Problem 1 - Accounting

Question

Revenue and expense data for Home-Mate Appliance Co. are as follows: \begin{tabular}{lrr} & \multicolumn{1}{c}{2006} & \multicolumn{1}{c}{2005} \\ \hline Sales & \(\$ 500,000\) & \(\$ 450,000\) \\ Cost of goods sold & 275,000 & 234,000 \\ Selling expenses & 90,000 & 94,500 \\ Administrative expenses & 60,000 & 63,000 \\ Income tax expense & 25,000 & 22,500 \end{tabular} a. Prepare an income statement in comparative form, stating each item for both 2006 and 2005 as a percent of sales. b. Comment on the significant changes disclosed by the comparative income statement.

Step-by-Step Solution

Answer

The income statement shows an increase in cost of goods sold percentage, with decreases in selling and administrative expenses percentage, indicating efficiency improvements or strategic pricing changes.

Step 1: Calculate each item as a percentage of sales for 2006

To express each item as a percentage of sales, divide the amount of each item by the total sales for 2006. For example, the cost of goods sold for 2006 is calculated as follows: \[ \frac{\text{Cost of Goods Sold}}{\text{Sales}} = \frac{275,000}{500,000} \times 100 = 55\% \]Continue this method for each item in 2006:- Selling expenses: \[ \frac{90,000}{500,000} \times 100 = 18\% \]- Administrative expenses: \[ \frac{60,000}{500,000} \times 100 = 12\% \]- Income tax expense: \[ \frac{25,000}{500,000} \times 100 = 5\% \]

Step 2: Calculate each item as a percentage of sales for 2005

Similarly, calculate each item as a percentage of sales for 2005 using the same process. For example, for the cost of goods sold: \[ \frac{234,000}{450,000} \times 100 = 52\% \]Continue this method for each item in 2005:- Selling expenses: \[ \frac{94,500}{450,000} \times 100 \approx 21\% \]- Administrative expenses: \[ \frac{63,000}{450,000} \times 100 \approx 14\% \]- Income tax expense: \[ \frac{22,500}{450,000} \times 100 = 5\% \]

Step 3: Prepare the comparative income statement

Summarize the data into a tabular format, showing each line item as a percentage of sales:\[\begin{array}{lcc} & \text{2006} & \text{2005} \hline\text{Sales} & 100\% & 100\% \\text{Cost of Goods Sold} & 55\% & 52\% \\text{Selling Expenses} & 18\% & 21\% \\text{Administrative Expenses} & 12\% & 14\% \\text{Income Tax Expense} & 5\% & 5\% \\end{array}\]

Step 4: Analyze the changes in the income statement

The comparative income statement shows certain shifts in expense percentages relative to sales. Cost of goods sold increased from 52% to 55%, signaling potentially higher production costs or less favorable purchasing conditions. Selling and administrative expenses decreased in percentage terms, possibly indicating better expense control. The income tax expense as a percentage of sales remained constant. These trends could reflect changes in company efficiency or pricing strategies.

Key Concepts

Revenue Analysis

Understanding revenue is fundamental in any financial analysis. Revenue refers to the income generated from normal business operations and is also known as "sales." In the context of a comparative income statement, revenue sets the baseline for evaluating all other financial metrics.

By comparing revenue over two years, such as 2005 and 2006, businesses can identify trends in sales growth or decline. For Home-Mate Appliance Co., sales increased from $450,000 in 2005 to $500,000 in 2006. This represents an overall increase of $50,000 or approximately 11.1%.

This growth suggests a positive trend in the company's ability to sell more products or possibly reflects an increase in prices. Analyzing why revenue increases or decreases can help a business make strategic decisions about marketing, pricing, and market expansion.

Expense Percentage

Converting each expense into a percentage of sales is a powerful tool for analyzing financial performance. This method allows stakeholders to assess how efficiently a company is operating relative to its revenue.

To calculate the expense percentage, divide each expense by total sales and multiply by 100. For instance, Home-Mate Appliance Co.'s 2006 cost of goods sold is $275,000. As a percentage of sales, this is \[\frac{275,000}{500,000} \times 100 = 55\%\]When compared to 2005, where the cost of goods sold was 52% of sales, this increase suggests higher production costs or lower purchasing efficiency.

Each expense type (selling expenses, administrative expenses, and income tax expenses) can also be converted into a percentage to provide insights into particular areas of cost management. It helps highlight where a company is improving or where it might need to tighten control over its spending.

Financial Analysis

Financial analysis involves examining financial data to understand the performance and strength of a business. One way to conduct financial analysis is through the comparative income statement, which helps in identifying trends and changes in expense and revenue patterns over time.

In the case of Home-Mate Appliance Co., a detailed comparison of financial data from 2005 to 2006 reveals significant changes. There was an increase in cost of goods sold as a percentage of sales. This might indicate rising material costs or labor expenses. Conversely, selling and administrative expenses showed a decrease as a percentage of sales. This suggests improved operational efficiency or cost reduction strategies.

Income tax expense remaining constant as a percentage of sales indicates stability in the company's taxable activities. Overall, such analyses provide insights into business efficiency and financial health, helping stakeholders make informed decisions.

Income Statement Preparation

Preparing an income statement involves organizing financial data to provide a clear picture of a company's financial performance over a specific period. The comparative income statement goes a step further by displaying financial data for multiple periods side-by-side, facilitating trend analysis.

For Home-Mate Appliance Co., data is arranged so that each item is expressed as a percentage of sales for 2005 and 2006. This layout helps identify how much of each sales dollar is used to cover different costs. By organizing data in this way, stakeholders can easily compare financial performance year over year, assessing areas of strength and opportunities for improvement.

The process requires accurate calculation of expense percentages and a clear, concise presentation of data. The end result is a valuable tool for interpreting a company's financial story and guiding strategic business decisions.