Chapter 7: Merchandising Businesses

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Learning Objectives[edit]

  • Learn about various types of businesses
  • Learn about key functions of a merchandising business
  • Learn about periodic and perpetual inventory systems
  • Learn how to record the purchase of inventory
  • Learn how to account for transportation costs
  • Learn how to account for purchase returns and allowances
  • Learn how to account for purchase discounts (net method and gross method)
  • Learn how to record the sale of inventory
  • Learn how to account for transaction taxes
  • Learn how to prepare closing entries for inventory
  • Learn how to prepare a multi-step income statement

Types of Businesses[edit]

Businesses come in all shapes and sizes but most businesses fall into one of three categories. The three different types of businesses are the following:

Service business: These businesses sell intangible goods (goods which do not have a physical form) or services and typically charge for labor or other services provided to consumers. Entertainers, housekeepers, tax prepares and photographers are examples of service businesses.

Merchandising or Retail Business: Merchandising businesses buy products from wholesalers or manufacturers with the intention of reselling those products. The retailer makes their profit by increasing the price, called marking up, of the product before it is sold to the consumer. Grocery stores, department stores and clothing stores are examples of merchandising businesses. A wholesaler is a business that purchases products in bulk from manufacturers with the intention of reselling that merchandise in bulk to retailers who will sell the merchandise to consumers.

Manufacturing business: Manufacturers take raw materials, such as coal, timber or cotton and convert those raw materials into products. They can also use individual parts from other manufacturers to make a different type of product from the parts. Examples of manufacturers are automakers, steel mills, and semiconductor factories.

Large businesses might have a business units that operates in each category. For example, many oil companies have oil production, oil refining and service stations. These same companies have business units that provide oil services to smaller companies.

In this chapter we will study accounting for merchandising businesses.

Merchandising Businesses[edit]

A Merchandising operation is a business that buys products, increases the price (called marking up) and then sells the products to customers. A wholesaler will buy product in bulk and resell it to retailers. When the retailer purchases products, they place those products into their inventory. An inventory is the products that the retailer currently has in stock at their stores or in their warehouses. For retailers, the retailer has a unique operating cycle called the merchandising operating cycle. Essentially, the merchandising operating cycle begins with cash on hand being spent to purchase inventory. The inventory is then sold to customers for cash or credit (accounts receivable). The cash is then used to repurchase more inventory to repeat the cycle. The operating cycle varies by the type of business. Grocery related businesses will have a shorter operating cycle due to consumers needing to buy food frequently. A car dealer on the other hand can have a longer operating cycle because cars can sit on the lot for months before being sold. For retailers, it is important to properly manage their accounts receivable (AR) because they will need a certain amount of cash to repurchase more inventory. If the retailer does not manage AR properly then the retailer will have a cash flow shortage. Likewise, the retailer will need to properly manage their inventory to make sure all customer needs are met.

RetailCycle.png

For retail operations their primary revenue account is called sales revenue or revenue. Expenses are divided into two primary categories: cost of goods sold and operating expenses.

  • Cost of Goods Sold (COGS): COGS is the expense associated with buying products that are resold. For example if you purchased televisions from your supplier for $70 each and resold them for $100 each then your COGS for each television sold would be $70. The $70 COGS is recorded when each television is sold. This ensures that we do not violate the matching principle (essential for accrual accounting). COGS also includes any costs needed to get the good ready for sale. If the retailer had to pay $10 unloading fee to the shipper then that cost gets added to COGS when the item is sold.
  • Operating Expenses:Operating expenses are all related expenses necessary to sell the products in your inventory. For example, the cost of operating a distribution center would be considered an operating expense.

Other terms worth mentioning is gross profit. Gross profit is calculated as revenue minus cost of goods sold. Gross profit is important because it shows how much revenue is left over to cover operating expenses. For a company to have long-term viability, the company must produce enough gross profit to cover operating expenses. The following income statement shows the unique characteristics of a retail operation.

Retailincomestatement.png

The above can be summarized as: Sales Revenue - Cost of Goods Sold = Gross Profit - Operating Expenses = Net Income or Net Loss

On the balance sheet, a significant asset is the retail company's inventory. The inventory is classified as a current asset.

Inventory Systems[edit]

As was previously discussed, inventory is the products purchased by a retailer for resale. The first step with inventory is to be able to record the amount of inventory on hand. To accomplish this, we can use either a periodic or perpetual inventory system.

  • Periodic Inventory System: Under this system, the inventory records are only updated periodically as necessary, usually at a fixed interval. New purchases are added to beginning inventory to calculate cost of goods available for sale. At the end of the period, physical inventory is counted to determine how much inventory is on hand. In order to calculate cost of goods sold, we subtract the ending inventory amount from cost of goods available for sale. Under the periodic system, our cost of goods sold would be calculated as follows:
PeriodicCOGS.png

The periodic system is often used by small businesses that don't need immediate inventory information. The system could also be used by larger businesses that have high-value, low count inventories such as automobile sellers or art dealers. One benefit of the periodic system is that inventory tracking computers or sophisticated point of sale (cash registers) machines do not need to be used.

  • Perpetual Inventory System: Under this system, the inventory records are updated continuously as inventory levels change. Using computerized inventory systems, cost of goods available for sale and cost of goods sold can be calculated after each sale even if sales are high volume. As the cost of computerized inventory systems decline, many large and small businesses are are using perpetual inventory systems. One of the benefits of a perpetual system is that the company will have access to an always up to date information about their inventory. For perpetual inventory systems, a periodic physical count will be performed to ensure accuracy of the overall inventory records. This physical count usually occurs at year end. Any discrepancies found during the physical count should be investigated. Inventory shortages could be due to damaged inventory, theft of inventory or spoilage (inventory going bad due to passage of time).

Recording Inventory Purchases[edit]

When a retail operation begins, they first must purchase their inventory from suppliers. As this inventory is sold, they repurchase more inventory throughout their operating cycle. Depending on the contractual relationship of the retailer and supplier the retailer will either pay the supplier with cash or be granted credit by the supplier. Most businesses have a short-term credit account with their suppliers. This credit is called trade credit and in accounting, we use the accounts payable account to record these transactions for the buyer. Once the retailer has decided what inventory to purchase, the supplier will issue an invoice to the retailer detailing the terms of the transaction, the date of the transaction, the cost of the transaction and a variety of other information essential to the transaction. The invoice becomes the source document for recording credit purchase transactions. For cash purchases, the source documents are canceled checks or cash register receipts. We record inventory purchases by debiting inventory and crediting cash. If the buyer agreed to credit terms then we credit accounts payable. The debit to inventory (asset) indicates that inventory is increasing while a credit to cash (asset) indicates that cash is decreasing. Likewise, a credit to accounts payable indicates that accounts payable is increasing (ie. we have a bill to pay). The journal entry is as follows:

InventoryJE-1.png

The above transaction is for a perpetual inventory system. If a periodic inventory system was used the debit would be to a purchases account. At the end of the period (month) the amount in the purchases account is shifted to inventory by crediting the purchases account and debiting inventory. The purchases account is returned to zero and the inventory account is increased. A physical inventory count would be conducted and then an amount would be assigned to cost of goods sold based on the remaining inventory on hand.

Transportation Costs[edit]

After the inventory is purchased from the supplier, it must be shipped to the retailer. Companies can use their own delivery trucks for local deliveries and for long distance a common carrier. A common carrier is a 3rd party company that specializes in transporting goods between customers and businesses. They use trucks, railroads, aircraft and ships to transport goods. The retailer and supplier agree to the terms of who pays for shipping. An important question is how do we record shipping costs? The answer to this question is that it depends on the shipping terms. There are two shipping terms we need to know: free on board (FOB): shipping point and FOB: destination. The term free on board means the seller will deliver place the purchased on the truck/ship or other transportation system at no additional cost.

  • FOB: Shipping Point: This means that the goods are placed free on board the truck and the buyer pays the shipping costs. For FOB: shipping point, the buyer adds the shipping cost to their cost of inventory. When the buyer pays for the shipping, the buyer debits inventory and cash is credited. The buyer recognizes freight expenses as the cost to acquire the inventory. When the inventory is sold, the freight expense associated with the sale of inventory is recognized as cost of goods sold.
FreightJE-1.png
  • FOB: Destination: This means that the goods are placed free on board the truck and the seller pays the shipping costs. For FOB: Destination, the buyer does not include the cost as part of their inventory. When the seller sells the inventory, the shipping cost is considered an ordinary and necessary business expense. Cash is credited and freight expense is debited. Freight expense is reported on the income statement as a selling expense.
FreightExpense.png

Another important concept is the ownership of legal title to the merchandise. The term having title means that you own the merchandise from a legal point of view. For FOB: shipping point contracts, the buyer owns the merchandise when it is placed on the truck. For FOB: destination contracts the buyer owns the merchandise when the merchandise is delivered to their place of business.

Purchase Returns and Allowances[edit]

Occasionally, products are sent to the buyer that are defective, poor quality or do not meet the customer's expectation. In such a situation, the buyer and seller have a variety of options. The first option is that the buyer and seller can agree to return the merchandise to the seller which is called a purchase return. The second option is that the buyer will keep the merchandise and the seller will agree to provide the buyer with future purchase credit which can be used for future purchases from the seller. The second option is called a purchase allowance. Our first example shows how a purchase return would be recorded:

On June 1st, 2016 New Horizons Software INC. returned $10,000 worth of inventory purchased from their supplier. New Horizon received cash from the transaction.

ReturnJE-1.png

If New Horizons paid on credit then accounts payable would be debited instead of cash. When accounts payable is debited, the debit is decreasing the account since accounts payable is a liability. If half of the merchandise was returned then the amount would be reduced by half.

In the case of a purchase allowance, we record the purchase allowance as follows:

PurchaseAllowanceJE.png

The above journal entry shows that we received $250 reduction in our accounts payable and received a $250 purchase allowance. The purchase allowance is called a contra account because it reduces an associated account. In this case, the purchase allowance is a contra asset for purchases. The contra account reduces purchases. Purchase allowances are generally only granted where trade credit has been extended. The above journal entry can also be related to a company issuing a debit memo. A debit memo is when a company debits their account paypal and issues the memo to the supplier. This puts the supplier on notice that the customer will be short paying the invoice.

Purchase Discounts[edit]

A purchase discount is a reduction in the transaction value offered by the seller to the buyer to encourage early payment of the invoice. These terms are indicated on the invoice as credit terms. The terms are generally referred to as net/30, net/10, or 2/30, among other combinations. If the credit terms for an invoice were "2/15, net/30" then these terms mean the buyer will get a 2% discount if the entire invoice is paid in full within 15 days of purchase. If the buyer does not pay within 15 days then they will need to pay the entire invoice within 30 days. These credit terms are read as "two-fifteen, net-thirty." The term net means that the invoice excludes returns or allowances. Another less often used term is EOM. EOM stands for end of month. This term is generally used as follows: "2/10 EOM" which means the buyer will receive a 2% discount if the invoice (entire or partial) is paid within 10 day after the end of the next month.

In order to understand how accounting for purchase discounts we need to think of how inventory is recorded. As you've learned from the above example about freight costs, we have learned that inventory is recorded at the cost to acquire and prepare the inventory for sale. With this in mind, a purchase discount is in essence reducing our cost to acquire the inventory. Therefore, a purchase discount will affect our inventory account by decreasing it (with a credit). The following example shows how the journal entry is prepared:

On may 1st, 2016, New Corporation purchased $5,000 of inventory from their supplier on credit. The credit terms were 2/10, net/30. On may 10th, 2016, New Corporation paid the invoice in full and received the 2% discount for paying the invoice within the discount period. Our journal entry on may 10th would be recorded as follows:

PurchaseReturnJE-1.png

Here we can see that accounts payable is being debited for $5,000 which reduces our liability to zero. Our cash is being credited for $4,900 and our inventory is being credited for $100. The overall affect is that our inventory cost $100 less to purchase due to the company paying the invoice within the discount period.

If New Corporation did not pay the invoice until the 25th month then the following entry would be recorded:

Purchasediscountafter.png

As you can see, no discount was received so we do not credit inventory for any discounts. For a direct cash purchase we would debit inventory for the amount of cash that was paid, net of the discount which means we will subtract the amount of the discount.

Recording Sale of Inventory[edit]

For retailer operations, customers place orders with the retailer for merchandise they are requesting to purchase. These transactions must follow the revenue recognition principle which states that revenue will only be recognized when the sales transaction is substantially complete. For retail operations, what this means is that the company will recognize revenue when the goods have been shipped to the customer or the customer has obtained legal title to the goods (ie. after you have paid for the items in your basket at the cash register). As with all accounting information, source documents are essential. For retail sales, invoices (credit/AP sales) and cash register receipts (cash sales) are the primary source documents used.

For each sale there will be two journal entries that must be recorded. The first journal entry will record the recognition of sales revenue and the second entry will record the expense associated with the sale of inventory. As you can see, this is the very essence of accrual accounting in the sense that we are using the matching principle to recognize revenue and the associated expense at the time of the sale. Both revenue and expense will be reported on the income statement. The following journal entries show the recording of sales revenue and expense.

On June 1st, 2016, New Retail Company Inc., sold merchandise for $9,000 to New Supply Company Inc. The merchandise was originally acquired for $8,500.

SaleandCOGSregonition.png

The above two journal entries can also be combined into a single journal entry to make the journal entry easier to identify when reviewing the books.

A business may also make sales by issuing short-term credit to the customer called trade credit. Transactions where short-term credit is issued is called making a sale on account. When a sale on account occurs the company will record an asset in the form of an account receivable. Using our rules of normal account balance, an asset account is increased with a debit. Therefore, our account receivable account will be increased with a debit. We will recognize revenue using a credit. Revenue accounts are increased with credit. The overall impact of this transaction is that we increase our account receivable and also increase our revenue. We also recognize the cost of inventory sold at the same time. The transaction is the same as the above transactions accept we debit the accounts receivable account rather than the cash account.

Sales Returns[edit]

A sales return occurs when the customer will return the merchandise back to the retailer. In this scenario, we have sold merchandise to a customer and the customer has had issues with the transaction. The merchandise might have been damaged in transit, become defective or be goods that don't meet the customer's order requirements. In this scenario we can offer the customer two options: return the merchandise for a refund or receive a reduced price for the order. The price is reduced through the use of an allowance and is only available to customers who have been issued trade credit.

To fully understand what journal entries we need to make, we need to understand what was recorded in the initial sales journal entry. As was mentioned above, when an order has been substantially completed we record revenue and the associated expense of the transaction. If the merchandise is return then what we need to reverse the sales and expense journal entries we previously recorded. Without these reversing entries being made, the revenue and expense amounts would be incorrect. Our revenue account would be overstated which means our revenue will be higher than it should be. Our expense account will also be overstated since the goods were returned to us. To record a sales return, we use the following journal entry:

SalesReturnJE-1.png

The above journal entry needs a little further explaining to grasp the big picture of what is going on. For the first entry, we use the account Sales Returns and Allowances which is called a contra revenue account (debit normal balance). A contra account reduces the parent account. For the Sales Returns and Allowances account, the parent account is Sales Revenue. When the income statement is created we will subtract the balance in the Sales Returns and Allowances account to figure out what our Sales Revenue for the period was. We credit cash because cash was returned to the customer.

The second entry's purpose is to reverse the expense recognition from the initial sales transaction. Remember, based on accrual accounting rules, we must recognize expense when the sale revenue is recognized to properly match revenue and expenses. Since the initial sales transaction has been returned we will need to reverse our expense recognition. This is accomplished by simply doing the opposite of what we did in the initial sales transaction. We debit Inventory and credit Cost of Goods Sold.

If we determine that the returned inventory is broken and can no longer be resold then we would not record the second entry. The cost of goods sold expense would be kept on the books. If the returned merchandise only had half its original value then we would debit inventory for that amount and credit cost of goods sold for the same amount.

Sales Allowances[edit]

A sales allowance is used to estimate the amount of potential returns that will occur from sales. An allowance can also be used to reduce the sales price to compensate for defects or other issues that occurred during the same. An allowance would be used if the customer does not need to return the merchandise. Significant to an allowance is that we need to estimate how much we expect to have in the allowance account. A variety of methods could be used. The goal is to set the allowance as close as possible to what the actual amount will be. Most companies will use historical trends of past sales to determine how much the allowance should be and will use a percentage of sales approach to determine the amount of allowance to use.

For example, lets assume your company has sold $100,000 in merchandise and you expect 5% of these sales to result in refunds or discounts being issued. The associated cost of goods sold for the merchandise that is expected to be returned is $5,000. To record this estimate, we will debit sales for 5% of the sales ($1,000) and credit refunds payable for the same amount. We also need a second entry where we record the expense. We will debit estimated returns and credit cost of goods sold of $1,000 for the expected merchandise to be returned.

Ch7SalesAllowanceJE-1.png

These two entries will allow us to report a liability on the balance sheet for the potential returns and book the expense immediately. We book the expense immediately due to the rule of conservatism.

If a customer returned their purchase that they initially agreed to pay $500 (with a COGS of $100) then the following entry would be made:

Ch7SalesAllowanceJE-2.png

These two entries will record the liability that is eliminated as a result of returning cash back to the customer. The second entry records the inventory being returned. We increase inventory and reduce the amount of estimated returns.

The above entry is focused on if the customer had returned the merchandise for a full refund. However, what if the customer would be satisfied with a 20% discount on the sale instead? In that case we would need to credit the payable account to reduce the amount that the customer would need to owe us. Lets assume that the customer accepts the 20% discount instead of a full return. The following entry would need to be recorded:

Ch7SalesAllowanceJE-3.png

After the company has credited the receivable a credit memo would be created for internal accounting purposes and also a copy would be sent to the customer to let them know they can reduce their account payable.

The following is a typical credit memo:

Ch7CreditMemo.png

Sales Discounts Offered to Customers[edit]

A sales discount is when the seller of merchandise offers a reduced price (a discount) for paying the invoice early. Using the standard credit terms of 2/10, n/30 the customer has the option of getting a discount for early payment. This concept only applies to credit sales where the customer did not pay in cash at the time of sale. If the sale was a cash sale then the cash and revenue would be recorded net of the discount. Overall, there are two methods which we can use to record sales discounts: the net method or the gross method. Lets discuss both.

The Net Method: Under this method, we will record the sales revenue at the net amount (after the discount). If the customer does not take the discount then we will account for that at the time of sale.

The Gross Method: Under this method, we will record the sales revenue at the gross amount (before the discount). If the customer took the discount then the discount would be recorded at the time of payment.

As you can see, the difference is based around when to record the discount. Lets elaborate on each method using examples.

The Net Method[edit]

As mentioned previously, the net method records the sales revenue net of the discount. To best understand this, we will work through an example in which a sale is made and then when the subsequent payment is made. We will also highlight the journal entry that will be made if the discount is made after the discount period.

Net Proceeds = Gross Price - Potential Discount

Lets assume you own a company which sold a product to a customer for $1,000 on credit with credit terms of 2/10, net/30. If the customer paid for the sale within the discount period they would save $20. Thus, we will record our sales revenue at $980 as seen below:

Ch7NetMethodSalesDiscountJE-1.png

If the payment was received within 10 days from the sale, the customer would qualify for the discount and the following journal entry would be recorded. Take note that we are simply recording the cash and eliminating the associated accounts receivable since the receivable was recorded net of the discount:

Ch7NetMethodSalesDiscountJE-2.png

If the payment was received after the 10 days from the sale, the customer would not qualify for the discount and the following journal entry would be recorded. With this entry we will have to reverse the discount that we previously recorded. We use the sales discount forfeited account to record it:

Ch7NetMethodSalesDiscountJE-3.png

The Gross Method[edit]

The gross method records the initial sales revenue at the gross amount, before factoring in the discount. Using the same fact pattern shown with the net method, we will record the $1,000 sale as follows:

Ch7GrossMethodSalesDiscountJE-1.png

If the payment was received within 10 days from the sale, the customer would qualify for the discount and the following journal entry would be recorded. Originally we recorded the sales revenue at the gross amount which means we will need to debit a contra revenue account to reduce the amount of revenue we originally recorded. We will use an account called sales discounts. The journal entry is shown below:

Ch7GrossMethodSalesDiscountJE-2.png

If the payment was received after the 10 days from the sale, the customer would not qualify for the discount and the following journal entry would be recorded. Since the original sales revenue journal entry was recorded at the gross amount we simply debit cash and credit accounts receivable to eliminate the account receivable:

Ch7GrossMethodSalesDiscountJE-3.png

Transaction Taxes[edit]

A transaction tax is a tax on the sale of most physical goods. The transaction is often referred to as a sales tax and is collected by the merchant at the time of sale. For sales tax the liability to the government is created when the sale occurs. The sales tax is not revenue to the business and the amount of sales tax collected must be kept in a separate account. The sales tax collected will be credited to a sales tax payable account. At the end of the month, the sales tax will be remitted to the government when the sales tax return is filed by the business.

CH7SalesTax.png

The remittance of the sales tax at the end of the month will be recorded as follows:

CH7SalesTaxRemittance.png

After the sales tax has been remitted the sales tax payable account should have a zero balance in it.

Inventory Counts and Closing Entries[edit]

At the end of the accounting period an inventory count must be conducted to make sure the ending balance of the inventory is an accurate reflection of the inventory on hand. Inventory may become obsolete, degrade, or get stolen due to theft. Without doing an inventory count on a regular interval, the value of the inventory account will be overstated (be reported at a higher value than it actually is). The process of the inventory count is quite simple: an employee or external auditor will go through the inventory and verify the amount of inventory on hand. Additional steps might be taken to make sure that no inventory is obsolete or damaged. Any discrepancy found will result in an investigation to make sure no serious issues are occurring for inventory (ie. rampant employee theft of inventory). If inventory is found to be overstated then the inventory account will be adjusted. To adjust the inventory we will debit cost of goods sold and credit inventory. The overall affect on the financial statements is that expense is reported on the income statement and the balance sheet inventory account is reduced.

To explain this further, just imagine that you are working for a company and you are assigned to perform the inventory count. The current inventory account is reporting inventory of $100,000. After the inventory count you conclude that $5,000 of inventory has become obsolete and another $3,000 worth of inventory was spoiled. The $8,000 worth of obsolete and spoiled inventory had no resale value and was disposed of. To record the reduced value of the inventory, we record the following journal entry:

InventoryCount.png

When the accounting cycle ends, merchandising businesses use the same set of rules for preparing closing entries. All temporary revenue and expense accounts are closed to income summary. Sales revenue and cost of goods sold are temporary accounts that will be closed to income summary. All expense and revenue accounts will also be closed to income summary. After these closing entries are made, the temporary accounts will have a zero balance which prepares them for the next accounting cycle. Finally, income summary is closed to retained earnings and dividends are closed directly to retained earnings. The retained earnings account is carried over to the next account cycle.

Step 1: Close the revenue accounts to income summary.

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Step 2: Close expense accounts to income summary.

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Step 3: Close income summary to retained earnings.

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Step 4: Close dividends directly to retained earnings.

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After these entries are posted, the post-closing trial balance is prepared and reviewed. If the post-closing trial balance is not equal there is an error which should be investigated. There should be no temporary accounts on the trial balance. Only permanent account should remain (asset, contra asset, liability, stockholder's equity and related accounts).

Multi-Step Income Statement[edit]

In chapter 4, Financial Statements, we learned about two formats for the income statement: the single-step and the multi-step income statement. The single-step income statement was relatively straight forward while the multi-step income statement involved more detail. Now we will review the finer details of the multi-step income statement and break it down step-by-step. We will begin with a high level review of the multi-step income statement followed by a step-by-step explanation and analysis of each step. The following image shows a complete multi-step income statement:

Multi-Step Income Statement, Chapter 4.png

The multi-step income statement begins by organizing revenues and expenses into two major categories: operating and non-operating. Operating revenue/expenses are directly related to the primary business operations of the business, such as, selling goods/services. The non-operating category organizes revenue/expenses/gains/loses based on activities that are not directly related to the primary operations. This could be activities like selling stock, earning interest income or gains from sale of real estate. The chart below illustrates the differences between operating and non-operating activities.

Operating.png

The first section of the multi-step income statement is to calculate net sales. We start with sales revenue and then subtract our contra-revenue accounts, sales returns and allowances and sales discounts. After subtracting those two accounts we arrive at net sales.

Net Sales.png

As seen above, we have $20,000 sales revenue and then we subtract $2,500 for sales returns and allowances and $2,500 for sales discount. When we subtract the $5,000 we get the net sales number of $15,000.

Our next step is to calculate gross profits. Gross profits is calculated as net sales minus cost of goods sold. Gross profit may also be referred to as gross margin. Gross profit is significant from a financial standpoint because it shows us how much potential profit is being generated from primary operations. The gross profit must be high enough to support the non-operating expenses of the business. Our gross profit is calculated below:

GrossProfit.png

As seen above, we had cost of goods sold of $6,000. The $6,000 COGS was subtracted from net sales to calculate our gross profit of $9,000. Another useful formula for financial analysis is the gross profit percentage. The gross profit percentage is calculated as: ((Net Sales - Cost of Goods Sold)/Net Sales) x 100. The gross profit percentage shows us how much revenue is converted into gross profit. It is useful for comparing it against competitor or comparing historical trends. Our gross profit percentage is calculated below:

GrossProfitFormula.png

Operating expenses is our next major category. For this category we categorize our operating expenses into either selling expenses or administrative expenses. Selling expenses are expenses that help to facilitate the sale of merchandise. Administrative expenses don't facilitate the direct sale of merchandise but are necessary for operating the business. The operating expenses are seen being calculated below:

IncomeFromOperations.png

As you can see, we have added up our selling and administrative expenses to get $3,000. The 3,000 operating expenses are subtracted from gross profit ($9,000) to get $6,000 income from operations. Income from operations shows us how much earnings were generated from our primary operations. Remember income from operations is not net income. To calculate net income we need to include revenues and expenses from non-operating activities as well the effect of taxes. We will now calculate our income before income tax. Income before income tax may also be referred to as earnings before income tax (EBIT).

IncomeBeforeIncomeTax.png

We have a gain on sale of stock for $500 and expenses of $750 from non-operating activities. These two numbers are combined to get -$250. The -$250 is subtracted from $6,000 income from operations to calculate $5,750 income before income tax. We separately report the gain on sale of stock because it is not directly related to the primary operations of the business. By separating out operating income/expenses from non-operating it allows financial statement users to better understand how the business is operating. Non-operating activities are also separately stated because they are assumed to be non-recurring whereas the operating activities are assumed to be recurring as the business operates.

We will now cover taxes. Taxes is a complicated subject so the sake of simplicity we only use amounts that are given to us. In reality, the income tax number will have to be calculated based on local tax laws. You will need to take a tax accounting class to learn how to calculate tax obligations for the business. More complicated aspects of taxation will be covered in more advanced financial accounting courses.

Netincomecalculation.png

Our income tax expense for the period was $1,000. We subtract $1,000 from income before income tax to arrive at net income of $4,750. Net income is the last line in the income statement and is often referred to as the "bottom line."

The image below summarizes the major sections of the multi-step income statement:

Multi-Step Income Statement summary.png