Ch_02 Measuring Income to Assess Performance
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CHAPTER 1© 2006 Prentice Hall Business Publishing Introduction to
Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Measuring Income to Assess Performance
CHAPTER
2
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Learning Objectives
Explain how accountants measure income
Determine when a company should record revenue from a sale
Use the concept of matching to record the expenses for a
period
Prepare an income statement and show how it is related to a balance
sheet
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Learning Objectives
After studying this chapter, you should be able to
Account for cash dividends and prepare a statement of retained
earnings
Explain how the following concepts affect financial statements:
entity, reliability, going concern, materiality, cost-benefit, and
stable monetary unit
Compute and explain earnings per share, price-earnings ratio,
dividend-yield ratio, and dividend-payout ratio
Explain how accounting regulators trade off relevance and
reliability in setting accounting standards
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Operating Cycle
Starts with
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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)
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Revenues and Expenses
Revenues and expenses are the key inflows and outflows of assets
that occur during a business’s 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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Revenues and Expenses
Retained earnings is the total cumulative equity generated by
income
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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 = Liabilities + Owners’ Equity
Sales +160,000 = +160,000
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Recognition of Revenues
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Applying Matching
Assets = Liabilities + Owners’ Equity
Store Equipment = Retained Earnings
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Recognition of Expired Assets
Rent, Depreciation,
Other Expenses)
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Expanded Balance Sheet Equation
(2) Assets = Liabilities + Paid-in Capital + Retained
Earnings
(3) Assets = Liabilities + Paid-in Capital + Revenues -
Expenses
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Relationship Between Income Statement and Balance Sheet
Balance Sheet
December 31
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Cash Dividends
Cash dividends
Are distributions of some of the company’s assets (cash) to
stockholders
Reduce Cash and Retained Earnings
Are not expenses—they are transactions with stockholders
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Cash Dividends
Assets = Liabilities + Stockholders’ Equity
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Cash Dividends
A cash dividend involves three important dates:
Declaration date—the date on which the board declares the
dividend
Record date—stockholders owning the stock on this date receive the
dividend
Payment date—the date on which the corporation pays the
dividend
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Statement of Retained Earnings
The statement of retained earnings consists of the
A net loss (negative net income) is subtracted from the beginning
balance of retained earnings
Negative retained earnings is called an accumulated deficit
Beginning balance
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Statement of Retained Earnings
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
Retained earnings, January 31, 20X2
Add: Net income for February
Total
$ 57,900
63,900
$121,800
50,000
$ 71,800
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Statement of Retained Earnings
Rent 2,000
Depreciation 100
Net income
Total
$176,000
112,100
$ 63,900
57,900
$121,800
50,000
$ 71,800
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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]
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Earnings Per Share (EPS)
EPS tells investors how much of a period’s net income “belongs to”
each share of common stock
Investors should predict a company’s future EPS before deciding
whether to buy the company’s common shares
Net Income
EPS =
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Price-Earnings (P-E) Ratio
The P-E ratio measures how much the investing public is willing to
pay for a chance to share the company’s potential earnings
A high P-E ratio indicates that investors predict the company’s net
income will grow rapidly
Market price per share of common stock
Earnings per share of common stock
P-E Ratio =
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Dividend-Yield Ratio
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
Current market price of stock
Common dividends per share
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Dividend-Payout Ratio
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
Common dividends per share
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Cost-Benefit Criterion and
Costly to produce
The FASB and the IASB must choose rules whose decision-making
benefits exceed their costs
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Aspects of Decision Usefulness
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
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
© 2006 Prentice Hall Business Publishing Introduction to Financial
Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Aspects of Decision Usefulness