1. Measuring Income to Assess Performance
Lecture 7
(Chapter 2)

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

3. 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

4. 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

5. LO 5 – Dividends/Stockholders’ Equity
Combined Statement of Retained Earnings
and Income Statement
Sales
Deduct expenses:
Cost of goods sold $110,000
Rent ,000
Depreciation
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

6. 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, , , $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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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?

14. 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)

15. 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)

16. 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

17. 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

18. LO 8 – TRADE-OFFS

19. 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

20. 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