In this chapter
- What an income statement reports
- Step 1: Group customer revenue and its cost
- Step 2: Classify operating expenses
- Use the cost's purpose to choose the function
- Step 3: Present nonoperating items and income tax
- Step 4: Check the completed income statement
- How classification errors distort income-statement subtotals
- Compare income statements across years
- Limits of income-statement comparisons
- Other comprehensive income and accumulated OCI
- End-of-chapter practice
- Prepare a statement for Northline
- Compare Northline's two years
- Sources
Unit 1 followed Beacon Design's transactions into adjusted balances and financial statements. You checked the accounting rules behind those statements. Then, in Chapter 5, you opened public filings and read reported amounts with their dates, units, and notes. Those statements were already finished. Unit 2 begins with the controller's work that comes before a reader can inspect the income statement: deciding where each amount belongs.
What an income statement reports
Sable Ridge Instruments is a fictional company you will follow through Unit 2. It makes laboratory analyzers, sells supplies for those analyzers, and installs the equipment. At the end of 2026, its accounting staff has recorded the year's transactions and adjustments. The controller must prepare an income statement for the chief financial officer to review.
Sable Ridge's net income is $600,000: its revenues and gains for the year exceed its expenses and losses by that amount after income taxes. That total does not show how the company earned it. Sales to customers, a gain on a warehouse sale, and income from investments all helped produce the result. A multiple-step statement reports those sources separately. Where did the year's income come from?
An income statement reports the revenues, gains, expenses, and losses included in net income for a stated period. A multiple-step income statement groups related amounts and shows intermediate totals on the way to net income. The controller must classify the amounts, check the arithmetic, and prepare the statement for comparison with other periods or companies.
The controller starts with adjusted account balances, as you did for Beacon. These are Sable Ridge's amounts for the year ended December 31, 2026. Each amount is in US dollars. Cost of revenue is the cost of the goods and services sold to customers. It includes Sable Ridge's product costs and the costs of its installation work. The discontinued-operation loss has already been measured after tax.
| Adjusted amount | US dollars |
|---|---|
| Instrument sales | $4,200,000 |
| Consumables sales | 1,850,000 |
| Installation and calibration revenue | 950,000 |
| Cost of revenue | (3,800,000) |
| Selling and marketing expense | (980,000) |
| Research and development expense | (620,000) |
| General and administrative expense | (645,000) |
| Loss on uncollectible supplier advance | (95,000) |
| Gain on sale of the Dayton warehouse | 180,000 |
| Realized gain on sale of investments | 40,000 |
| Interest and dividend income | 60,000 |
| Interest expense | (140,000) |
| Income tax expense | (250,000) |
| Loss from discontinued operations, net of tax | (150,000) |
The list contains no subtotals. Deciding which items belong together is part of preparing the statement. Income-statement classification is the name for that placement decision. Moving an amount to another line does not change the amount itself.
- Mistaken idea: Classification changes the recorded total
Correction: Correcting an item's statement location does not, by itself, change the amount recorded. It can change an intermediate total, such as gross profit or current liabilities, while leaving the relevant final total unchanged.
Read the full explanation
Step 1: Group customer revenue and its cost
Customer revenue comes from the company's sales of goods and services. A gain from selling an asset used by the business is a different kind of income. Sable Ridge's customer sales add to $7,000,000:
| Customer revenue calculation, US dollars | Amount |
|---|---|
| Instrument sales | $4,200,000 |
| Consumables sales (supplies for analyzers) | 1,850,000 |
| Installation and calibration | 950,000 |
| Total customer revenue | $7,000,000 |
Gross profit is customer revenue less the cost of goods and services sold. The $180,000 warehouse gain belongs outside customer revenue. It is neither customer revenue nor the cost of those sales, so it does not enter gross profit. Sable Ridge reports it later among other gains.
Quick checkIf the controller adds the warehouse gain to sales, what is wrong with the resulting $7,180,000 revenue line?
Answer: It includes $180,000 from selling a warehouse among amounts earned from customers for Sable Ridge's products and services. The gain belongs elsewhere in this statement. Correcting the error changes some subtotals, but not net income.
Sable Ridge uses the name cost of revenue because it sells both manufactured products and installation services. Cost of goods sold (COGS) names the cost of products sold; a manufacturer or retailer often uses it when reporting goods. A service company may instead report cost of services. A company that sells both can combine these costs under cost of revenue or present them separately. Check the company's line names and notes before comparing its gross profit with another company's.
Gross profit shows what remains before selling, research, and general office expenses. Sable Ridge recorded $3,800,000 of cost of revenue for its instruments, supplies, and installation work. Its gross profit is $3,200,000 ($7,000,000 revenue − $3,800,000 cost of revenue).
Sales and cost of revenue
Year Ended December 31, 2026 · US Dollars
| Account | Amount |
|---|---|
| Revenue | 7,000,000 |
| Cost of revenue | (3,800,000) |
| Gross profit | 3,200,000 |
The distinction between cost of revenue and operating expense depends on what the cost is for. Freight to bring inventory to Sable Ridge becomes part of inventory cost and reaches cost of revenue when that inventory is sold. Freight to deliver a finished product to a customer is normally a selling expense.
Quick checkA draft includes Sable Ridge's $980,000 selling and marketing expense in cost of revenue. If the controller moves it below gross profit, which total changes? Does net income change?
Answer: Gross profit rises by $980,000. Net income stays the same because the expense remains on the statement and is deducted once.
Step 2: Classify operating expenses
Operating expenses are costs of carrying out the company's business that are outside the cost of the goods and services sold. Their form depends on the business: a manufacturer may report research and development, selling, and administration, while a professional service firm may report staff and office costs under different names. The business's operating activities include producing or providing what it sells and the functions that support those sales. Operating income is the result from those activities after the related cost of revenue and operating expenses, before the nonoperating items and income taxes shown below. Sable Ridge reports selling and marketing, research and development, and general and administrative expenses after gross profit. The controller has determined that the $95,000 loss on an uncollectible supplier advance belongs in operating expenses. The next chapter explains why the loss remains in continuing operations and how a material unusual or infrequent item is presented.
Use the cost's purpose to choose the function
Classify a cost by the function that used the resource:
- Cost of revenue includes resources used to produce goods or perform services that the company sold. It can include both direct costs and a reasonable allocation of indirect production or service costs. The cost enters gross profit when the related good or service enters revenue.
- A selling expense supports marketing, obtaining sales, or distributing a finished product after it is ready for sale. It enters operating income after gross profit.
- An administrative expense supports the direction or operation of the company as a whole. It is not assigned to production, performing a service, selling, or another separately reported function. It also enters operating income after gross profit.
This purpose test can classify a new cost without relying on a memorized list. For example, the salary of an employee who installs a service sold to a customer is a cost of revenue. A salesperson's commission is a selling expense. The salary of an employee who runs company-wide payroll is an administrative expense. Classify the cost based on the work performed, not the employee's title.
These three categories do not include every operating function. A company may report research and development or another function on a separate operating-expense line. Sable Ridge does so below.
Some costs sit near a boundary or serve more than one function. A company must apply a reasonable classification or allocation policy consistently. Its business model and presentation policy can therefore produce a different answer from another company's answer. If the available information does not identify how the resource was used, inspect the company's accounting policy instead of assuming that one classification applies to every company.
Quick checkClassify three costs: labor used to install an analyzer sold to a customer, a commission for obtaining that sale, and the salary of the company-wide human-resources director.
Answer: Installation labor is cost of revenue because it performs the service sold. The commission is a selling expense because it helps obtain the order. The human-resources director's salary is an administrative expense because it supports the company as a whole.
Operating expenses
Year Ended December 31, 2026 · US Dollars
| Account | Amount |
|---|---|
| Gross profit | 3,200,000 |
| Selling and marketing | (980,000) |
| Research and development | (620,000) |
| General and administrative | (645,000) |
| Loss on uncollectible supplier advance | (95,000) |
| Operating income | 860,000 |
Sable Ridge's operating income is $860,000. To compare it with another company's operating income, inspect the lines included in each subtotal and read the notes and accounting policies. If one company places a material cost above operating income and another places a similar cost below it, adjust the subtotals when the disclosures provide enough detail. Otherwise, state the classification difference rather than treating the two figures as equivalent.
Quick checkA colleague moves the supplier-advance loss below operating income because it happened only once. What should the controller ask before accepting that change?
Answer: The controller should ask what the advance was for and how Sable Ridge presents similar items. Here it supported the analyzer supply chain. An item does not move below operating income merely because it occurred once.
Sable Ridge's adjusted results include a $150,000 after-tax loss from its veterinary instruments line. For this chapter, the controller has determined that the line meets the discontinued-operations test. The loss belongs below the after-tax result of the activities Sable Ridge continues to run. The next chapter explains how the controller makes that determination and presents the tax effect.
Step 3: Present nonoperating items and income tax
Nonoperating items arise outside the activities used to produce and sell the company's goods and services. An income statement can show nonoperating gains and income, then nonoperating expenses, as separate lines or in clearly labeled groups. The warehouse sale produced a gain of $180,000: proceeds less the warehouse's carrying amount, which is its recorded value after depreciation and other reductions. The gain is not the proceeds. Sable Ridge shows that gain, a $40,000 investment gain, $60,000 of income earned from investments, and $140,000 of interest expense on borrowing as separate lines below operating income. Showing investment income and borrowing cost separately lets a reader see both sources rather than only their net effect.
Income before income taxes, or pretax income, includes operating and nonoperating items before income tax expense. Sable Ridge reports $1,000,000. Some statements show another subtotal before interest expense and tax to isolate the effect of borrowing costs. That subtotal may still include other nonoperating items, so check its components before comparing companies. Income tax expense follows pretax income because it is a separate tax cost, not a cost of production, selling, or borrowing. Taxable income can differ from pretax accounting income. The current tax amount is based on taxable income; income tax expense on the financial statements can also include deferred tax expense or benefit. In this course, use the supplied financial-statement income tax expense or benefit. Do not derive it from pretax accounting income. Income from continuing operations is the after-tax result excluding activities reported as discontinued operations. It includes both operating and nonoperating items.
From operating income to net income
Year Ended December 31, 2026 · US Dollars
| Account | Amount |
|---|---|
| Operating income | 860,000 |
| Warehouse gain | 180,000 |
| Investment gain | 40,000 |
| Interest and dividend income | 60,000 |
| Interest expense | (140,000) |
| Income before income taxes | 1,000,000 |
| Income tax expense | (250,000) |
| Income from continuing operations | 750,000 |
| Discontinued-operation loss, net of tax | (150,000) |
| Net income | 600,000 |
Sable Ridge reports $750,000 from continuing operations and a separately presented $150,000 after-tax loss from the veterinary line. Its net income is $600,000.
- Mistaken idea: Continuing operations means recurring
Correction: Income from continuing operations reports the after-tax result of the activities that remain in the business, including related operating and nonoperating items. It can include gains and losses that may happen only once. Calling it continuing does not make each item recurring.
Read the full explanation
Step 4: Check the completed income statement
The controller can now put the lines together. Read the heading before the figures: this statement covers Sable Ridge for the year ended December 31, 2026, and its amounts are in US dollars. It reports activity over a year, unlike a balance sheet, which reports balances at a date.
Income Statement
Year Ended December 31, 2026 · US Dollars
| Account | Amount |
|---|---|
| Instrument sales | $4,200,000 |
| Consumables sales | 1,850,000 |
| Installation and calibration revenue | 950,000 |
| Revenue | 7,000,000 |
| Cost of revenue | (3,800,000) |
| Gross profit | 3,200,000 |
| Selling and marketing | (980,000) |
| Research and development | (620,000) |
| General and administrative | (645,000) |
| Loss on uncollectible supplier advance | (95,000) |
| Operating income | 860,000 |
| Gain on sale of the Dayton warehouse | 180,000 |
| Realized gain on sale of investments | 40,000 |
| Interest and dividend income | 60,000 |
| Interest expense | (140,000) |
| Income before income taxes | 1,000,000 |
| Income tax expense | (250,000) |
| Income from continuing operations | 750,000 |
| Loss from discontinued operations, net of tax | (150,000) |
| Net income | $600,000 |
The controller checks that revenue includes only sales of goods and services, cost of revenue includes the related goods and service costs, and the warehouse and investment gains appear below operating income. The resulting subtotals separate operating performance from the other items included in the $600,000 net income. This is a teaching form. Public companies may use different line names. For commercial and industrial companies, the Securities and Exchange Commission's Regulation S-X Rule 5-03 sets minimum income-statement captions. The company's business and notes help explain its specific lines.
If you want another worked case before the independent problem, the lesson on building income-statement subtotals uses different company facts. The reading gives you everything needed for the Northline problem below.
How classification errors distort income-statement subtotals
The meaning of a subtotal depends on the lines above it. A classification error can overstate gross profit and operating income without changing pretax income or net income. To evaluate any company's statement, identify what belongs in each group and trace which subtotals an incorrect placement would affect.
The draft below makes that error: it includes Sable Ridge's $180,000 warehouse gain in customer revenue instead of showing it below operating income. The controller should correct the draft. The transaction and tax amount do not change. The table compares the correct 2026 statement with the incorrect draft, in US dollars:
| Income-statement line | Correct statement | Incorrect draft: gain in sales |
|---|---|---|
| Customer revenue | $7,000,000 | $7,180,000 |
| Gross profit | 3,200,000 | 3,380,000 |
| Operating income | 860,000 | 1,040,000 |
| Income before income taxes | 1,000,000 | 1,000,000 |
| Net income | 600,000 | 600,000 |
The draft overstates revenue, gross profit, and operating income by $180,000 each. It still reports $600,000 of net income. The gain arose from selling a warehouse, not from selling analyzers or services. Checking only the final total would miss the error. The income-statement classification guide gives another placement example.
Quick checkSuppose another draft incorrectly includes the $40,000 investment gain in customer sales rather than below operating income. What would that draft report for gross profit, operating income, pretax income, and net income?
Answer: Gross profit would be $3,240,000 and operating income $900,000, both $40,000 too high. Pretax income would remain $1,000,000 and net income $600,000. The gain is still counted once, but it is in the wrong group.
Compare income statements across years
The controller prepares a two-year statement for the chief financial officer (CFO). The 2025 adjusted amounts below show the source of the earlier column. Both years are for the same company and in US dollars.
| Sable Ridge, year ended December 31, 2025 | US dollars |
|---|---|
| Instrument sales | $3,900,000 |
| Consumables sales | 1,650,000 |
| Installation and calibration revenue | 850,000 |
| Cost of revenue | (3,520,000) |
| Selling and marketing expense | (900,000) |
| Research and development expense | (580,000) |
| General and administrative expense | (700,000) |
| Interest and dividend income | 55,000 |
| Interest expense | (155,000) |
| Income tax expense on continuing operations | (150,000) |
| Income from the veterinary line, net of tax | 135,000 |
The controller groups the 2025 amounts under the same line names used for 2026. The completed statement lets the CFO compare each line and subtotal directly.
The veterinary-line result is shown as discontinued operations in both income-statement years so the continuing-operations columns describe the same set of activities. The next chapter explains the classification test and how earlier income statements are presented after a qualifying disposal.
Comparative Income Statements
Years Ended December 31 · US Dollars
Change = 2026 less 2025
| Account | 2025 | 2026 | Change |
|---|---|---|---|
| Instrument sales | $3,900,000 | $4,200,000 | $300,000 |
| Consumables sales | 1,650,000 | 1,850,000 | 200,000 |
| Installation and calibration revenue | 850,000 | 950,000 | 100,000 |
| Revenue | 6,400,000 | 7,000,000 | 600,000 |
| Cost of revenue | (3,520,000) | (3,800,000) | (280,000) |
| Gross profit | 2,880,000 | 3,200,000 | 320,000 |
| Selling and marketing | (900,000) | (980,000) | (80,000) |
| Research and development | (580,000) | (620,000) | (40,000) |
| General and administrative | (700,000) | (645,000) | 55,000 |
| Loss on uncollectible supplier advance | — | (95,000) | (95,000) |
| Operating income | 700,000 | 860,000 | 160,000 |
| Gain on sale of the Dayton warehouse | — | 180,000 | 180,000 |
| Realized gain on sale of investments | — | 40,000 | 40,000 |
| Interest and dividend income | 55,000 | 60,000 | 5,000 |
| Interest expense | (155,000) | (140,000) | 15,000 |
| Income before income taxes | 600,000 | 1,000,000 | 400,000 |
| Income tax expense | (150,000) | (250,000) | (100,000) |
| Income from continuing operations | 450,000 | 750,000 | 300,000 |
| Discontinued operations, net of tax | 135,000 | (150,000) | (285,000) |
| Net income | $585,000 | $600,000 | $15,000 |
Revenue rose by $600,000, gross profit by $320,000, and operating income by $160,000. Net income rose by only $15,000 because the $300,000 increase in continuing income was largely offset by a $285,000 decline in the veterinary-line result.
A dollar change shows how much an amount changed. Percentage growth compares that change with the earlier amount:
Percentage growth = (Current amount − Earlier amount) ÷ Earlier amount
Sable Ridge's revenue grew by 9.4%: ($7,000,000 − $6,400,000) ÷ $6,400,000. Its operating income grew by 22.9%: ($860,000 − $700,000) ÷ $700,000. Operating income therefore grew faster than revenue. That comparison measures the relative growth of two statement amounts; it does not explain what caused either amount to change.
A profit margin asks a different question. It expresses a statement subtotal as a share of revenue for the same period. Percentage growth follows one amount across years; a margin compares two amounts within one year. Each margin uses a different income-statement subtotal in the numerator, so each shows what remains after a different set of costs:
| Rate and what it includes | 2025 calculation | 2026 calculation |
|---|---|---|
| Gross profit rate (gross margin): revenue left after cost of goods and services sold | $2,880,000 ÷ $6,400,000 = 45.0% | $3,200,000 ÷ $7,000,000 = 45.7% |
| Operating margin: revenue left after operating expenses too | $700,000 ÷ $6,400,000 = 10.9% | $860,000 ÷ $7,000,000 = 12.3% |
| Net profit margin: revenue left after all items in net income | $585,000 ÷ $6,400,000 = 9.1% | $600,000 ÷ $7,000,000 = 8.6% |
For each dollar of 2026 revenue, Sable Ridge kept about 46 cents of gross profit and 12 cents of operating income. Its operating margin rose even though net profit margin fell. The veterinary-line loss helps explain that difference. Gross margin can change because of prices, product mix, costs, or cost classification; the rate alone cannot identify which. Before comparing companies, check that their revenue and cost groups are comparable. These are income rates, not measures of cash available to pay a debt.
- Mistaken idea: Matching subtotal labels prove comparability
Correction: A subtotal name tells you where to look. It does not, by itself, tell you that two companies included the same kinds of costs. To compare gross profit or operating income, inspect the lines and notes behind each amount.
Read the full explanation
Quick checkIf someone says Sable Ridge's operating income rose by $160,000 only because it sold more, which 2025 and 2026 amounts would you inspect first? Do these statements establish the cause?
Answer: Compare revenue, cost of revenue, and operating expenses in both years. Revenue rose $600,000, gross profit rose $320,000, and operating income rose $160,000. The figures measure changes; they do not establish what caused more sales, different costs, or different expense levels.
Limits of income-statement comparisons
The statements show that reported continuing income rose by $300,000. They do not show whether prices, sales volume, product mix, or costs caused the increase. To investigate, the CFO needs sales and cost detail and the relevant notes. To assess debt payments, a lender also needs cash flows, collection and payment patterns, and debt terms.
Income from continuing operations includes the warehouse and investment gains. A reader assessing the business's ongoing earning power should identify those gains and examine whether similar transactions are expected. The reported increase alone cannot establish future income or available cash.
Quick checkA lender says the $300,000 rise in continuing income proves Sable Ridge has $300,000 more cash for debt payments. Which part of that statement is measured, and what would the lender need to check?
Answer: The rise in reported continuing income is measured. It is not a cash balance or cash-flow change. The lender needs cash collections and payments, the statement of cash flows, and debt terms before making the payment claim.
Other comprehensive income and accumulated OCI
Net income is one measure of the period's performance, but some recognized gains and losses bypass net income under specific accounting rules. Those items enter other comprehensive income (OCI). Comprehensive income is net income plus OCI for the period. Owner investments and dividends are neither net income nor OCI.
To determine whether an item enters OCI, identify the item and its accounting classification, then apply the specific guidance for that item. Common OCI categories include changes from translating a foreign operation's statements into the reporting currency, certain gains and losses on cash flow hedges, some changes in employee retirement plans, and holding gains and losses on available-for-sale debt securities. A company can designate a financial contract as a cash flow hedge when it offsets changes in expected cash receipts or payments. A debt security is an investment that gives its holder a right to receive payments. For one classified as available for sale, a change in its fair value, or current market-based value, can enter OCI while the company holds it. A gain or loss recognized on sale enters net income. Other classifications can produce different treatment, so do not classify a gain from the word unrealized alone. ASC 220-10-45-10A identifies the OCI categories; other accounting guidance supplies the recognition and measurement requirements for each item.
- Mistaken idea: OCI means unrealized or noncash
Correction: Other comprehensive income (OCI) contains certain gains and losses that specific accounting rules exclude from net income. The item's accounting classification decides its route. Whether cash moved, or whether the company sold the asset, is not enough to decide.
Read the full explanation
Sable Ridge's securities are classified as available for sale. During 2026, their value increases, producing an $80,000 holding gain before tax, or $60,000 after tax, in OCI. Sable Ridge also sells a security with a gain that had previously entered OCI. The $40,000 pretax gain enters net income when recognized on sale. A $30,000 after-tax reclassification adjustment removes the related earlier gain from OCI. The adjustment keeps that gain from remaining in both net income and current OCI. This adjustment follows the accounting rule for a sale; the earlier warehouse-in-sales example was an incorrect draft. These amounts are supplied for presentation practice. ASC 220-10-45-15 explains the reclassification adjustment.
Statement of Comprehensive Income
Year Ended December 31, 2026 · US Dollars
| Account | Amount |
|---|---|
| Net income | $600,000 |
| Unrealized holding gain, net of tax | 60,000 |
| Reclassification adjustment, net of tax | (30,000) |
| Other comprehensive income | 30,000 |
| Comprehensive income | $630,000 |
Accumulated other comprehensive income (AOCI) is the cumulative OCI balance reported in equity, separately from retained earnings. Sable Ridge began the year with $45,000 of AOCI. Its $30,000 of current-year OCI brings ending AOCI to $75,000. OCI is a change during 2026; AOCI is a balance at December 31.
Quick checkIs Sable Ridge's $75,000 of ending AOCI another asset? Can you add it to 2026 comprehensive income?
Answer: No. AOCI is an equity balance, not an asset or another gain for 2026. Current OCI of $30,000 is already included in the $630,000 comprehensive-income total.
Quick checkWhich amount is a change during 2026: $30,000 of OCI or $75,000 of ending AOCI? What date does the other amount describe?
Answer: The $30,000 OCI is the change during 2026. The $75,000 AOCI is the equity balance at December 31, 2026, after adding that change to the $45,000 beginning balance.
Quick checkA company holds a debt security whose classification sends fair-value holding changes to net income. Does a holding gain enter OCI merely because the company has not sold the security? What fact would you need to check?
Answer: No. Check the security's accounting classification and the rule that applies to it. Sable Ridge's example uses available-for-sale debt securities, whose holding gains normally enter OCI. A different classification can send a holding gain to net income.
End-of-chapter practice
Prepare a statement for Northline
Northline Components reports six 2026 activities in Step 1 below. Each amount is in US dollars and belongs in the income statement for the year ended December 31, 2026. Northline also reports income tax expense of $225,000 for 2026. Use that supplied expense to calculate net income. There is no discontinued operation.
First decide where each amount enters the statement and which subtotal it can change. The facts are not listed in statement order. Then calculate the 2026 subtotals and rates. The feedback points to the placement or amount that needs another look.
1. Place the 2026 activities
Northline: place each 2026 activity
Read what Northline did. Choose where each amount enters the subtotal sequence. Step 2 shows the separate lines and asks you to calculate the subtotals.
6 items over 3 buckets. Your result is saved in this browser and is not sent.
If the checks are unavailable, write down where each amount goes. The worked answer is below the two-year comparison.
2. Calculate the 2026 subtotals and rates
| Row | A | B |
|---|---|---|
| 1 | Statement line | US dollars |
| 2 | Net sales | $9,000,000 |
| 3 | Cost of goods sold | ($5,400,000) |
| 4 | Gross profit | |
| 5 | Selling expenses | ($1,500,000) |
| 6 | Administrative expenses | ($1,100,000) |
| 7 | Operating income | |
| 8 | Gain on sale of unused land | $200,000 |
| 9 | Interest expense | ($300,000) |
| 10 | Income before income taxes | |
| 11 | Income tax expense | ($225,000) |
| 12 | Net income | |
| 13 | Gross profit rate | |
| 14 | Operating margin |
6 cells to fill in. Your result is saved in this browser and is not sent.
Enter full dollar amounts. For a rate, enter a percentage such as 40%. Income tax expense is supplied. Each blank is checked separately.
The land gain and borrowing cost both follow operating income, but they belong on separate lines. Now test the effect of putting the $200,000 land gain in sales. Which subtotals would be overstated if the gain were counted only once?
Compare Northline's two years
Northline also supplies its 2025 amounts below. These are for the same company, for the year ended December 31, 2025, in US dollars. There was no land-sale gain or discontinued operation that year.
| 2025 item | Amount |
|---|---|
| Net sales | $8,400,000 |
| Cost of goods sold | (5,040,000) |
| Selling expenses | (1,400,000) |
| Administrative expenses | (1,100,000) |
| Interest expense | (260,000) |
| Income tax expense | (150,000) |
Calculate the 2025 subtotals and rates in Step 3. Then use the two-year table in Step 4 to test what changed in dollars and what changed as a share of sales. In Step 5, use the accounting classification given in each separate case to decide whether a gain or loss enters net income or OCI. Before opening the worked answer, write one claim the Northline statements support and one question they cannot answer. Could a lender treat either year's net income as cash available for debt payments?
3. Calculate the 2025 subtotals and rates
| Row | A | B |
|---|---|---|
| 1 | Statement line | US dollars |
| 2 | Net sales | $8,400,000 |
| 3 | Cost of goods sold | ($5,040,000) |
| 4 | Gross profit | |
| 5 | Selling expenses | ($1,400,000) |
| 6 | Administrative expenses | ($1,100,000) |
| 7 | Operating income | |
| 8 | Gain on sale of unused land | $0 |
| 9 | Interest expense | ($260,000) |
| 10 | Income before income taxes | |
| 11 | Income tax expense | ($150,000) |
| 12 | Net income | |
| 13 | Gross profit rate | |
| 14 | Operating margin |
6 cells to fill in. Your result is saved in this browser and is not sent.
Enter full dollar amounts. For a rate, enter a percentage such as 40%. Income tax expense is supplied. Each blank is checked separately.
4. Explain what changed between 2025 and 2026
Use your statements and rates to judge the claims below. The rates compare profit with sales in each year.
| Measure | 2025 | 2026 |
|---|---|---|
| Net sales | $8,400,000 | $9,000,000 |
| Gross profit | $3,360,000 | $3,600,000 |
| Operating income | $860,000 | $1,000,000 |
| Income before income taxes | $600,000 | $900,000 |
| Net income | $450,000 | $675,000 |
| Gross profit rate | 40.0% | 40.0% |
| Operating margin | 10.2% | 11.1% |
5. Decide whether each gain or loss enters net income or OCI
Classify gains and losses: net income or OCI
Assume each item is recognized this year and ignore tax. Use the stated accounting classification, not whether cash changed hands.
4 items over 2 buckets. Your result is saved in this browser and is not sent.
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Check Northline's statement
Northline's income statement below shows each calculation. The land sale happened outside Northline's ordinary sales, so its $200,000 gain appears below operating income. The $225,000 tax expense is supplied; the exercise does not determine it from Northline's pretax accounting income.
Income Statement
Year Ended December 31, 2026 · US Dollars
| Account | Amount |
|---|---|
| Net sales | $9,000,000 |
| Cost of goods sold | (5,400,000) |
| Gross profit | 3,600,000 |
| Selling expenses | (1,500,000) |
| Administrative expenses | (1,100,000) |
| Operating income | 1,000,000 |
| Gain on sale of unused land | 200,000 |
| Interest expense | (300,000) |
| Income before income taxes | 900,000 |
| Income tax expense | (225,000) |
| Net income | $675,000 |
If Northline put the land gain in net sales and removed it from other income, sales would be $9,200,000 and gross profit $3,800,000. Each would be $200,000 too high. Operating income would rise to $1,200,000. Pretax income would stay $900,000, and net income would stay $675,000. The gain is counted once, but the wrong placement makes operating performance look stronger.
The 2025 costs produce the subtotals in the comparison below. Use the supplied $150,000 tax expense to calculate 2025 net income.
| Northline subtotal, US dollars | 2025 | 2026 | Change |
|---|---|---|---|
| Net sales | $8,400,000 | $9,000,000 | $600,000 |
| Gross profit | $3,360,000 | $3,600,000 | $240,000 |
| Operating income | $860,000 | $1,000,000 | $140,000 |
| Income before income taxes | $600,000 | $900,000 | $300,000 |
| Net income | $450,000 | $675,000 | $225,000 |
Sales rose $600,000 and gross profit rose $240,000. The gross profit rate was 40.0% in both years ($3,360,000 ÷ $8,400,000 and $3,600,000 ÷ $9,000,000). Operating margin rose from 10.2% ($860,000 ÷ $8,400,000) to 11.1% ($1,000,000 ÷ $9,000,000). Sales grew 7.1% ($600,000 ÷ $8,400,000), while operating income grew 16.3% ($140,000 ÷ $860,000). Operating income therefore grew faster than sales. The $300,000 rise in pretax income consists of that $140,000 operating increase, a $200,000 land gain that 2025 did not have, and $40,000 more interest expense. The latter reduces, rather than adds to, the change. Net income rose $225,000. A sound measured claim is that reported operating income rose by $140,000, or 16.3%. The statements do not explain whether prices, volume, product mix, or costs caused the change.
The lender cannot treat either year's net income as cash ready for debt payments. Northline may still be waiting to collect some sales, and the statements do not show debt principal due or other cash needs. The lender needs the cash-flow statement and debt terms for that question.
For Step 5, the land-sale loss and the gain recognized when the company sells an available-for-sale debt security enter net income. The holding gain on an available-for-sale debt security and the foreign-operation translation adjustment enter OCI. A sale of the debt security can also require a reclassification adjustment to remove a related earlier gain from OCI. Use the supplied accounting classification and the type of event to apply the appropriate presentation rule. The absence of a cash receipt does not, by itself, place a gain in OCI.
Sources
- SEC Regulation S-X Rule 5-03, income-statement captions for commercial and industrial companies
- ASC 220-10-45-10A, categories of other comprehensive income; ASC 220-10-45-15, reclassification adjustments
- FASB Statement No. 130, historical introduction of comprehensive-income reporting