©© 2010 Pearson Education Inc. Publishing as Prentice Hall 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Introduction to Financial Accounting, 10/e
Measuring Income to Assess
Performance
CHAPTER
2
©© 2010 Pearson Education Inc. Publishing as Prentice Hall 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Introduction to Financial Accounting, 10/e
Learning Objectives (LO)
After studying this chapter, you should be able to1. Explain how accountants measure income2. Determine when a company should record revenue
from a sale3. Use the concept of matching to record the expenses
for a period4. Prepare an income statement and show how it is
related to a balance sheet
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©© 2010 Pearson Education Inc. Publishing as Prentice Hall 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Introduction to Financial Accounting, 10/e
Learning Objectives (LO)
After studying this chapter, you should be able to5. Account for cash dividends and prepare a statement
of stockholders’ equity6. Explain how the following concepts affect financial
statements: entity, reliability, going concern, materiality, cost-benefit, and stable monetary unit
7. Compute and explain earnings per share, price-earnings ratio, dividend-yield ratio, and dividend-payout ratio
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LO 1 - Measuring Income
• Income – key measure of performance and value; measure of increase in wealth over a period of time– Calendar year vs. Fiscal year– Interim reports vs. Annual reports– Operating cycle – average time taken by a firm in
converting merchandize or raw material back into cash
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LO 1 - Measuring Income
• Revenues – are increases in assets received in exchange for the delivery of goods or services to customers. Revenues increase owners' equity.
• Expenses – are decreases in assets as a result of goods or services being delivered to customers. Expenses decrease owners' equity.
• Income (profit, earnings) – excess of revenues over expenses in a reporting period.
• Retained Earnings – total cumulative owners’equity generated by income or profits.
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LO 1 - Measuring Income
• Cash Basis – revenues are recognized when a company receives cash and expenses are recognized when a company pays cash.– Ignores activities that increase or decrease assets other
than cash
• Accrual Basis – revenues are recorded as they are earned and expenses are recorded as they are incurred, regardless whether cash changes hands.– Ignores that a company can go bankrupt if it does not
manage its cash properly, no matter how well it seems to be doing according to the other financial statements
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LO 1 - Measuring Income
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• 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 = Liabilit ies + Owners’ Equity
Accounts Merchandise RetainedReceivable Inventory Earnings
Cost of inventory sold –100,000 –100,000(cost of goods sold)
Sales on credit +160,000 +160,000(sales revenues)
©© 2010 Pearson Education Inc. Publishing as Prentice Hall 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Introduction to Financial Accounting, 10/e
LO 2 - Revenues Recognition
• Criteria to recognize revenues:– Revenues must be earned - All (or substantially all)
of the goods or services the customer wants have been delivered to and accepted by customers
– Revenues must be realized or realizable - Cash or a formal promise by the customer to pay cash has been received for the goods or services delivered
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LO 3 - Matching
• Matching – the process of recognizing and recording expenses in the same period the related revenues are recognized.
• Product costs – are linked with product revenues earned in that period (e.g. cost of goods, commissions, etc).
• Period costs – are linked to a period of time itself and are recorded in the period incurred (e.g. rent, admin. salaries, etc.)
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LO 3 - Matching
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AssetsUnexpired costs(e.g. Inventory, Prepaid Rent,
Equipment)
ExpensesExpired costs
(e.g. Cost of Goods Sold, Rent,
Depreciation, etc.)
Acquisition Expiration
InstantaneouslyOr Eventually
Become
Cost Recovery Concept – Assets are unexpired costs held back from expense and carried forward to future periods in the balance sheet.
©© 2010 Pearson Education Inc. Publishing as Prentice Hall 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Introduction to Financial Accounting, 10/e
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
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LO 4 – Income Statement
• Balance sheet – presents financial position at discrete points in time, e.g. fiscal year end.
• Income statement (Statement of Earnings, Operations, Profit and Loss) – presents changes that took place between those points in time attributable to the performance of management.
• Net Income – important measure of managerial performance.
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LO 5 – Dividends/Stockholders’ Equity
• Retained earnings increase as profits accumulate and decrease when a net loss occurs or as company pays cash dividends.
• Cash dividends are distributions of assets that reduce a portion of the ownership claim.
• Cash dividends are not expenses, and, therefore, are not deductible.
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LO 5 – Dividends/Stockholders’ Equity
• Statement of Stockholders’ Equity shows all changes in each stockholders’ equity account during the reporting period.
• Changes in Stockholders’ Equity arise from three main sources.– net income / loss– transactions with shareholders (payment of dividends,
repurchases or sale of own stock)– other comprehensive income
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LO 6 – BASIC CONCEPTSThere are a number of concepts and conventions that guide the accounting process:
•Entity Concept – an economic entity is separate from its owners or other organizations
•Reliability Concept – assures decision makers that the information presented captures the conditions or events it claims to represent
•Going Concern Convention – assumes that the entity will continue to exist indefinitely
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LO 6 – BASIC CONCEPTS
• Materiality Convention – states that an item should be included in the financial statements, or is material, if its omission or misstatement would tend to mislead the reader
• 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 7 – FINANCIAL RATIOS
• Basic EPS vs. Diluted EPS– Basic (no additional shares)– Diluted (rights are exercised to buy more shares)
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Net IncomeAverage number of common shares outstanding
EPS =
How much of the period’s net income “belongs”to each share of common stock?
Earnings Per Share - EPS
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LO 7 – FINANCIAL RATIOS
• P-E ratio is determined in the marketplace as company ’s share price is established in the market.
• P-E ratio indicates investor’s predictions about the company ’s future net income.
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Market price per share of common stock
Earnings per share of common stockP-E Ratio =
How much the investors are willing to pay for a chance to share the company’s potential earnings?
Price-Earnings Ratio – P/E (Earnings Multiple)
©© 2010 Pearson Education Inc. Publishing as Prentice Hall 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e Introduction to Financial Accounting, 10/e
LO 7 – FINANCIAL RATIOS
• The return to investors when they invest in stocks takes two forms:– Cash dividends– Increases in the market price
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Current market price per shareCommon dividends per share
Dividend-Yield Ratio =
How much is one share of stock returning to itsowners in the form of dividends from the past year?
Dividend-Yield Ratio
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LO 7 – FINANCIAL RATIOS
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Common dividends per share
Earnings per shareDividend-Payout Ratio =
What proportion of net income does a companyelect to pay in cash dividends?
Dividend-Payout Ratio
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