Download Income - Moodle Lille 2

Measuring Income
to Assess
Performance
© 2010 Pearson Education Inc. Publishing as Prentice Hall
CHAPTER
2
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
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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, priceearnings ratio, dividend-yield ratio, and dividendpayout ratio
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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
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LO 1 - Measuring Income
• Income – increase in wealth over time
• Basic accounting equation + specific accounts
+ OWNERS’ EQUITY
ASSETS = LIABILITIES
Cash
Accounts Payable
Accounts Receivable Notes Payable
Prepaid items
Equipment
Building
Land
Paid in Capital
Retained (Income = $60,000)
Revenue $160,000
Expenses $100,000
Gains
Losses
Distributions to owners
Dividends
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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
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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
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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
Receivable Inventory
Cost of inventory sold
Sales on credit
+160,000
© 2010 Pearson Education Inc. Publishing as Prentice Hall
–100,000
Retained
Earnings
–100,000
(cost of goods sold)
+160,000
(sales revenues)
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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
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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
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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
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LO 3 - Matching
On Acquisition
On Expiration
Expenses
Assets
Unexpired costs
such as Inventory,
Prepaid Rent,
Equipment
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Instantaneously
Or Eventually
Become
Expired costs,
such as
Cost of Goods Sold,
Rent, Depreciation,
Other Expenses)
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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
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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
Cash
Equipment
14,000
+ 14,000
= Liabilities + Paid in
Capital
–100 *
+
Retained Earnings
–100 Depreciation
Expense
* $14,000 / 140 months expected life = $100 per month
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LO 4 – Income Statement
• Income – increase in wealth over time
• Basic accounting equation + specific accounts
ASSETS =
LIABILITIES + OWNERS’ EQUITY
Cash
Accounts Payable
Accounts Receivable Notes Payable
Prepaid items
Equipment
Building
Land
Paid in Capital
Retained Earnings
Revenue
Expenses
Gains (later)
Losses (later)
Distributions to owners
Dividends
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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)
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LO 4 – Income Statement
Balance Sheet
December 31
20X1
Balance Sheet
February 28
20X2
Balance Sheet
January 31
20X2
Income
Statement
For January
Income
Statement
For February
Balance Sheet
March 31
20X2
Income
Statement
For March
Time
Time
Income Statement for Quarter Ended March 31, 20X2
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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
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LO 5 – Dividends/Stockholders’ Equity
Name of Company
Statement of Stockholders’ (Shareholders’) Equity
For the period Jan 1, 20X1 to 20X3
1/1/20X1
Paid-in
Retained
Comprehensive
Capital
Earnings
Income (Chap 11)
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
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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
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$176,000
112,100
$ 63,900
57,900
$ 121,800
50,000
$ 71,800
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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
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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
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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
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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
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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
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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
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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
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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?
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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)
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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)
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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
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LO 7 – FINANCIAL RATIOS
What proportion of net income does a company
elect to pay in cash dividends?
Dividend-Payout Ratio =
Common dividends per share
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
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