1. Measuring Income to Assess Performance
Lecture 6
(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 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

5. 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

6. 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

7. 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

8. 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, –100,000
(cost of goods sold)
Sales on credit , ,000
(sales revenues)

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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)

17. 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

18. 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

19. Calculate Net Income

20. Calculate Net Income (Solution)