5. A company's net income appears significantly lower than its gross profit on a multi-step income statement. What causes the difference between gross profit and net income?
Answer: D
The company's operating and other expenses reduce total profit.
The difference between gross profit and net income is primarily due to the company’s operating and other expenses that must be deducted from gross profit to arrive at net income.
A) The company is using a cash-based accounting method.
This option is incorrect because the accounting method used (cash-based or accrual) does not directly account for the difference between gross profit and net income. Both methods can show significant differences based on how expenses are recognized, but the operational expenses are what lead to the net income reduction, not the accounting approach itself.
B) Cost of goods sold is not included in the calculation.
This choice is also incorrect because cost of goods sold (COGS) is indeed included in the calculation of gross profit. Gross profit is calculated as revenues minus COGS, so this statement does not reflect the reality of how gross profit is determined versus net income.
C) Revenue and net income should always be the same.
This statement is incorrect as revenue and net income represent different financial metrics. Revenue is the total income from sales before any expenses are deducted, while net income is the profit remaining after all expenses, including operating costs, have been subtracted from revenue.
D) The company's operating and other expenses reduce total profit.
This option is correct because operating expenses (such as selling, general and administrative expenses) and other expenses (like interest and taxes) must be deducted from gross profit to calculate net income. This deduction explains why net income is significantly lower than gross profit on the multi-step income statement.
Conclusion
The correct answer highlights that operating and other expenses are the critical factors that lower net income from gross profit. While other options misrepresent the relationship between gross profit, net income, and accounting methods, option D accurately captures the essence of the income statement flow and the deductions involved in calculating net income.