Mark Farber: Hi.
I'm Mark Farber.
This is Accounting Fundamentals.
Today we're going to talk about multiple step income statements.
Now, up until now, we've been looking at income statements that were fairly simplistic.
Here's an example of one.
I haven't put a title on it, only because I'm trying to save space, as usual.
We have a company with sales of $10,000, and then we've listed off all the expenses.
There's cost of goods sold, so it's a merchandising company.
You've got salaries, rent, utilities, marketing expense.
They've borrowed some money, so they have some interest expense.
We're assuming this is a corporation, so it has tax expense.
Remember that a sole proprietorship or a partnership wouldn't pay any taxes directly.
It would be paid by the owners of the company.
But this is a corporation, so it has tax expense.
They have a profit of $2,000.
Now, that's a perfectly okay income statement.
It's got all the information from the company.
But it's kind of hard for us to take a whole lot of information that's quite useful out
of that without doing some calculations.
A multiple-step income statement just restates this with a bit more flair, if you will, in
order to make it easier for us to pull some very important information about the company
out of the income statement very easily.
Remember that we're creating income statements and all financial statements for investors
to use, and we want to make it easy for the investors to be able to compare one company
to another and for them to be able to draw information about our company and figure out
what the story is by looking at the statements.
If I was to redo this as a multiple-step income statement ... I'm going to do it in two columns.
Normally it would just be one, but we'll do what we can with space.
We'll do it exactly the same way.
We're going to start with sales.
I'll just put it over here.
That's $10,000.
The first expense we're going to show is the cost of goods sold.
Remember, sales is the price that we received for the units that we sold, times the number
of units.
Cost of goods sold is the cost that the company paid in order to acquire those units.
The difference between those is kind of an important number.
It tells us how much are we making on the pure selling of the units, what's the profit
that we get from that.
In our case, cost of good sold is $6,000, and the difference between those we call gross
profit.
This company, between the difference of what it sold units for and what it paid for those
units, earned $4,000, and it now has $4,000 to pay all of its other expenses and to generate
a profit.
If this number were negative, then we'd know that every time they're selling stuff, the
costs are greater than the revenues that they're earning, and the more they sell, the bigger
problem they're going to have, the more loss they're going to have.
We would always just expect this to be a positive number.
After gross profit, we're going to have operating expenses.
An operating expense is simply the expenses that are incurred in the day to day operations
of the business.
Things that are required to keep this business running.
The things that we're going to list off under operating expenses will include salaries,
you've got to pay your workers, and we can put in the amounts here, $1,000.
Rent.
Obviously you need to have a place to run your business.
That's an operating expense.
Utilities, the cost of heating and lighting in your place of business.
Finally, marketing.
Getting customers to come in through the door and know about your product.
That's part of the company's operations.
Those are the operating expenses for the business, and when we add them up, we see that it's
$1,850.
So what we're left with is something called operating profit.
Notice we keep using the term "profit."
We had gross profit, and now we have operating profit.
We have to be very careful that we don't just say "profit," but that we're explicit in terms
of which one we mean.
The operating profit is going to be the gross profit minus the operating expenses, which
in this case is $2,150.
This company generated $2,150 from its day to day operations.
We can compare that to other similar companies in terms of what's their operating profit
and how much do they make from operating their core business.
After this, we have another thing called non-operating expenses.
This should fall underneath, but I'm just moving it to a new column.
Non-operating expenses are expenses ... It could be a non-operating income as well.
It's things that are not associated with the day to day operations of the business.
In our case, interest expense is what we have.
Interest is not an operating expense, it's referred to as a financing expense.
Because remember, there's two ways that a company can buy assets.
One is to use liabilities, debt, which is what they've done here and they've incurred
interest expense.
The other is to use the equity of the business, whether it's investment from the owners or
profits that have not been distributed that are used to pay for things.
That's a financing decision.
It has nothing to do with the day to day operations of the business.
One company can choose to use more debt and the other can choose to use less debt.
What we care about with respect to operating profit is how well are they doing at doing
whatever their core business is.
This we break out because it's non-core.
An example, for instance, of a non-operating income might be if this was a store and they
had extra space and they leased out some of the extra space to somebody, the rental income
that they're getting from leasing out extra space has nothing to do with their core business
of buying and selling goods.
It's an additional little stream of income.
We would list that as a non-operating income and separate it out from the core business.
In our case here, we have interest expense, I'll put in the amount of $50.
Now, when I subtract my interest expense from my operating profit, I'm left with something
called profit before tax, and that's going to be $2150 minus $50, $2,100.
Then, finally, we have our income tax.
That's always shown at the end separately.
The reason for that is I need to calculate my profit before tax in order to determine
how much income tax I have.
Usually it's a percentage of this amount here.
My income tax expense, and we're not calculating it as an expense, we're just taking a fixed
number for this example.
We'll put it in as $100 and subtract that.
I should put a line there, sorry.
We're left with net profit.
Net profit is profit before tax, minus the income tax expense, $2,000.
We get to the exact same place, but if you look at the multiple-step income statement,
it tells us a whole bunch of stuff.
We know exactly how much money the company had after it incurred the cost of paying for
the things that it sold.
It can't make these sales without incurring that cost, no matter what.
That's an important number for us to consider.
We know what the operating expenses are as opposed to the non-operating expenses, and
we can see how much money the company generated from doing whatever its core activity is.
Then we know what the non-operating expenses are, or if there was non-operating income,
that would be broken down here as well.
We have a sense of how much does the company make before it has any taxable expenses, and
then finally we have the tax expense.
The reason we call this a multiple-step income statement is we refer to each of these subtotals,
each of these profits, as a step.
In this case, we have one step over there, we have our second step over here, then we
have a third step over here, profit before tax, and then finally a fourth step.
This would be a four-step income statement, if you want.
We don't normally call them multiple-step income statements, we just refer to them as
income statements, but in general, this is the proper format to use when preparing an
income statement.