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NOTE session-06

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What is the deepest lake in the world? Take a moment to choose an answer before we begin.

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The answer is Lake Baikal in Siberia. Welcome to Session 6. Today we ask how a company earned its net income by building a multiple-step income statement and reading the layers inside it.

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Our first objective is to prepare a multiple-step income statement. You will place supplied amounts in the correct sections and calculate each subtotal through net income.

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Our second objective is to analyze operating performance with income-statement subtotals. We will compare years, calculate margins, and separate measured conclusions from claims that require more evidence.

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Granite Harbor Manufacturing is our fictional cabinet maker. We will prepare its statement for the year ended December 31, 2025, in United States dollars, then use its subtotals to explain the year's results.

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We begin with the statement from revenue through operating income. The order matters because each subtotal answers a different question.

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Read this example from top to bottom. Gross profit leaves sales after cost of goods sold. Operating income then includes central operating expenses.

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Pretax income adds other items, continuing income deducts tax, and net income includes any discontinued result.

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Apply the O C I rule first. If generally accepted accounting principles route the item to other comprehensive income, it goes there.

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Otherwise decide whether it comes from producing, selling, or supporting goods or services, while separately checking unusual events and disposals.

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Operating activity covers what the company provides to customers and the functions supporting those sales. Other income or expense arises outside those central operations.

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The first group affects operating income; the second first affects pretax income.

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Within operating activity, customer activities produce revenue. Costs are classified by the function that used the resource: cost of revenue, selling, or administrative.

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Cost of revenue produces goods or performs services sold. Selling costs market or distribute a finished product. Administrative costs manage the company as a whole.

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Use the work performed, including reasonable allocations, rather than relying only on an employee's title.

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This table ties each named cost to Granite Harbor's supplied totals.

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Production labor enters cost of goods sold, outbound freight is selling expense, executive salary is administrative expense, and interest and the flood loss appear outside operating income in this case.

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Net sales of 118 million dollars less 70 million dollars of cost of goods sold gives 48 million dollars of gross profit.

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This is the amount available to absorb selling and administrative costs and the items below operating income.

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From gross profit, deduct 14 million dollars of selling expense and 8 million dollars of administrative expense. Granite Harbor reports 26 million dollars of operating income from its central operations.

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A professional service firm's employees perform work billed to clients. Where would their compensation ordinarily appear: cost of revenue, selling expense, administrative expense, or other expense?

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Choose before continuing.

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Choose A, cost of revenue. These employees perform the service reported as revenue. Selling obtains or supports sales, administration supports the organization, and other expense sits outside central operations.

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Now complete the lower part of the statement. We will place gains, losses, interest, income tax, and discontinued results.

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Sale proceeds minus carrying amount equals the gain or loss. Carrying amount is the recorded amount after depreciation and other reductions.

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Granite Harbor's supplied 2 million dollar van gain, rather than the sale proceeds, appears outside cabinet sales.

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Interest and asset-disposal gains or losses follow operating income because they arise outside Granite Harbor's central cabinet operations. Labels can vary, but these items first change income before income taxes.

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Here are the facts behind the flood loss. In June 2025, a river flood reached Granite Harbor's Ashford cabinet plant. The plant is outside a designated floodplain and had not flooded in more than 50 years.

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Granite Harbor recognized a material 2 million dollar loss for inventory, equipment, and cleanup, with no insurance recovery.

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The loss is unusual and infrequent, but it damaged the continuing cabinet operation, so it stays in continuing operations. Granite Harbor's policy places it in other expense, before income tax.

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Next class we compare this event with a qualifying component disposal.

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Start with 26 million dollars of operating income. Add the 2 million dollar van gain, subtract the 2 million dollar flood loss and 1 million dollars of interest expense, and pretax income is 25 million dollars.

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Income tax expense follows pretax income, but pretax accounting income alone does not provide the amount. Tax accounting can include current and deferred amounts.

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In this course, we supply the financial-statement income tax expense or benefit, and you place it.

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Deduct the supplied 5 million dollars of income tax expense from 25 million dollars of pretax income. Income from continuing operations is 20 million dollars.

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A qualifying discontinued result appears below continuing income and net of its related tax effect. For this case, the controller supplies that the cabinet-hardware disposal qualifies.

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Chapter 7 teaches how to make that determination.

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Granite Harbor reports 20 million dollars from continuing operations and a 3 million dollar discontinued-operation loss after tax. Net income is 17 million dollars.

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Classify loan interest, delivery freight, assembly labor, and the chief executive's salary. For each, name its location and the first subtotal it affects. These amounts are already included in the supplied totals.

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Loan interest is other expense and first affects pretax income. Delivery freight is selling expense under the case policy. Assembly labor is cost of goods sold and first affects gross profit.

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The chief executive's salary is administrative expense. Do not add these component amounts again.

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Now place the cabinet-hardware disposal, flood loss, and delivery-van gain. Identify the statement section and first affected subtotal for each supplied result.

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The van gain and flood loss follow operating income and first affect pretax income. The flood loss stays in continuing operations, in other expense under Granite Harbor's policy. Unusual does not mean discontinued.

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The qualifying cabinet-hardware disposal appears below continuing income, net of tax, and first affects net income.

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Here is the complete 2025 statement. Trace the subtotals: 48 million dollars of gross profit, 26 million of operating income, 25 million pretax, 20 million from continuing operations, and 17 million of net income.

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Next, use a new set of amounts to prepare Granite Harbor's 2024 statement. Then we can compare the two years.

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A building-sale loss belongs in other expense, but a draft puts it in cost of goods sold.

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When corrected, do gross profit and operating income rise while pretax stays the same, does only operating income rise, does pretax rise, or does gross profit fall?

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Choose A. Removing the loss from cost of goods sold raises gross profit and operating income. Putting the same loss below operating income leaves pretax income unchanged because the loss remains on the statement once.

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For 2024, classify 60 million dollars of production cost, advertising, sales salaries, delivery freight, accounting and human-resources salaries, and executive and office costs.

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Then place the land gain, interest, and tax. These amounts describe the continuing cabinet operation, so work through income from continuing operations.

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The cabinet-hardware line also operated in 2024, and it qualifies for discontinued-operation reporting. Session 7 explains why. Hardware sales were 10 million dollars.

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Cost of hardware sold was 6 million dollars, and selling and administrative expenses were 1.5 million dollars. That leaves 2.5 million dollars of pretax income, and the supplied income tax expense is 500,000 dollars.

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Calculate the line's income net of that tax. Place it below 2024 continuing income of 16 million dollars, and calculate 2024 net income.

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The 60 million dollars of cabinet materials and production labor enter cost of goods sold. Net sales of 100 million less that cost gives 40 million dollars of gross profit.

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Advertising, sales salaries, and delivery freight total 12 million dollars of selling expense. Accounting, human resources, executive, and office costs total 8 million dollars of administrative expense.

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Operating income is 20 million dollars.

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The 2 million dollar land-sale gain and 2 million dollars of interest expense follow operating income. They offset, leaving income before income taxes at 20 million dollars.

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Deduct 4 million dollars of income tax expense from 20 million dollars of pretax income. Income from continuing operations is 16 million dollars.

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The hardware line earned 2.5 million dollars before tax, less 500,000 dollars of supplied tax expense, so income from discontinued operations is 2 million dollars. Net income is 18 million dollars.

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Review the complete 2024 form. Each line appears once. The sequence ties 100 million dollars of net sales to 16 million dollars from continuing operations.

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Adding the 2 million dollar discontinued result gives 18 million dollars of net income.

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The dollar columns show that sales, gross profit, operating income, and continuing income increased.

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The discontinued result moved from a 2 million dollar gain in 2024 to a 3 million dollar loss in 2025, so net income fell by 1 million dollars. These statements measure the changes but do not identify their causes.

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Dollar changes are only one comparison. Next we calculate gross profit rate, operating margin, and net profit margin using amounts from the same year.

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Gross profit divided by net sales equals the gross profit rate. A 40 percent rate means 40 cents of each sales dollar remains after cost of goods sold. Check line definitions before comparing companies.

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For 2024, 40 million divided by 100 million is 40 percent. For 2025, 48 million divided by 118 million is about 40.7 percent, an increase of seven-tenths of a percentage point.

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Operating income divided by net sales equals operating margin. A 20 percent margin means central operations produced 20 cents of income for each sales dollar.

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Operating margin rose from 20 percent to 22 percent, a 2 percentage-point increase. Operating-income dollars rose from 20 million to 26 million, which is 30 percent growth.

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Margin change and dollar growth answer different questions.

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Net income divided by net sales equals net profit margin. It includes other income and expense, tax, and discontinued results, so it can move differently from operating margin.

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Net margin fell from 18 percent in 2024 to 14.4 percent in 2025, a decline of 3.6 percentage points. In 2025, continuing income margin was 16.9 percent, but the discontinued loss reduced the final rate by 2.5 points.

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Meanwhile operating margin rose.

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All three rates use net sales as the denominator. Their numerators move down the statement: gross profit, operating income, and net income. Each successive rate includes another layer of costs or other results.

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Year 1 has revenue of 100 and operating income of 18. Year 2 has revenue of 120 and operating income of 24. Which conclusion about operating margin is supported?

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Choose A. Year 1 margin is 18 percent, and Year 2 margin is 20 percent. The increase is 2 percentage points. The increase in operating income changes the numerator; it is not the percentage point change.

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After net income, we turn to other comprehensive income. Keep current O C I separate from accumulated O C I in equity.

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Specific accounting rules route certain foreign-currency adjustments, cash-flow hedge results, pension changes, and available-for-sale debt-security holding changes to O C I.

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Neither the word unrealized nor the absence of cash decides the route.

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Ordinary depreciation and ordinary asset-disposal gains or losses enter net income. A qualifying cash-flow-hedge gain or an available-for-sale debt-security holding gain can enter O C I. Apply the rule for the item.

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Granite Harbor reports 17 million dollars of net income and a 1 million dollar after-tax holding gain in O C I. Comprehensive income is 18 million dollars. The debt securities are supplied as available for sale.

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Current O C I is a period change. Accumulated O C I is the cumulative equity balance.

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With no reclassifications or other changes, 2 million dollars of opening A O C I plus 1 million of current O C I gives 3 million dollars ending A O C I.

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A company records depreciation and an effective gain on a derivative designated and qualifying as a cash-flow hedge. Which pairing correctly places those results?

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Choose A. Depreciation is an expense in net income. The supplied qualifying cash-flow-hedge gain enters O C I. Cash status alone does not move either result.

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We have built and compared the statements. Now decide what the reported results establish and what evidence a broader claim still needs.

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The income statement establishes recognized results, its subtotals, and measured changes in comparable amounts. Causes need operating detail and notes. Available cash needs cash-flow and debt information.

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One margin cannot establish a future result.

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Granite Harbor's gross profit rate rose from 40 percent to 40.7 percent. That increase is measured.

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The statement does not establish that higher prices caused it; test selling prices, cost of goods sold, volume, and product mix.

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Net margin rose from 8 percent to 10 percent while operating margin fell from 14 percent to 12 percent. Which conclusion follows from those two rates?

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Choose A. The final net result improved per sales dollar, while central operating profitability declined.

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Neither rate establishes cash generated, and the opposite directions show why the statement layers must remain distinct.

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Before Tuesday, read Chapter 7 on discontinued operations. The Unit 2 review is due Sunday, September 27, at 11:59 p.m. in D 2 L. Optional Chapter 6 practice is available on the course site.