© 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Measuring Income to Assess Performance CHAPTER 2

© 2012 Pearson Education Introduction to Financial Accounting, 10/e Learning Objectives (LO) 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 2 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e 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.Compute and explain earnings per share, price- earnings ratio, dividend-yield ratio, and dividend- payout ratio 3 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 1 - Measuring Income Income – increase in wealth over time –Calendar year – Jan 1 to Dec 31 –Fiscal year – Start anytime; end 365 days later Annual financial reports –Interim periods – weekly, monthly, quarterly Quarterly (3 months) financial reports –Operating cycle – time lapse between 4 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 1 - Measuring Income Income – increase in wealth over time Basic accounting equation + specific accounts ASSETS = LIABILITIES + OWNERS’ EQUITY CashAccounts Payable Paid in Capital Accounts ReceivableNotes Payable Retained (Income = $60,000) Prepaid items Revenue $160,000 Equipment Expenses $100,000 BuildingGains LandLosses Distributions to owners Dividends 5 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 1 - Measuring Income Revenues - net assets received from customers in exchange for delivery of goods or services Expenses – net assets given up or consumed when delivering goods or services to customers Income (profit, earnings) – revenues less expenses during some reporting period –Revenues/Expenses – usual and frequent –Gains/Losses – unusual and/or infrequent Retained Earnings – income less dividends since the inception of the business 6 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 1 - Measuring Income When to measure in and out flows? –Cash-only in and out flows Used by many small businesses due to its objectivity and simplicity Unrealistic - many events are initially on credit –Accrual Measures in and outflows of all transactions, events, circumstances, when they occur regardless of whether cash flows are involved Used by most companies to prepare their financial statements 7 of 35

© 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e LO 1 - Measuring Income 8 of 35 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 Accounts Merchandise Retained Receivable Inventory Earnings Cost of inventory sold–100,000 –100,000 (cost of goods sold) Sales on credit +160, ,000 (sales revenues)

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 1 - Measuring Income Accounts receivable - amounts owed by customers to the business as a result of a usual and frequent transaction not involving cash Cost of goods sold (an expense) - the cost of the products the business sold to the customer that generated the revenue 9 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 2 - Revenues Recognition Revenues are recognized when they are –Earned - All (or substantially all) of the goods or services the customer wants have been delivered to and accepted by customers –Realized - Cash has been received from the customer for those goods or services –Realizable - If anything else besides cash (e.g. accounts receivable) are received, it (they) should be readily convertible into cash Revenues increase Retained Earnings and Stockholders’ Equity 10 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 3 - Matching Expenses –Usual and frequent assets sacrificed or liabilities assumed for goods or services that contributed to revenue earned in this reporting period –Deductions from stockholders’ equity Matching –List as expenses only those things that directly or indirectly contributed to this period’s revenue Product costs – more closely tied to product Period costs – more closely tied to the period 11 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 3 - Matching 12 of 35 Assets Unexpired costs such as Inventory, Prepaid Rent, Equipment Expenses Expired costs, such as Cost of Goods Sold, Rent, Depreciation, Other Expenses) On AcquisitionOn Expiration Instantaneously Or Eventually Become

© 2012 Pearson Education Introduction to Financial Accounting, 10/e 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 –Probably listed as period cost (expense) –If it was merchandise inventory – product cost Acquire/use same time – Rent Expense - $2, of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 3 - Matching Assets=Liabilities+Paid in Capital + Retained Earnings CashEquipment 14, ,000 –100 *–100 Depreciation Expense 14 of 35 * $14,000 / 140 months expected life = $100 per month 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

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 4 – Income Statement Income – increase in wealth over time Basic accounting equation + specific accounts ASSETS = LIABILITIES + OWNERS’ EQUITY CashAccounts Payable Paid in Capital Accounts ReceivableNotes Payable Retained Earnings Prepaid items Revenue Equipment Expenses BuildingGains (later) LandLosses (later) Distributions to owners Dividends 15 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 4 – Income Statement Balance sheet - financial position/condition at discrete points in time, e.g. fiscal year end Income statement ( Statement of Earnings, Operations, Profit and Loss) - changes that took place between those points in time attributable to operating the business Revenues Expenses Gains/Loses Net income (loss) 16 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 4 – Income Statement 17 of 35 Balance Sheet December 31 20X1 Balance Sheet January 31 20X2 Balance Sheet February 28 20X2 Balance Sheet March 31 20X2 Income Statement For January Income Statement For February Income Statement For March Time Income Statement for Quarter Ended March 31, 20X2

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 4 – Income Statement Dynamics (ethical dilemmas) –Interpreting economic events/preparing financial reports requires judgment –Management Exercises that judgment Is rewarded on the reports’ content 18 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 5 – Dividends/Stockholders’ Equity Name of Company Statement of Stockholders’ (Shareholders’) Equity For the period Jan 1, 20X1 to 20X3 Paid-in Retained Comprehensive Capital Earnings Income (Chap 11) 1/1/20X1 Beginning Balance Beginning Balance Beginning Balance New issues Net Income Various increases (Buy backs/retirements) (Dividends) Various decreases 12/31/20X1 Ending balance Ending balance * Ending balance * (Repeat for two more years) * Could be a negative number 19 of35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 5 – Dividends/Stockholders’ Equity 20 of 35 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 $ 63,900 57,900 $ 121,800 50,000 $ 71,800 Combined Statement of Retained Earnings and Income Statement 112,100

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 5 – Dividends/Stockholders’ Equity Note how the combined statement of income and retained earnings is anchored to the balance sheet equation 21 of359 Assets = Liabilities + Paid-in Capital + Retained earnings [Beginning balance + Revenues - Expenses - Dividends] [57, , ,100 - $50,000] Ending Retained Earnings Balance = $71,800 Net income from the Income Statement Retained earnings is one type of claim against the net assets (assets less liabilities); it is not cash

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 5 – Dividends/Stockholders’ Equity Cash dividends –Board of directors decides whether to issue dividends –If such a decision is made, three important dates Declaration – when publically announced –Liabilities (Dividends Payable) increase –Retained Earnings decrease –Does not affect income statement (expenses) Record – owners, as of that day, get the dividend Payment – check is “in the mail” –Assets (cash) and liabilities (Div. Pay.) decrease 22 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 6 – BASIC CONCEPTS (Economic) Entity - an organization that stands apart from other organizations and individuals as a separate economic unit –The first line in the statements’ headings –Personal transactions are not recorded by a business entity Stable Monetary Unit –Currency is used to measure events –Its purchasing power is assumed to be stable (low inflation) over time 23 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 6 – BASIC CONCEPTS Going concern (continuity) –Reporting entity will continue to exist indefinitely, i.e. can use historical costs to measure long-lived assets –If liquidation is in sight, assets should be revalued to their current market value Materiality –If it makes a difference to a decision maker, information should be separately identifiable –Immaterial – combine with other information 24 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 6 – BASIC CONCEPTS Cost-benefit –Apply established criteria, i.e. U.S. GAAP or IFRS –If the costs to comply with that criteria exceed the benefits of doing so, deviations are permissible Difficult to measure benefits – judgment which can easily lead to disagreements U.S. GAAP contains verbiage permitting deviations justified by cost-benefit considerations 25 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 6 – BASIC CONCEPTS Reliability –Management prepares and is rewarded by the content of financial statements (possible bias) –Independent auditors, in theory, add quality to those statements by offering three opinions “Fair” presentation (unqualified) Prepared according to the relevant accounting standards Adequacy of internal controls –Higher quality statements makes them more reliable (useful) in decision making 26 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 7 – FINANCIAL RATIOS Calculated results mean nothing unless –Same accounting principals are used –Totals are reported similarly –There are other numbers to make comparisons (budget, historical, competitors) Comparisons mean nothing unless other data –Has underlying comparable quality –Covers comparable periods –Uses the same formulas 27 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 7 – FINANCIAL RATIOS Assuming one has high quality comparative data, the investor, when using ratio analysis must still keep in mind –Will historical relationships continue to exist in their same proportions? –Is the past a good predictor of the future? –Will unforeseen events occur that will alter the future? 28 of 35

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 7 – FINANCIAL RATIOS Shares –Preferred (has higher preferences) than common –Outstanding – in the hands of stockholders Basic (no additional shares) Diluted (rights are exercised to buy more shares) 29 of 35 Net Income Average number of common shares outstanding EPS = How much of the period’s earnings “belong” to the common shareholders?

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 7 – FINANCIAL RATIOS Conceptually, a higher than normal ratio suggests investors predict the company’s net income will grow Factually, a higher ratio has proven to be good and bad news (and vice versa) 30 of 35 Market price per share of common stock Earnings per share of common stock P-E Ratio = How much more is an investor willing to pay for one share of stock than it is earning?

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 7 – FINANCIAL RATIOS The return to investors when they invest in stocks is twofold: –Appreciation in Value –Receipt of dividends 31 of 35 Current market price per share Common dividends per share Dividend-Yield Ratio = How much is one share of stock returning to its owners in the form of dividends from the past year?

© 2012 Pearson Education Introduction to Financial Accounting, 10/e LO 7 – FINANCIAL RATIOS 32 of 35 Common dividends per share Earnings per share Dividend-Payout Ratio = What proportion of net income does a company elect to pay in cash dividends? Dividend policy is set by the Board of Directors Younger companies tend to pay no dividends More mature companies often pay dividends –Irregular amounts each year –Recurring or increasing amounts each year

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