Businesses are required to show expenses on the income statement based on either the nature or the function of the expense. The nature of an expense is determined by its basic characteristics (what it is). For example, when expenses are listed on the income statement as interest, depreciation, income tax, or wages, this identifies the nature of each expense. In contrast, the function of an expense describes the grouping of expenses based on their purpose (what they relate to). For example, an income statement that shows cost of goods sold, selling expenses, and general and administrative expenses has grouped expenses by their function. When expenses are grouped by function, additional information must be disclosed to show the nature of expenses within each group. The full disclosure principle is the generally accepted accounting principle that requires financial statements to report all relevant information about the operations and financial position of the entity. Information that is relevant but not included in the body of the statements is provided in the notes to the financial statements.
A merchandising income statement can be prepared in different formats. For this article, only one format will be introduced — the classified multiple-step format. This format is generally used for internal reporting because of the detail it includes. An example of a classified multiple-step income statement is shown in above figure using assumed data for XYZ Inc. for its month ended December 31, 2015.
Notice that the classified multiple-step income statement shows expenses by both function and nature. The broad categories that show expenses by function include operating expenses, selling expenses, and general and administrative expenses. Within each category, the nature of expenses is disclosed including sales salaries, advertising, depreciation, supplies, and insurance. Notice that Rent Expense has been divided between two groupings because it applies to more than one category or function.
The normal operating activity for XYZ Inc. is merchandising. Revenues and expenses that are not part of normal operating activities are listed under Other Revenues and Expenses. XYZ Inc. shows Rent Revenue under Other Revenues and Expenses because this type of revenue is not part of its merchandising operations. Interest earned, dividends earned, and gains on the sale of property, plant, and equipment are other examples of revenues not related to merchandising operations. XYZ Inc. deducts Interest Expense under Other Revenues and Expenses. Interest expense does not result from operating activities; it is a financing activity because it is associated with the borrowing of money. Another example of a non-operating expense is losses on the sale of property, plant, and equipment. Income tax expense is a government requirement so it is shown separately. Notice that income tax expense follows the subtotal ‘Income before tax’.