8 - The Income Statement

Question 1

Why is a business’s income statement important?

Answer 1

A business’s income statement is important because it summarises the results (revenues, expenses and net income) of the
business’s operating activities for an accounting period. This information is useful in the decision making of both internal and
external users because it helps to show how well the business’s management has performed during the period and how it is
performing from period to period.

Question 2

What is another name for an income statement?

Answer 2

Profit and Loss statement

Question 3

What is an income statement?

Answer 3

An income statement is a financial statement that shows you the company’s income and expenditures. It also shows whether a company is making a profit or loss for a given period.

Question 4

What is the purpose of an income statement?

Answer 4

A business’s income statement plays a key role in the decision making of users of financial information by communicating the business’s revenue, expenses, and net income (or net loss) for a specific time period. A business earns income by selling inventory (goods) or by providing services to customers during an accounting period. Recall that revenues are amounts earned by a business in charging its customer for goods or services.

Question 5

How do external users use the income statement for decision making?

Answer 5

The income statement lets them compare a business’s actual operating performance over several years, or compare this with the operating performance of other businesses.

Question 6

Why is it important to measure financial performance?

Answer 6

Measuring performance for any business is ultimately a measure of its success. Financial performance is a subjective measure of how well a firm can use assets from its primary mode of business and generate revenues. The term is also used as a general measure of a firm’s overall financial health over a given period.

A business must know the total of each of its revenues and the total of each of its expenses for the accounting period, so it can report these items in a useful manner on its income statement for that period.

Question 7

How are changes in a business’s income statement accounts recorded in its accounting system?

Answer 7

Changes in a business’s balance sheet accounts are recorded in its accounting system by creating a separate column for each asset,
liability, and owner’s capital account. These accounts are called permanent accounts because they are used for the life of the business to record its balance sheet transactions.

Changes in a business’s income statement accounts are recorded in its accounting system by creating a separate column under ‘Owner’s equity’ for each revenue account and each expense account, while still retaining the ‘Owner’s capital’ account column.

A business uses these revenue and expense accounts to record its net income transactions for only one accounting period, so they are called temporary accounts.

Question 8

What are permanent accounts?

Answer 8

Accounts used for the life of a business to record the effects of its transactions on its balance sheet (assets, liabilities, and owner’s capital accounts)

Question 9

What is operating income?

Answer 9

All the revenues earned, less the expenses incurred in the primary operating activities of a business.

Question 10

What are other items?

Answer 10

Revenues and expenses that are not directly related to the primary operations of a business.

Question 11

What are the parts of a retail business’s classified income statement, and what do they contain?

Answer 11

The classified income statement of a retail business includes two parts: an ‘Operating income’ section and an ‘Other items’ section.

The operating income section includes revenues, cost of goods sold, and operating expenses subsections related to a business’s primary operating activities.

The other items section includes any revenues or expenses that are not directly related to the business’s primary operations.

Question 12

What is revenue?

Answer 12

Revenue is income that arises during the course of the ordinary activities of a business.

Question 13

What are the effects of an increase in assets on the balance sheet?

Answer 13

There is an increase in revenues, which increases net income on the income statement (and therefore increases owner’s equity on balance sheet)

Question 14

What are the effects of a decrease in assets on the balance sheet?

Answer 14

Increase in cost of goods sold (expenses increase or revenues decrease), which decreases net income on the income statement (and therefore decreases owner’s equity on the balance sheet).

Question 15

What are the three types of policies related to the sales of their goods or services?

Answer 15

1. Discount policies
2. Return policies
3. Sales allowance policies

Question 16

What are quantity discounts?

Answer 16

Reduction in the sales price of a good or service because of the number of items purchased or because of a sales promotion.

Question 17

What is a sales discount?

Answer 17

Percentage reduction of the invoice price if the customer pays the invoice within a specific period.

Question 18

What is a cash discount?

Answer 18

Percentage reduction of the invoice price if the customer pays the invoice within a specific period.

Question 19

What is a sales return?

Answer 19

When a customer returns previously purchased merchandise and receives a refund.

Question 20

What is a sales allowance?

Answer 20

When a customer agrees to keep damaged merchandise and the business refunds a portion of the original sales price.

Question 21

What is a credit memo?

Answer 21

A business document that lists the information for a sales return or allowance.

Question 22

What is sales revenue?

Answer 22

Sales revenue is the income received by a company from its sales of goods or the provision of services.

Question 23

What are expenses?

Answer 23

Expenses are outflows that arise as a result of the ordinary activities of a business.

Question 24

What are cost of goods sold?

Answer 24

A major expense of a retail business consisting of the cost of the goods (merchandise) that it sells during the accounting period.

Question 25

What is a perpetual inventory system?

Answer 25

System that keeps a continuous record of the cost of inventory on hand and the cost of inventory sold.

Question 26

What is a periodic inventory system?

Answer 26

System that does not keep a continuous record of the inventory on hand and sold, but determines the inventory at the end of each accounting period by physically counting it.

Question 27

What are net purchases?

Answer 27

Amount of merchandise purchases adjusted for purchase returns, allowances and discounts.

Question 28

What is cost of ending inventory?

Answer 28

The dollar amount of merchandise on hand, based on a physical count, at the end of the accounting period

Question 29

What is gross profit?

Answer 29

Net sales minus cost of goods sold.

Question 30

How do you calculate cost of goods sold?

Answer 30

Cost of goods sold = COBI + CONP - COEI

COBI = Cost of beginning inventory
CONP = Cost of net purchases
COEI = Cost of ending inventory

Question 31

What is inventory?

Answer 31

Inventory is the merchandise a retail business is holding for resale.

Question 32

What inventory systems may be used by a business?

Answer 32

1. Perpetual inventory system

2. Periodic inventory system

Question 33

What are operating expenses?

Answer 33

Expenses (other than cost of goods sold) that a business incurs in its day-to-day operations.

Question 34

What are selling expenses?

Answer 34

Operating expenses related to the sales activities of a business.

Question 35

What are general and administrative expenses?

Answer 35

Operating expenses related to the general management of a business.

Question 36

What are financial expenses?

Answer 36

Expenses related to the financing of the business and its operations. and to debt collection.

Question 37

What are the main concerns of external decision-makers when they use a business’s income statement to evaluate its performance?

Answer 37

When external decision-makers use a business’s income statement to evaluate its performance, they are concerned with the business’s risk, operating capability, and financial flexibility.

Risk is uncertainty about the future earnings potential of the business. Operating capability refers to the business’s ability to continue a given level of operations. Financial flexibility refers to the business’s ability to adapt to change.

Question 38

What is ratio analysis?

Answer 38

Calculations made in financial analysis in which an item on a business’s financial statements is divided by another related item.

Question 39

What is a profit margin?

Answer 39

Net income divided by net sales

Question 40

What is the gross profit percentage?

Answer 40

Gross profit divided by net sales

Question 41

Why do businesses prepare financial statements?

Answer 41

Accounting information helps managers plan, operate, and evaluate business activities. Managers use accounting information on a day-to-day basis to help them make decisions that will achieve their objective of earning a profit and thereby increase the business’s value.

At the end of a specific time period, managers prepare financial statements to report the cumulative results of their day-to-day decisions to external users. By analysing a business’s financial statements, external users can evaluate how well managers’ decisions have worked and decide whether to work with the business.

Question 42

What are temporary accounts?

Answer 42

Accounts used for one accounting period to record the effects of a business’s transactions on its net income (revenues and expenses)

Question 43

Why does a business close off its revenue and expense accounts at the end of each period?

Answer 43

The income statement summarises the results of the business by matching revenues and expenses to determine profit or loss. This result should flow onto the owners of the business. The statement of changes in owner’s equity helps to complete the picture in terms of the accounting cycle and the financial outcome (profit or loss) of the business which flows to the owners.

Revenue and expense accounts are viewed as temporary accounts used to accumulate information about the total revenues and expenses for a period. At the end of the period, balances are transferred to a profit and loss summary to enable calculation of the profit or loss for the period and close the accounts to zero balance.

Question 44

What type of analysis is used by external decision-makers to evaluate a business’s profitability?

Answer 44

Ratio analysis is used by external users to evaluate a business’s profitability. It involves calculations in which an item on the business’s financial statements is divided by another related item.

The ratios are compared with the business’s ratios in previous periods, or with other businesses’ ratios. The ratios used to evaluate a business’s profitability include the profit margin (net income/net sales) and the gross profit percentage (gross profit/net sales).