chapter 2 - measuring income to assess performance

©© 2010 Pearson Education Inc. Publishing as Prentice Hall 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Introduction to Financial Accounting, 10/e

Measuring Income to Assess

Performance

CHAPTER

2


Learning Objectives (LO)

After studying this chapter, you should be able to1. Explain how accountants measure income2. Determine when a company should record revenue

from a sale3. Use the concept of matching to record the expenses

for a period4. 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 to5. Account for cash dividends and prepare a statement

of stockholders’ equity6. 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, price-earnings ratio, dividend-yield ratio, and dividend-payout ratio

3 of 35 ©© 2010 Pearson Education Inc. Publishing as Prentice Hall 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Introduction to Financial Accounting, 10/e

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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• 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.



• 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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• 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 = Liabilit ies + Owners’ Equity

Accounts Merchandise RetainedReceivable Inventory Earnings

Cost of inventory sold –100,000 –100,000(cost of goods sold)

Sales on credit +160,000 +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

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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.)


LO 3 - Matching

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AssetsUnexpired costs(e.g. Inventory, Prepaid Rent,

Equipment)

ExpensesExpired costs

(e.g. Cost of Goods Sold, Rent,

Depreciation, etc.)

Acquisition Expiration

InstantaneouslyOr Eventually

Become

Cost Recovery Concept – Assets are unexpired costs held back from expense and carried forward to future periods in the balance sheet.


LO 3 - Matching

• Acquire before it contributes to revenue– Acquire 3 month’s rent in advance of usage

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


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.

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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 CONCEPTSThere 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

• Basic EPS vs. Diluted EPS– Basic (no additional shares)– Diluted (rights are exercised to buy more shares)

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Net IncomeAverage number of common shares outstanding

EPS =

How much of the period’s net income “belongs”to each share of common stock?

Earnings Per Share - EPS



• P-E ratio is determined in the marketplace as company ’s share price is established in the market.

• P-E ratio indicates investor’s predictions about the company ’s future net income.

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Market price per share of common stock

Earnings per share of common stockP-E Ratio =

How much the investors are willing to pay for a chance to share the company’s potential earnings?

Price-Earnings Ratio – P/E (Earnings Multiple)



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

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Current market price per shareCommon dividends per share

Dividend-Yield Ratio =

How much is one share of stock returning to itsowners in the form of dividends from the past year?

Dividend-Yield Ratio



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Common dividends per share

Earnings per shareDividend-Payout Ratio =

What proportion of net income does a companyelect to pay in cash dividends?

Dividend-Payout Ratio

chapter 2 - measuring income to assess performance

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