At the end of the accounting cycle, all businesses prepare financial statements to communicate information regarding the financial well-being of the business entity. Merchandising businesses, manufacturers, and service businesses all prepare an income statement and a balance sheet, and all are very similar. A merchandising business, however, has a few slight differences in its income statement and balance sheet.
The balance sheet of the merchandising business expands its assets section to include merchandise inventory and sometimes estimated returns inventory. Merchandise inventory is the merchandise purchased to be sold to consumers. Merchandise inventory is categorized as a current asset. Estimated returns inventory is a current asset and is the account used to document the return of merchandise for either dissatisfaction or damage. Depending on the materiality of estimated returns, sometimes it may be reflected as a separate account on the balance sheet or it may be part of the inventory account and reflected only in the notes to the financial statements.
In addition to the inclusion of merchandise inventory, the balance sheet for the merchandising business includes a new liability, customer refunds payable. Customer refunds payable is the account used to document refund payments to customers as a result of returned or damaged merchandise. Customer refunds payable is a current liability.
Merchandising businesses use the multiple-step income statement, as it provides more information for financial statement users on the profits made from the actual merchandise versus the costs of running the business. With a simplistic format for preparing an income statement, the single-step income statement shows only revenues less expenses, and does not include gross profit. It contains fewer subsections or subtotals than the multiple-step income statement, which is an income statement with sections, subsections, and subtotals, including gross profit, operating income, other income, and other expenses, as well as net income.
The first step in a multiple-step income statement is to calculate gross profit. To compute gross profit, the cost of merchandise sold is subtracted from the sales. Revenues from the sale of goods to consumers are sales and are recorded in the sales account. The cost associated with the goods sold is recorded in an expense account titled "cost of merchandise sold." Gross profit shows how much profit was made purely on the merchandise that was sold.
The next step in a multiple-step income statement is operating income. Gross profit is reduced by operating expenses to arrive at operating income, which is the income earned from normal business operations. To successfully buy and sell merchandise, most merchandising businesses have a support staff and other expenses that are necessary to make their business run. Examples include marketing, sales staff, advertising, purchasing agents, and more.
The final step in a multiple-step income statement is net income. Operating income is adjusted by other revenues or expenses that do not directly relate to the business's day-to-day operations. These costs are called nonoperating expenses. Examples include interest expense or income, taxes, lawsuits, or gains and losses from the sale of investments.By breaking down the income statement into steps, statement users can now see three key elements: gross profit, operating income, and net income. This allows for analysis on how much profit is made directly on the merchandise that is sold, how much is spent on expenses to support the business (operating expenses), and how much is spent on expenses that do not directly relate to daily operations (nonoperating expenses). For example, in the income statement for Unique Products, Inc., the gross profit is $25,000. This means that on $100,000 of sales, the company has $25,000 left over to cover the operating costs. For every dollar in sales generated, 25 cents were left to pay for the cost of daily operations. Operating expenses totaled $13,000. So after paying for the daily cost of doing business, Unique Products was left with $12,000 of operating income. Finally, nonoperating income was reported at $6,000, giving the business a total of $18,000 net income. By breaking the information down into steps, users can see that of $18,000 of net income, $12,000 of it is from daily operations and $6,000 was contributed by other elements, such as interest revenue, that do not directly relate to the company's daily business.