In preceding chapters, we illustrated the unclassified (or single-step) income statement. An unclassified income statement has only two categories - revenues and expenses. In contrast, a classified income statement divides both revenues and expenses into operating and nonoperating items. The statement also separates operating expenses into selling and administrative expenses. A classified income statement is also called a multiple-step income statement.

In Exhibit 39, we present a classified income statement for Hanlon Retail Food Store. This statement uses the previously presented data on sales (Exhibit 35) and cost of goods sold (Exhibit 38), together with additional assumed data on operating expenses and other expenses and revenues. Note in Exhibit 39 that a classified income statement has the following four major sections:

• Operating revenues.
• Cost of goods sold.
• Operating expenses.
• Nonoperating revenues and expenses (other revenues and other expenses).

The classified income statement shows important relationships that help in analyzing how well the company is performing. For example, by deducting cost of goods sold from operating revenues, you can determine by what amount sales revenues exceed the cost of items being sold. If this margin, called gross margin, is lower than desired, a company may need to increase its selling prices and/or decrease its cost of goods sold. 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.

An accounting perspective: Business insight

Management chooses whether to use a classified or unclassified 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.

HANLON RETAIL FOOD STORE
Income Statement
For the Year Ended 2010 December 31

 Exhibit 39: Classified income statement for a merchandising company

Next, we explain the major headings of the classified income statement in Exhibit 39. The terms in some of these headings are already familiar to you. Although future illustrations of classified income statements may vary somewhat in form, we retain the basic organization.

• Operating revenues are the revenues generated by the major activities of the business - usually the sale of products or services or both.
• Cost of goods sold is the major expense in merchandising companies. Note the cost of goods sold section of the classified income statement in Exhibit 39. This chapter has already discussed the items used in calculating cost of goods sold. Merchandisers usually highlight the amount by which sales revenues exceed the cost of goods sold in the top part of the income statement. The excess of net sales over cost of goods sold is the gross margin or gross profit. To express gross margin as a percentage rate, we divide gross margin by net sales. In Exhibit 39, the gross margin rate is approximately 39.3 per cent (USD 103,000/USD 262,000). The gross margin rate indicates that out of each sales dollar, approximately 39 cents is available to cover other expenses and produce income. Business owners watch the gross margin rate closely since a small percentage fluctuation can cause a large dollar change in net income. Also, a downward trend in the gross margin rate may indicate a problem, such as theft of merchandise. For instance, one Southeastern sporting goods company, SportsTown, Inc., suffered significant gross margin deterioration from increased shoplifting and employee theft.
• Operating expenses for a merchandising company are those expenses, other than cost of goods sold, 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.

Certain operating expenses may be shared by the selling and administrative functions. For example, a company might incur rent, taxes, and insurance on a building for both sales and administrative purposes. Expenses covering both the selling and administrative functions must be analyzed and prorated between the two functions on the income statement. For instance, if USD 1,000 of depreciation expense relates 60 per cent to selling and 40 per cent to administrative based on the square footage or number of employees, the income statement would show USD 600 as a selling expense and USD 400 as an administrative expense.

• Nonoperating revenues (other revenues) and nonoperating expenses (other expenses) are revenues and expenses not related to the sale of products or services regularly offered for sale by a business. An example of a nonoperating revenue is interest that a business earns on notes receivable. An example of a nonoperating expense is interest incurred on money borrowed by the company.

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

• Net sales = Gross sales - (Sales discounts + Sales returns and allowances).
• Net purchases = Purchases - (Purchase discounts + Purchase returns and allowances).
• Net cost of purchases = Net purchases + Transportation-in.
• Cost of goods sold = Beginning inventory + Net cost of purchases - Ending inventory.
• Gross margin = Net sales - Cost of goods sold.
• Income from operations = Gross margin - Operating (selling and administrative) expenses.
• Net income = Income from operations + Nonoperating revenues - Nonoperating 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 may realize only a very small percentage of the gross margin as profit. The classifications in the income statement allow a user to focus on the whole picture as well as on how net income was derived (statement relationships).

An ethical perspective: World auto parts corporation

John Bentley is the chief financial officer for World Auto Parts Corporation. The company buys approximately USD 500 million of auto parts each year from small suppliers all over the world and resells them to auto repair shops in the United States. Most of the suppliers have cash discount terms of 2/10, n/30. John has instructed his personnel to pay invoices on the 30th day after the invoice date but to take the 2 per cent discount even though they are not entitled to do so. Whenever a supplier complains, John instructs his purchasing agent to find another supplier who will go along with this practice. When some of his own employees questioned the practice, John responded as follows:

This practice really does no harm. These small suppliers are much better off to go along and have our business than to not go along and lose it. For most of them, we are their largest customer. Besides, if they are willing to sell to others at a 2 per cent discount, why should they not be willing to sell to us at that same discount even though we pay a little later? The benefit to our company is very significant. Last year our profits were USD 100 million. A total of USD 10 million of the profits was attributable to this practice. Do you really want me to change this practice and give up USD 10 million of our profits?