
gross margin. Cost of goods sold
includes the following elements:

• Raw materials
• Purchased components
• Direct labor
• Operating and repairing the
equipment used to manufacture the
products
• Other manufacturing expenses,
including utilities and maintenance of
the production facility
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 Cost of Goods Sold

The amount recorded as cost of goods sold is related to the difference between
expenses and expenditures, discussed in Chapter 1.
Cost of goods sold is an expense, and cost of production is an expenditure.
Cost of goods sold will be different from cost of production because of changes
in inventory.
If inventory levels decrease during the period, then the cost of goods sold will be
higher than the cost of production by the amount of the change in inventory.

If this were a service business, the equivalent of cost of goods sold would
be called direct cost.

Direct cost  the sum total of all of the spending necessary to

provide the company’s customers with a valuable experience.

It includes the wages paid to all the people who interface with the
customers, plus all of the support spending necessary to help those
people perform their jobs.
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26. Gross Margin, $1,401,000

This measures the profitability

achieved as a result of producing
and selling products and services.

It measures manufacturing
efficiency and the desirability of the
company’s products in the
marketplace.

Gross margin percentage is

another measure of that
performance.

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27. General and Administrative
Expenses, $1,033,000

This amount represents:

The cost of operating the entire
infrastructure of the company.

Included in this category are :

• staff expenses (accounting,
computer operations, senior
management),
• selling expenses (salaries, travel),
promotional expenses (advertising,
trade shows), and
• research and development
(technological research).

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28. Depreciation Expense,
$56,000

 This is the portion of prior capital

expenditures that has been
allocated
to the current year and is recorded
as an expense in that year.

It is not a cash expenditure.

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29. Net Income Before Tax,
$312,000

 This amount is equal to revenue

minus all operating and non
operating expenses incurred by the
company.

For Metropolitan Manufacturing

Company, Inc., it is:

10
30. Federal Income Tax, $156,000

 In the United States, corporations pay

approximately 34 percent of their profit to
the federal government in the form of
income taxes.

For the Metropolitan Manufacturing

Company example, however,
we used a rate of 50 percent to keep
the calculations simple.

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31. Net Income, $156,000

 This is the amount of profit that

the corporation has achieved
during the year.

All expenses related to purchases

from vendors and all other operating
expenses have been taken into
account.

The owners of the business may keep

this profit for their personal use
(dividends) or reinvest all or part of it
in the corporation to finance
expansion and modernization
(retained earnings).

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32. Cash Dividends, $46,000

This is the portion of the year’s

profits that were distributed to the
owners of the business.

The remainder (the portion of net

income that was not paid to the
owners) was retained in the business
each year.

Therefore:

13
33. Change in Retained
Earnings, $110,000

 This represents the portion of the

profits that the owners reinvested
in the business in the year 2011.

The cumulative amount that the owners

have reinvested in the business since
its inception is $1,357,000.

This is the cumulative retained

earnings; it appears on the balance
sheet on line 21.

Notice on the balance sheet that

line 21 increased by $110,000 in 2011,
which represents that year’s
reinvestment.
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Analysis of the Income Statement

A decline in revenue is not necessarily bad. There

are times when revenue is flat but gross profit is
improving.

This is often a sign that the company is ‘‘cleansing’’ its

product mix, or eliminating those products whose
profitability is much less than the company average.

It may be doing this for a number of possible reasons:

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Analysis of the Income Statement
A number of possible reasons:

• The products are just not very profitable.

• Available productive capacity is limited, and the company will use these newly
available facilities to produce fastergrowing, higher-margin products.

• The products being eliminated are not of high enough quality, impairing the
company’s reputation as a provider of high-quality products.

• The eliminated products were consuming large amounts of cash, as they

required high levels of inventory and accounts receivable to support the business.

• The company decided to outsource the production of these products to

third parties. It continues to provide the products to its customers, but it now
earns a sales commission rather than the full revenue.

The company now leases some equipment to customers rather than selling it
outright. Revenue will decline for a while. This happens when software providers
convert to a software licensing strategy rather than sell the software. Revenue will
decline for a while
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Analysis of the Income Statement

If revenue is increasing but the gross profit percentage is decreasing,  the

company is probably gaining more business by reducing its selling prices.

An increase in gross profit dollars improves the company’s cash flow.

There is no negative connotation to reducing prices if the strategy is

necessary and successful.

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Analysis of the Income Statement

Provision for Federal Income Tax

 This is the corporate tax rate, which is usually in the 34 percent

range, times the income before tax.

It is not necessarily the amount of taxes that the company actually paid.

This is because the accounting methodology used for a company’s

financial reports to shareholders is different from the methodology that
the company uses in preparing its tax return.

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Analysis of the Income Statement

Net Income

Remember,
This is not the amount of cash that has actually been generated by the
business.
Cash from revenue generated may not yet have been collected, and many
expenses, particularly depreciation, are not expenditures.

If the company is performing well, net income should increase much

faster than revenue.

Growth enhances efficiency and provides financing for technological

investment. Companies with a high proportion of fixed costs should
show considerable profit improvement relative to revenue growth

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