Measuring Income to Assess Performance Lecture 7 (Chapter 2)

Learning Objectives (LO) After studying this chapter, you should be able to 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

Learning Objectives (LO) After studying this chapter, you should be able to Account for cash dividends and prepare a statement of stockholders’ equity 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

LO 5 – Dividends/Stockholders’ Equity Name of Company Statement of Stockholders’ (Shareholders’) Equity For the period Jan 1, 20X1 to 20X3 Paid-in Retained Capital Earnings 1/1/20X1 Beginning Balance Beginning Balance New issues Net Income (Buy backs/retirements) (Dividends) 12/31/20X1 Ending balance Ending balance * (Repeat for two more years) * Could be a negative number

LO 5 – Dividends/Stockholders’ Equity Combined Statement of Retained Earnings and Income Statement 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 $ 71,800 112,100

LO 5 – Dividends/Stockholders’ Equity 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] Net income from the Income Statement Ending Retained Earnings Balance = $71,800 Retained earnings is one type of claim against the net assets (assets less liabilities); it is not cash

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

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

LO 6 – BASIC CONCEPTS Going concern (continuity) Materiality 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

LO 6 – BASIC CONCEPTS Cost-benefit Apply established criteria, (like 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 GAAP may contain deviations justified by cost-benefit considerations

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

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

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?

LO 7 – FINANCIAL RATIOS How much of the period’s earnings “belong” to the common shareholders? Net Income EPS = Average number of common shares outstanding 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)

Earnings per share of common stock LO 7 – FINANCIAL RATIOS How much more is an investor willing to pay for one share of stock than it is earning? Market price per share of common stock P-E Ratio = Earnings per share of common stock 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)

LO 7 – FINANCIAL RATIOS The return to investors when they invest in stocks is twofold: Appreciation in Value Receipt of dividends How much is one share of stock returning to its owners in the form of dividends from the past year? Common dividends per share Dividend-Yield Ratio = Current market price per share

LO 7 – FINANCIAL RATIOS What proportion of net income does a company elect to pay in cash dividends? Common dividends per share Dividend-Payout Ratio = Earnings per share 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

LO 8 – TRADE-OFFS

LO 8 – TRADE-OFFS Trying to make the information provided to Decision Makers (DM) useful Relevance – Will it make a difference to the DM? Predictive Value (helps predict the future) Confirmatory value (confirms/refutes expectations) E.g. Present value of an asset - Land Faithful Representation - is what happened Free of bias, material errors and is neutral E.g. Historical cost of an asset – land Trade-off – Land at what value? Cost or value

LO 8 – TRADE-OFFS Characteristics that enhance relevance and faithful representation Comparability – consistent use of same measures Verifiability – able to be checked for accuracy Timelines – reach DM in time to be useful Understandability – clear and consistent information that avoids undo complexity