MODULE 2

INCOME STATEMENT AND CAPITAL STATEMENT

Intended Learning Outcomes

After the end of this module, you should be able to:

1. identify the elements of the Income Statement describe each of the items for
service business and a merchandising business;
2. prepare an Income Statement for a service business using the single-step
approach; and
3. prepare an Income Statement for a merchandising business using the
multistep approach.
4. Comprehend and prepare a capital statement

INCOME STATEMENT

An income statement is a formal statement showing the financial performance of an entity for
a given period of time. The financial performance of an entity is primarily measured in terms of the
level of income earned by the entity through the effective and efficient utilization of its resources. It is
sometimes referred to as the profit and loss statement (P&L), statement of comprehensive income, or
statement of income. We will use income statement and throughout the discussion.
The income statement is important because it shows the profitability of a company during the
time interval specific period of time. The period that the statement covers is chosen by the business and
will vary. For example, the heading may state:
➢ "For the Quarter Ended December 31, 2017" (The period of October 1 through December 31,
2017.)
➢ "For the Year Ended December 31, 2017" (The period of January 1 through December 31,
2017.)
➢ "The Fiscal Year Ended June 30, 2017" (The period of July 1, 2016 through June 30, 2017.)
Keep in mind that the income statement shows revenues, expenses, gains, and losses; it does not
show cash receipts (money you receive) nor cash disbursements (money you pay out).
People pay attention to the profitability of a company for many reasons. For example, if a company
was not able to operate profitably—the bottom line of the income statement indicates a net loss—a
banker/lender/creditor may be hesitant to extend additional credit to the company. On the other hand, a
company that has operated profitably—the bottom line of the income statement indicates a net
income—demonstrated its ability to use borrowed and invested funds in a successful manner. A
company's ability to operate profitably is important to current lenders and investors, potential lenders
and investors, company management, competitors, government agencies, labor unions, and others.

Elements of Income Statement

The format of the income statement will vary according to the complexity of the business activities.
However, most companies will have the following elements in their income statements:

I. Revenues and Gains

1. Operating Revenues
2. Non-Operating Revenues
3. Gains (e.g., gain on the sale fixed assets)

II. Expenses and Losses

1. Operating Expenses
2. Non-Operating Expenses
3. Losses (e.g., loss on the sale of fixed assets)
If the net amount of revenues and gains minus expenses and losses is positive, the bottom line
of the income statement is labeled as net income. If the net amount (or bottom line) is negative, there is
a net loss.

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I. Revenues and Gains

1. Revenues from primary activities are often referred to as operating revenues.

The primary activities of a retailer are purchasing merchandise and selling the merchandise. The
primary activities of a manufacturer are producing the products and selling them. For retailers,
manufacturers, wholesalers, and distributors the revenues resulting from their primary activities are
referred to as sales revenues or sales.

The primary activities of a company that provides services involve acquiring expertise and
selling that expertise to clients. For companies providing services, the revenues from their primary
services are referred to as service revenues or fees earned. (Some people use the word income
interchangeably with revenues.)

It's critical that you don't confuse revenues with receipts. Under the accrual basis of accounting,
service revenues and sales revenues are shown at the income statement in the period they are earned or
delivered, not in the period when the cash is collected or received. Put simply, revenues occur when
money is earned, receipts occur when cash is received.

For example, if a retailer gives customers 30 days to pay, revenues occur (and are reported)
when the merchandise is sold to the buyer, not when the cash is received 30 days later. If merchandise
is sold in December, the sale is reported on the December income statement. When the retailer receives
the check in January for the December sale, the retailer has a January receipt—not January revenues.

Similarly, if a consulting company asks clients to pay within 30 days of receiving their service,
revenues occur (and are reported) when the service is performed (earned), not 30 days later when the
consulting company receives the cash from the client. If an attorney requires a client to prepay P8,000
before beginning to research the client's case, the attorney has a receipt, but does not have revenues
until some of the research is done (unearned revenue).

If a company sells an item to a buyer who immediately pays for it with cash, the company has
both a receipt and revenues for that day—it has a cash receipt because it received cash; it has sales
revenues because it sold merchandise.

By knowing the difference between receipts and revenues, we make certain that revenues from
a transaction are reported only once—when the primary activities have been completed (and not
necessarily when the cash is collected).

Below examples are the distinction between revenues and receipts. (Keep in mind that all the
examples assume the accrual basis of accounting.)
➢ A company borrows P10,000 from its bank by signing a promissory note due in 90 days. The
company will have a receipt of P10,000 at the time of the loan, but it does not have revenues
because it did not earn the money from performing a service or from a sale of merchandise.
➢ If a company provided a P9,000 service on January 31 and gave the customer until March 10 to
pay for the service, the company's January income statement will show revenues of P9,000.
When the money is received in March, the March income statement will not show revenues for
this transaction. (In March the company will report a receipt of cash and a reduction/collection
of an accounts receivable.)
➢ A company performs a P54,000 service on December 31 and receives the P54,000 on the very
same day (December 31). This company will report P54,000 in revenues on December 31—not
because the company had a cash receipt on December 31, but because the service was
performed (earned) on that day.
➢ On December 10, a new client asks your consulting company to provide a P2,500 service in
January. You are uncertain as to whether or not this client is credit worthy, so to be on the safe
side you ask for an immediate partial payment of P1,000 before you agree to schedule the work
for January. Although your consulting company has a receipt of P1,000 in December, it does
not have revenues in December. (In December your company will record a liability of P1,000.)
Your consulting company will report the P1,000 of revenues when it performs P1,000 of
services in January.

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2. Revenues from secondary activities are often referred to as non-operating revenues.
These are the amounts a business earns outside of purchasing and selling goods and services.
For example, when a retail business earns interest on some of its idle cash, or earns rent from some
vacant space, these revenues result from an activity outside of buying and selling merchandise. As a
result the revenues are reported on the income statement separate from its primary activity of sales or
service revenues.

As is true with operating revenues, nonoperating revenues are reported on the profit and loss
statement during the period when they are earned, not when the cash is collected.

3. Gains from sale of assets.

A gain is reported on the income statement as the net of two amounts: the proceeds received
from the sale of fixed asset minus the amount listed for that item on the company's books (book value).
A gain occurs when the proceeds are more than the book value.

Example: Assume that a SM Department Store decides to dispose of the company's car and sells
it for P160,000. The P160,000 received for the car (the proceeds from the disposal of the car)
will not be included with sales revenues since the account Sales is used only for the sale of
merchandise. Since this department store is not in the business of buying and selling cars, the
sale of the car is outside of the retailer's primary activities. Over the years, the cost of the car
was being depreciated on the company's accounting records and as a result, the money received
for the car (P160,000) was greater than the carrying value shown for the car on the accounting
records (P120,000). This means that the company must report a gain equal to the amount of the
difference—in this case, the gain is reported as P40,000. This gain should not be reported as
sales revenues, nor should it be shown as part of the merchandiser's primary activities. Instead,
the gain will appear in a section on the income statement labeled as "nonoperating gains" or
"other income". The gain is reported in the period when the disposal occurred.

II. Expenses and Losses

1. Operating Expenses- Expenses involved in primary activities are expenses that are incurred in order
to earn normal operating revenues.
Selling expenses are expenses directly related to sales efforts such as advertising and
promotions, salesmen’s salaries and commissions, delivery expenses (freight-out) and depreciation
expense of delivery equipment and store property, plant and equipment.

General and administrative expenses are those incurred in the administration and general
operations of the business such as officers and office salaries, bad debts expense, office supplies
expense, expenses of non-sales department, certain taxes and depreciation of office property, plant and
equipment.

2. Expenses from secondary activities are referred to as nonoperating expenses.

For example, interest expense is a nonoperating expense because it involves the finance
function of the business, rather than the primary activities of buying/producing and selling.

3. Losses from sale of assets.

A loss is reported as the net of two amounts: the amount listed for the item on the company's
books (book value) minus the proceeds received from the sale. A loss occurs when the proceeds are
less than the book value.

Let's assume that SM Department Store decides to dispose of the company's car. The proceeds
from the disposal are P200,000. This is less than the P350,000 amount shown in the company's
accounting records. Since this department store is not in the business of buying and selling cars (the
sale of the car is outside of the operating activities of buying and selling clothing), the money received
for the car will not be included in sales revenues, and the loss experienced on the sale of the car
(P150,000) will not be included in operating expenses. Instead, the P150,000 loss will appear in a
section on the income statement labeled "nonoperating gains or losses" or "other income or losses".
The loss is reported in the time period when the disposal occurs.

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Formats of Income Statement

A. Single-step Income Statement

A single-step income statement is one of two commonly used formats for the income statement
or profit and loss statement. The single-step format uses only one subtraction to arrive at net income.
Net Income = (Revenues + Gains) – (Expenses +Losses)

An extremely condensed income statement in the single-step format would look like this:

PhaYo Department Store

Income Statement
For the Month Ended January 31, 2017

Revenues and Gains P300,000.00

Less: Expenses and Losses 230,000.00
Net Income P 70,000.00

The heading of the income statement conveys critical information. The name of the company
appears first, followed by the title "Income Statement." The third line tells the reader the time interval
reported in the income statement. Since income statements can be prepared for any period of time, you
must inform the reader of the precise period of time being covered.
Another example income statement in the single-step format would look like this:

PhaYo Department Store

Income Statement
For the Month Ended January 31, 2017

Revenues and Gains

Sales Revenue 200,000.00
Interest Revenue 2,500.00
Gain on sale of fixed assets 11,000.00
Total revenues and gains 213,500.00

Less: Expenses and Losses

Cost of Goods Sold 150,000.00
Commission expense 3,000.00
Office supplies expense 1,200.00
Depreciation expense 3,000.00
Advertising expense 450.00
Interest expense 340.00
Loss on sale of fixed assets 4,500.00
Total expenses and losses 162,490.00
Net Income 51,010.00

B. Multiple-step Income Statement

An alternative to the single-step income statement is the multiple-step income statement,
because it uses multiple subtractions in computing the net income shown on the bottom line.

The multiple-step profit and loss statement segregates the operating revenues and operating
expenses from the nonoperating revenues, nonoperating expenses, gains, and losses. The multiple-step
income statement also shows the gross profit (net sales minus the cost of goods sold).

Here is a sample income statement in the multiple-step format:

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 PhaYo Department Store
Income Statement
For the Month Ended January 31, 2017

Note
Net Sales 1 P200,000.00
Less: Cost of Goods Sold 2 150,000.00
Gross profit P 50,000.00
Less: Operating expense
Selling Expenses
Advertising expense P 450.00
Commissions expense 3,000.00 P3,450.00
General and Administrative Expenses
Office supplies expense P1,200.00
Depreciation expense 3,000.00 4,200.00
Total Operating expenses 7,650.00
Operating Income P 42,350.00

Non-Operating Revenues and Gains

Interest revenue P 2,500.00
Gain on sale of fixed assets 11,000.00 13,500.00
Non-Operating Expenses and Losses
Interest expense P 340.00
Loss on sale of fixed assets 4,500.00 (4,840.00)
Net Income P 51,010.00

PhaYo Department Store

Schedule Accompanying Income Statement
For the Month Ended January 31, 2017

Schedule 1 - Computation of Net Sales

Gross sales P250,000.00

Sales returns and allowances (30,000.00)
Sales discounts (20,000.00)
Net Sales 200,000.00

Schedule 2 - Computation of Cost of Goods Sold

Inventory, January 1 P30,000.00

Net Purchases
Purchases P200,000.00
Purchase returns and allowances 30,000.00
Purchase discounts 12,000.00
Freight-in 5,000.00 163,000.00
Cost of Goods available for sale P193,000.00
Less: Inventory, January 31 43,000.00
Cost of Goods Sold P150,000.00

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There are benefits to using a multiple-step income statement instead of a single-step income statement:
➢ The multiple-step income statement clearly states the gross profit amount. Many readers of
financial statements monitor a company's gross margin (gross profit as a percentage of net
sales). Readers may compare a company's gross margin to its past gross margins and to the
gross margins of the industry.
➢ The multiple-step income statement presents the subtotal operating income, which indicates the
profit earned from the company's primary activities of buying and selling merchandise.
➢ The bottom line of a multiple-step income statement reports the net amount for all the items on
the income statement. If the net amount is positive, it is labeled as net income. If the net amount
is negative, it is labeled as net loss.

STATEMENT OF CHANGES IN OWNER’S EQUITY

The statement of changes in owner’s equity, also known as capital statement or statement of
changes in equity, is a basic statement that shows the movement in the elements or contents of the
capital. It shows how the Income Statement and the Statement of Financial Position or Balance Sheet
are related.
Although the details of the statement may vary according to the organizational form of the
company, the basic format of this financial statement for sole proprietorship is presented below.

PhaYo Department Store

Statement of Changes in Owner's Equity
For the Month Ended January 31, 2017

PhaYo, capital, January 1, 2017 P100,000.00

Additional Investment 20,000.00
Net Income 51,010.00
Withdrawals (10,000.00)
PhaYo, capital, January 31, 2017 P161,010.00

EXERCISES

1. Below are selected accounts that Pinaasa Repairs reported in its August 31, 2017 financial statements:
P. Naasa, Capital, Aug 31 P102,600 Interest expense P 4,950
Service Revenue 203,625 Accounts receivable 58,500
Unearned revenue 3,038 Salaries payable 1,912
Salaries expense 34,875 Depreciation expense 22,950
Accumulated depreciation 98,750 Rent expense 13,275
Supplies expense 3,150 P. Naasa, drawing 90,000
Interest revenue 8,575 Supplies 2,475
A. Prepare the Income Statement for the month ended August 31, 2017 using the (a) single-step format and (b)
multistep format.
B. Prepare the Capital Statement for the month ended August 31, 2017.

2. Umasa Ak Co. has the following items seen on its December 31, 2017 income statement:
Sales P757,593 Office Salaries Expense P142,540
Sales Returns and Allowances 3,483 Legal and Auditing Expense 6,750
Purchases 338,067 Office Telephone Expense 3,240
Purchase Returns and Allowances 5,727 Miscellaneous and General Expense 6,259
Freight-in 4,292 Interest Income 675
Sales Salaries Expense 80,420 Interest Expense 405
Advertising Expense 52,650 Merchandise Inventory, beginning 192,510
Merchandise Inventory, ending 236,250 Gain on sale of fixed assets 200,000
Prepare the Income Statement for the year ended December 31, 2017 using the multistep format.

/NaBergonia2018

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