Measuring Income to Assess Performance Lecture 6 (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 1 - Measuring Income Income – increase in wealth over time Calendar year – Jan 1 to Dec 31 Fiscal year – Start anytime; end 365 days later (busy) Annual financial reports Interim periods – weekly, monthly, quarterly Quarterly (3 months) financial reports Operating cycle – time lapse between

LO 1 - Measuring Income Income – increase in wealth over time Basic accounting equation + specific accounts ASSETS = LIABILITIES + OWNERS’ EQUITY Cash Accounts Payable Paid in Capital Accounts Receivable Notes Payable Retained (Income = $60,000) Prepaid items Revenue $160,000 Equipment Expenses $100,000 Building Gains (later) Land Losses (later) Distributions to owners Dividends

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 (later) – unusual and/or infrequent Retained Earnings – income less dividends since the inception of the business

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

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 Accounts Merchandise Retained Receivable Inventory Earnings Cost of inventory sold –100,000 –100,000 (cost of goods sold) Sales on credit +160,000 +160,000 (sales revenues)

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

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

LO 3 - Matching Expenses Matching 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

LO 3 - Matching Expired costs, Unexpired costs such as Acquisition Expiration Expenses Expired costs, such as Cost of Goods Sold, Rent, Depreciation, Other Expenses) Assets Unexpired costs such as Inventory, Prepaid Rent, Equipment Instantaneously Or Eventually Become

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 - $2,000

LO 3 - 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 Assets = Liabilities + Paid in Capital + Retained Earnings Cash Equipment 14,000 + 14,000 –100 * –100 Depreciation Expense * $14,000 / 140 months expected life = $100 per month

LO 4 – Income Statement Income – increase in wealth over time Basic accounting equation + specific accounts ASSETS = LIABILITIES + OWNERS’ EQUITY Cash Accounts Payable Paid in Capital Accounts Receivable Notes Payable Retained Earnings Prepaid items Revenue Equipment Expenses Building Gains (later) Land Losses (later) Distributions to owners Dividends

LO 4 – Income Statement Balance sheet - financial position/condition at discrete points in time, e.g. fiscal year end Income statement (AKA: 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 (later) Net income (loss)

Income Statement for Quarter Ended March 31, 20X2 LO 4 – Income Statement 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 Time Income Statement for Quarter Ended March 31, 20X2

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 Circumstances have, do, and will occur where Honest disagreements occur Window dressing opportunities will tempt some A few will go too far and commit illegal acts

Calculate Net Income

Calculate Net Income (Solution)