Preparing multistep income statement merchandising

A merchandising company uses the same four financial statements we learned before:

income statement
statement of retained earnings
balance sheet
statement of cash flows

A handwritten money ledger.

The income statement for a merchandiser is expanded to include groupings and subheadings necessary to make it easier for investors to read and understand. We will look at the income statement only as the other statements have been discussed previously.

In preceding chapters, we illustrated the income statement with only two categories—revenues and expenses. In contrast, a multi-step income statement divides both revenues and expenses into operating and nonoperating (other) items. The statement also separates operating expenses into selling and administrative expenses. A multi-step income statement is also called a classified income statement.

Watch this video about preparing a multi-step income statement. Come back as many times as you need to practice creating a multi-step income statement:

The multi-step income statement shows important relationships that help in analyzing how well the company is performing. For example, by deducting COGS from operating revenues, you can determine by what amount sales revenues exceed the COGS. If this margin, called gross margin, is lower than desired, a company may need to increase its selling prices and/or decrease its COGS. The classified income statement subdivides operating expenses into selling and administrative expenses. Thus, statement users can see how much expense is incurred in selling the product and how much in administering the business. Statement users can also make comparisons with other years’ data for the same business and with other businesses. Nonoperating revenues and expenses appear at the bottom of the income statement because they are less significant in assessing the profitability of the business.

Management chooses which income statement to present a company’s financial data. This choice may be based either on how their competitors present their data or on the costs associated with assembling the data.

The major headings of the classified multi-step income statement are explained below:

Net Sales are the revenues generated by the major activities of the business—usually the sale of products or services or both less any sales discounts and sales returns and allowances.
COGS is the major expense in merchandising companies and represents what the seller paid for the inventory it has sold.
Gross margin or gross profit is the net sales COGS and represents the amount we charge customers above what we paid for the items. This is also referred to as a company’s markup.
Operating expenses for a merchandising company are those expenses, other than COGS, incurred in the normal business functions of a company. Usually, operating expenses are either selling expenses or administrative expenses. Selling expenses are expenses a company incurs in selling and marketing efforts. Examples include salaries and commissions of salespersons, expenses for salespersons’ travel, delivery, advertising, rent (or depreciation, if owned) and utilities on a sales building, sales supplies used, and depreciation on delivery trucks used in sales. Administrative expenses are expenses a company incurs in the overall management of a business. Examples include administrative salaries, rent (or depreciation, if owned) and utilities on an administrative building, insurance expense, administrative supplies used, and depreciation on office equipment.
Income from Operations is Gross profit (or margin) operating expenses and represents the amount of income directly earned by business operations.
Other revenues and expenses are revenues and expenses not related to the sale of products or services regularly offered for sale by a business. This typically includes interest earned (interest revenue) and interest owed (interest expense).
Net Income is the income earned after other revenues are added and other expenses are subtracted.

For example, here are income statements from The Home Depot, Inc. annual report for the fiscal year ended February 2, 2020:

THE HOME DEPOT INC.
CONSOLIDATED STATEMENTS OF EARNINGS

in millions, except per share data	Fiscal 2019	Fiscal 2018	Fiscal 2017
Net sales	$ 110,225	$ 108,203	$ 100,904
Cost of sales	72,653	71,043	66,548
Gross Profit	Single line 37,572	Single line 37,160	Single line 34,356
Subcategory, Operating expenses:	Single line	Single line	Single line
Selling, general and administrative	19,740	19,513	17,864
Depreciation and amortization	1,989	1,870	1,811
Impairment loss	—	247	—
Total operating expenses	Single line 21,729	Single line 21,630	Single line 19,675
Operating income	Single line 15,843	Single line 15,530	Single line 14,681
Subcategory, Interest and other (income) expenses:	Single line	Single line	Single line
Interest and investment income	(73)	(93)	(74)
Interest expense	1,201	1,051	1,057
Other	—	16	—
Interest and other, net	Single line 1,128	Single line 974	Single line 983
Earnings before provision for income taxes	Single line 1,128	Single line 974	Single line 983
Provision for income taxes	3,473	3,435	5,068
Net earnings	Single line $ 11,242 Double line	Single line $ 11,121 Double line	Single line $ 8,630 Double line

One of the important features of the multiple-step income statement is the sub-total for operating income. Notice that net income is the bottom line but it includes a provision for income taxes and also interest expense. If you were comparing two different companies, one that was capitalized by owner equity, and the other that relied heavily on borrowed money (that incurs interest expense), the subtotal for operating income would give you a figure to compare between the two that is strictly the results of business operations.

Summary

To summarize the important relationships in the income statement of a merchandising firm in equation form:

Net sales = Sales revenue − Sales discounts − Sales returns and allowances.
Gross profit = Net sales − Cost of goods sold.
Operating expenses = Selling expenses + Administrative expenses.
Operating income = Gross margin − Operating (selling and administrative) expenses.
Other income/revenues and expenses = Other Revenues − Other Expenses
Net income/Net earnings = Income from operations + Other revenues − Other expenses.

Each of these relationships is important because of the way it relates to an overall measure of business profitability. For example, a company may produce a high gross margin on sales. However, because of large sales commissions and delivery expenses, the owner(s) may realize only a very small amount of the gross margin as profit.