Measuring Income to Assess Performance
CHAPTER
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Learning Objectives
After studying this chapter, you should be able to
1. Explain how accountants measure income 2. Determine when a company should record revenue from a sale 3. Use the concept of matching to record the expenses for a period 4. Prepare an income statement and show how it is related to a balance sheet
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Learning Objectives
After studying this chapter, you should be able to
5. Account for cash dividends and prepare a statement of retained earnings 6. Explain how the following concepts affect financial statements: entity, reliability, going concern, materiality, cost-benefit, and stable monetary unit 7. Compute and explain earnings per share, priceearnings ratio, dividend-yield ratio, and dividendpayout ratio 8. Explain how accounting regulators trade off relevance and reliability in setting accounting standards
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Measuring Income
Income is a measure of the increase in the wealth of an entity over a period of time Accountants have agreed on a common set of rules for measuring income and wealth Income is generated primarily through the operating cycle
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Operating Cycle
Starts with Cash $100,000
Buys Merchandise
Merchandise Inventory $100,000
Sells Merchandise
Accounts Receivable $160,000
Collects Cash
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The Accounting Time Period
Companies measure their performance over discrete time periods The calendar year is the most common time period for measuring income or profits About 40% of large companies use a fiscal year that differs from a calendar year
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The Accounting Time Period
The fiscal year-end date is often the low point in annual activity when inventories can be counted more easily Companies also prepare financial statements for interim periods Interim periods may be for a month or a quarter (3-month period)
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Revenues and Expenses
Revenues and expenses are the key inflows and outflows of assets that occur during a businesss operating cycle Revenues are the amount of assets received in exchange for the delivery of goods or services to customers Expenses are measures of the assets that a company gives up or consumes in order to deliver goods or services to a customer
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Revenues and Expenses
Income is the excess of revenues over expenses Profits or earnings are common synonyms for income Retained earnings is the total cumulative equity generated by income
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Revenues and Expenses
Sales on open account for the entire month of January amount to $160,000. The cost of the inventory sold is $100,000
Assets Accounts Receivable = Liabilities + Owners Equity Retained Earnings
Merchandise Inventory
Sales
Cost of inventory sold
+160,000
+160,000 (sales revenues)
-100,000
-100,000 (cost of goods sold expenses)
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Revenues and Expenses
Accounts receivable are the amounts owed by customers as a result of delivering goods or services on account in the ordinary course of business
Cost of goods sold expense is the original acquisition cost of the inventory that a company sells to customers during the reporting period
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Accrual Basis and Cash Basis
The accrual basis recognizes the impact of transactions in the financial statements for the time periods when revenues and expenses occur
Accountants record revenue as a company earns it, and they record expenses as the company incurs them
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Accrual Basis and Cash Basis
The cash basis recognizes the impact of transactions in the financial statements only when a company receives or pays cash The accrual basis is the best basis for measuring economic performance
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Recognition of Revenues
Revenues are recognized when they
Are earned A company earns revenues when it delivers goods or services to customers And are realized A company realizes revenues when it receives cash or claims to cash in exchange for goods or services
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Matching
There are two kinds of expenses in every accounting period:
Product costs are those linked with the revenues earned that period Period costs are those linked with the time period itself
Matching occurs when the expenses incurred in a period are matched to the revenues generated in the same period
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Applying Matching
Depreciation is the systematic allocation of the acquisition cost of long-lived assets to the periods that benefit from the use of the assets Land is not subject to depreciation because it does not deteriorate over time
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Applying Matching
The following transaction records depreciation expense
Assets Store Equipment = Liabilities + Owners Equity = Retained Earnings
Recognize depreciation expense
-100
-100 (increase depreciation expense)
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Applying Matching
We can account for the purchases and uses of goods and services in two basic steps:
The acquisition of the assets The expiration of the assets as expenses
Expense accounts are deductions from stockholders equity
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Recognition of Expired Assets
Acquisition Expiration
Expenses (Expired costs, such as Cost of Goods Sold, Rent, Depreciation, Other Expenses)
Assets (Unexpired costs, such as Inventory, Prepaid Rent, Equipment)
Instantaneously Or Eventually Become
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Expanded Balance Sheet Equation
(1) Assets = Liabilities + Stockholders Equity
(2) Assets
Liabilities + Paid-in Capital + Retained Earnings
(3) Assets
Liabilities + Paid-in Capital + Revenues - Expenses
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Expanded Balance Sheet Equation
The income statement collects all the changes in owners equity for the accounting period and combines them in one place Revenue and expense accounts are nothing more than subdivisions of stockholders equity temporary stockholders equity accounts
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The Income Statement
An income statement is a report of all revenues and expenses pertaining to a specific time period Net income = revenues minus all expenses A net loss occurs if expenses exceed revenues
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Relationship Between Income Statement and Balance Sheet
A balance sheet shows the financial position of the company at a discrete point in time An income statement explains the changes that take place between those points in time
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Relationship Between Income Statement and Balance Sheet
Balance Sheet December 31 20X1 Income Statement For January Time
Balance Sheet January 31 20X2 Income Statement For February
Balance Sheet February 28 20X2 Income Statement For March
Balance Sheet March 31 20X2
Time
Income Statement for Quarter Ended March 31, 20X2
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Cash Dividends
Cash dividends
Are distributions of some of the companys assets (cash) to stockholders Reduce Cash and Retained Earnings Are not expensesthey are transactions with stockholders
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Cash Dividends
Cash dividends of $50,000 are disbursed to stockholders
Assets Cash
Declaration and payment of cash dividends
= Liabilities + Stockholders Equity = Retained Earnings
-50,000
-50,000 (dividends)
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Cash Dividends
A cash dividend involves three important dates:
Declaration datethe date on which the board declares the dividend Record datestockholders owning the stock on this date receive the dividend Payment datethe date on which the corporation pays the dividend
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Retained Earnings and Cash
In order to pay a cash dividend, a corporation needs
Cash Retained Earnings
Cash and Retained Earnings are two entirely separate accounts, sharing no necessary relationship Retained earnings is a residual claim, not a pot of gold
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Statement of Retained Earnings
The statement of retained earnings consists of the
Beginning balance + Addition of net income - Deduction of dividends = Ending balance
A net loss (negative net income) is subtracted from the beginning balance of retained earnings Negative retained earnings is called an accumulated deficit
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Statement of Retained Earnings
Retained earnings, January 31, 20X2 Add: Net income for February Total Less: Dividends declared Retained earnings, February 28, 20X2 $ 57,900 63,900 $121,800 50,000 $ 71,800
Some companies add the statement of retained earnings to the bottom of the income statement
The next slide shows a combined statement of income and retained earnings
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Statement of Retained Earnings
Sales Deduct expenses: Cost of goods sold $110,000 Rent 2,000 Depreciation 100 Net income Retained earnings, January 31, 20X2 Total Less: Dividends declared Retained earnings, February 28, 20X2
$176,000
112,100 $ 63,900 57,900 $121,800 50,000 $ 71,800
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Statement of Retained Earnings
Note how the combined statement of income and retained earnings is anchored to the balance sheet equation
Assets = Liabilities + Paid-in Capital + Retained earnings
[Beginning balance + Revenues - Expenses - Dividends] [57,900 + 176,000 - 112,100 - $50,000]
Ending Retained Earnings Balance = $71,800
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The Entity Concept
An accounting entity is an organization that stands apart from other organizations and individuals as a separate economic unit Personal transactions are not recorded by a business entity
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The Reliability Concept
Reliability is the quality of information that assures decision makers that the information captures the conditions or events it purports to represent
Reliable data can be verified by independent auditors
Only certain types of events can be reliably recorded as accounting transactions
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Going Concern Convention
The going concern (continuity) convention is the assumption that an entity will continue to exist indefinitely For a going concern, it is reasonable to
Use historical cost to record long-lived assets Report liabilities at the amount to be paid at maturity
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Materiality Convention
The materiality convention asserts that an item should be included in a financial statement if its omission or misstatement would tend to mislead the reader of the financial statements under consideration Many acquisitions that a company theoretically should record as assets are immediately written off as expenses because they are not material
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Cost-Benefit Criterion
The cost-benefit criterion states that a system should be changed when the expected additional benefits of the change exceed its expected additional costs
The FASB safeguards the cost-effectiveness of its standards by
Assuring that a standard does not impose costs on the many for the benefit of a few Seeking alternative ways of handling an issue that are less costly and only slightly less efficient
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Stable Monetary Unit
The ability to use historical cost accounting depends on a stable monetary unit A stable monetary unit is one that is not expected to change in value significantly over time With low levels of inflation, changes in the value of the monetary unit do not hinder accounting rules
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Earnings Per Share (EPS)
EPS = Net Income Average number of shares outstanding
EPS tells investors how much of a periods net income belongs to each share of common stock Investors should predict a companys future EPS before deciding whether to buy the companys common shares
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Price-Earnings (P-E) Ratio
P-E Ratio = Market price per share of common stock Earnings per share of common stock
The P-E ratio measures how much the investing public is willing to pay for a chance to share the companys potential earnings A high P-E ratio indicates that investors predict the companys net income will grow rapidly
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Dividend-Yield Ratio
Dividend-Yield Ratio = Common dividends per share Current market price of stock
The dividend-yield ratio gauges dividend payouts Investors in common stock who seek regular cash returns of their investments pay particular attention to dividend-yield ratios
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Dividend-Payout Ratio
Common dividends per share Dividend-Payout Ratio = Earnings per share
The dividend-payout ratio shows what proportion of net income a company elects to pay in cash dividends to its shareholders Many companies elect to pay a reasonably constant dollar amount in dividends, even if this means variations in its dividend-payout ratio
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Cost-Benefit Criterion and Accounting Regulation
Accounting information is
A benefit or economic good Costly to produce
The FASB and the IASB must choose rules whose decision-making benefits exceed their costs
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Aspects of Decision Usefulness
Relevance and reliability are the two main qualities that make accounting information useful for decision making Reliability is a quality of information that captures the conditions or events it purports to represent Relevance refers to whether the information makes a difference to the decision maker
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Aspects of Decision Usefulness
Accounting is filled with trade-offs between relevance and reliability Historical cost is reliable, but not very relevant The current value of land is more relevant than historical cost, but estimates of the current value are subjective and may not be reliable
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Aspects of Decision Usefulness
For information to be relevant, it must help decision makers predict the outcomes of future events (predictive value) or confirm or update past predictions (feedback value)
Relevant information must also be available on a timely basis
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Aspects of Decision Usefulness
Reliability is characterized by verifiability for objectivity, neutrality, and validity Verifiability means that information can be checked to make sure it is correct Validity (also called representational faithfulness) means the information provided represents the events or objects it is supposed to represent
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Aspects of Decision Usefulness
Neutrality, or freedom from bias, means that information is objective and is not weighted unfairly Comparability requires all companies to use similar concepts and measurements Consistency requires conformity within a company from period to period with unchanging policies and procedures
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Aspects of Decision Usefulness
Predictive Value Consistency Verifiability
Feedback Value
Relevance
Decision Usefulness
Reliability
Neutrality
Timeliness
Comparability
Validity
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