4 Revenue and Expenses
Income Statement Fundamentals
If I was an investor, I might ask how much a company spends on inventory compared to its selling price. This is commonly referred to as the mark-up, calculated as sales revenue less cost of goods sold. On the Income Statement gross profit is mark-up on inventory sold, in other words the amount of sales revenue that is left over to pay for other expenses and contribute to shareholder profit. Excellent! What else?
There are lots of other costs besides just inventory production that occur from operating a business model. For example, a company regularly pays administrative and selling costs like website development and maintenance, heating and electricity bills, and rent. These recurring costs are necessary to operate a business, and costs will differ depending on the company’s business model. Now, if we take our gross profit and subtract all these necessary and recurring costs, we get operating income. Operating income is profit the company earns by running their business model!
But the company will also have other income/expenses; gains and losses. There are transactions like interest paid and received, dividends received, and sale of PPE, where these types of transactions are not part of the company’s business model. Each of these transactions will be recorded in an Income Statement section called Other income/expenses; Gains and losses, located just below Operating Income. In this section you will find interest revenue, interest expense, and gains/losses from selling assets. These are described as peripheral items because they occur outside of the company’s business model.
Ok, that’s heavy and calls for a table. Below is a description of each item in the Other income/expense; Gains and losses section and an explanation of why each would be considered peripheral to a company’s business model.
| Interest Income | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Transaction (How the Account Gets a Balance) | A company invests cash and makes interest off their investment. | ||||||||||
| Example | A company has an investment of $100,000 that pays interest of 5% per year. In the current year, the investment paid $5,000 on their fiscal year end of 31 December.
|
||||||||||
| Why the Account is Classified as Peripheral | Unless the company is an investment company or a financial service company, it is not in the business of making investments. Therefore, all income from these investments is peripheral. | ||||||||||
| Interest Expense | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Transaction (How the Account Gets a Balance) | A company borrows money from the bank to finance operations and pays interest over time. | ||||||||||
| Example | A company has a loan payable to the bank of $70,000 and pay interest at a rate of 10% annually on their fiscal year end of December 31.
|
||||||||||
| Why the Account is Classified as Peripheral | Companies can’t create value directly through loans, rather the loan is used to finance operations. Therefore, loans and payment of interest is not a business model, and all expenses from these investments is peripheral. | ||||||||||
| Gains | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Transaction (How the Account Gets a Balance) | A company sells a non-current asset, such as PPE, and receives more for the asset than the recorded book value. | |||||||||||||||
| Example | A company sells land for $150,000. The recorded value of the land (on the SFP) is $130,000.
|
|||||||||||||||
| Why the Account is Classified as Peripheral | Unless a company is in the business of selling land, building, equipment, machinery, etc., in which case these items would be inventory, this type of transaction does not occur from operating the company’s business model and is therefore peripheral. | |||||||||||||||
| Losses | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Transaction (How the Account Gets a Balance) | A company sells a non-current asset, such as PPE, and receives less for the asset than the recorded book value. | |||||||||||||||
| Example | A company sells land for $100,000. The recorded value of the land (on the SFP) is $130,000.
|
|||||||||||||||
| Why the Account is Classified as Peripheral | See gains above | |||||||||||||||
Tell Me More
What about Income Taxes? You’ll notice there’s no income tax expense in the table. That’s done on purpose because income tax expense has its own special place on the multi-step income statement: right at the bottom. Think about income tax expense this way: income before taxes is the starting point for a company’s income tax return, so income tax expense is recorded at the end of the income statement. Income tax expense is usually calculated as income before taxes multiplied by the company’s tax rate.
To practice, let’s take a look at some income and expense accounts and classify them as operating or peripheral. Remember that operating accounts are necessary and recurring in running the business model. The company is a retail bookstore that buys books and sells them at a profit. I’ll do the first few so you can get the hang of it, then you fill in the rest:
- My Turn
| Account | Operating or Peripheral | Explanation |
|---|---|---|
| Interest Income | Peripheral | The company is a bookstore and not in the business of lending money. |
| Gain from Sale of Equipment | Peripheral | The business model is selling books, not selling equipment. |
| Utilities Expense | Operating | Heat and electricity are necessary and recurring costs for the bookstore. |
