Learning Objectives (LO)

After studying this chapter, you should be able to

Measuring Income to Assess Performance

CHAPTER

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 (LO)

After studying this chapter, you should be able to
5. Account for cash dividends and prepare a statement of stockholders equity 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

LO 1 - Measuring Income
Income key measure of performance and value; measure of increase in wealth over a period of time
Calendar year vs. Fiscal year Interim reports vs. Annual reports Operating cycle average time taken by a firm in converting merchandize or raw material back into cash

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LO 1 - Measuring Income
Revenues are increases in assets received in exchange for the delivery of goods or services to customers. Revenues increase owners' equity. Expenses are decreases in assets as a result of goods or services being delivered to customers. Expenses decrease owners' equity. Income (profit, earnings) excess of revenues over expenses in a reporting period. Retained Earnings total cumulative owners equity generated by income or profits.
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LO 1 - Measuring Income
Cash Basis revenues are recognized when a company receives cash and expenses are recognized when a company pays cash.
Ignores activities that increase or decrease assets other than cash

Accrual Basis revenues are recorded as they are earned and expenses are recorded as they are incurred, regardless whether cash changes hands.
Ignores that a company can go bankrupt if it does not manage its cash properly, no matter how well it seems to be doing according to the other financial statements

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LO 1 - Measuring Income
Accrual Accounting Example - Sales on open account for the entire month of January
amount to $160,000. The cost of the inventory sold is $100,000
Assets = Liabilities + Owners Equity Retained Earnings 100,000 (cost of goods sold) +160,000 (sales revenues)

LO 2 - Revenues Recognition
Criteria to recognize revenues:
Revenues must be earned - All (or substantially all) of the goods or services the customer wants have been delivered to and accepted by customers Revenues must be realized or realizable - Cash or a formal promise by the customer to pay cash has been received for the goods or services delivered

Accounts Merchandise Receivable Inventory Cost of inventory sold Sales on credit +160,000 100,000

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LO 3 - Matching
Matching the process of recognizing and recording expenses in the same period the related revenues are recognized. Product costs are linked with product revenues earned in that period (e.g. cost of goods, commissions, etc). Period costs are linked to a period of time itself and are recorded in the period incurred (e.g. rent, admin. salaries, etc.)
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LO 3 - Matching
Cost Recovery Concept Assets are unexpired costs held back from expense and carried forward to future periods in the balance sheet.
Acquisition Expiration

Assets Unexpired costs (e.g. Inventory, Prepaid Rent, Equipment)

Instantaneously Or Eventually Become

Expenses Expired costs (e.g. Cost of Goods Sold, Rent, Depreciation, etc.)

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LO 3 - Matching
Acquire before it contributes to revenue
Acquire 3 months rent in advance of usage

LO 4 Income Statement
Balance sheet presents financial position at discrete points in time, e.g. fiscal year end. Income statement (Statement of Earnings, Operations, Profit and Loss) presents changes that took place between those points in time attributable to the performance of management. Net Income important measure of managerial performance.

Consume one month s rent Assets (Prepaid Rent) decreases $2,000 Equity (Rent Expense) decreases $2,000

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LO 5 Dividends/Stockholders Equity
Retained earnings increase as profits accumulate and decrease when a net loss occurs or as company pays cash dividends. Cash dividends are distributions of assets that reduce a portion of the ownership claim. Cash dividends are not expenses, and, therefore, are not deductible.

LO 5 Dividends/Stockholders Equity
Statement of Stockholders Equity shows all changes in each stockholders equity account during the reporting period. Changes in Stockholders Equity arise from three main sources.
net income / loss transactions with shareholders (payment of dividends, repurchases or sale of own stock) other comprehensive income

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LO 6 BASIC CONCEPTS
There are a number of concepts and conventions that guide the accounting process: Entity Concept an economic entity is separate from its owners or other organizations Reliability Concept assures decision makers that the information presented captures the conditions or events it claims to represent Going Concern Convention assumes that the entity will continue to exist indefinitely

LO 6 BASIC CONCEPTS
Materiality Convention states that an item should be included in the financial statements, or is material, if its omission or misstatement would tend to mislead the reader Stable Monetary Unit currency is used to measure events; its purchasing power is assumed to be stable (low inflation) over time

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LO 7 FINANCIAL RATIOS Earnings Per Share - EPS

How much of the periods net income belongs to each share of common stock? Net Income EPS = Average number of common shares outstanding Basic EPS vs. Diluted EPS
Basic (no additional shares) Diluted (rights are exercised to buy more shares)

LO 7 FINANCIAL RATIOS Price-Earnings Ratio P/E (Earnings Multiple)

How much the investors are willing to pay for a chance to share the companys potential earnings?
Market price per share of common stock

P-E Ratio =

Earnings per share of common stock

P-E ratio is determined in the marketplace as company s share price is established in the market. P-E ratio indicates investors predictions about the company s future net income.

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LO 7 FINANCIAL RATIOS Dividend-Yield Ratio

The return to investors when they invest in stocks takes two forms:
Cash dividends Increases in the market price

LO 7 FINANCIAL RATIOS Dividend-Payout Ratio

What proportion of net income does a company elect to pay in cash dividends?
Common dividends per share Earnings per share

Dividend-Payout Ratio =

How much is one share of stock returning to its owners in the form of dividends from the past year?
Dividend-Yield Ratio =
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Common dividends per share Current market price per share

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