Measuring Income to Assess Performance

CHAPTER 
2
Learning Objectives
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
After studying this chapter, you should be able to
•	Account for cash dividends and prepare a statement of retained earnings
•	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
Measuring Income
•	Income is a measure of the increase in the “wealth” of an entity over a period of time
•	Accountants have agreed on a common set of rules for measuring income and wealth
•	Income is generated primarily through the operating cycle
Operating Cycle
The Accounting Time Period
•	Companies measure their performance over discrete time periods
•	The calendar year is the most common time period for measuring income or profits
•	About 40% of large companies use a fiscal year that differs from a calendar year
The Accounting Time Period
•	The fiscal year-end date is often the low point in annual activity when inventories can be counted more easily
•	Companies also prepare financial statements for interim periods
•	Interim periods may be for a month or a quarter (3-month period)
Revenues and Expenses
•	Revenues and expenses are the key inflows and outflows of assets that occur during a business’s operating cycle
•	Revenues are the amount of assets received in exchange for the delivery of goods or services to customers
•	Expenses are measures of the assets that a company gives up or consumes in order to deliver goods or services to a customer
Revenues and Expenses
•	Income is the excess of revenues over expenses
•	Profits or earnings are common synonyms for income
•	Retained earnings is the total cumulative equity generated by income

Revenues and Expenses
Revenues and Expenses
•	Accounts receivable are the amounts owed by customers as a result of delivering goods or services on account in the ordinary course of business
•	Cost of goods sold expense is the original acquisition cost of the inventory that a company sells to customers during the reporting period
Accrual Basis and Cash Basis
•	The accrual basis recognizes the impact of transactions in the financial statements for the time periods when revenues and expenses occur
•	Accountants record revenue as a company earns it, and they record expenses as the company incurs them
Accrual Basis and Cash Basis
•	The cash basis recognizes the impact of transactions in the financial statements only when a company receives or pays cash
•	The accrual basis is the best basis for measuring economic performance
Recognition of Revenues
•	Revenues are recognized when they
–	Are earned
•	A company earns revenues when it delivers goods or services to customers
–	And are realized
•	A company realizes revenues when it receives cash or claims to cash in exchange for goods or services
Matching
•	There are two kinds of expenses in every accounting period:
–	Product costs are those linked with the revenues earned that period
–	Period costs are those linked with the time period itself
•	Matching occurs when the expenses incurred in a period are matched to the revenues generated in the same period
Applying 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
Applying Matching
Applying Matching
•	We can account for the purchases and uses of goods and services in two basic steps:
–	The acquisition of the assets
–	The expiration of the assets as expenses
•	Expense accounts are deductions from stockholders’ equity
Recognition of Expired Assets
Expanded Balance Sheet Equation
Expanded Balance Sheet Equation
•	The income statement collects all the changes in owners’ equity for the accounting period and combines them in one place
•	Revenue and expense accounts are nothing more than subdivisions of stockholders’ equity – temporary stockholders’ equity accounts
The Income Statement
•	An income statement is a report of all revenues and expenses pertaining to a specific time period
•	Net income = revenues minus all expenses
•	A net loss occurs if expenses exceed revenues
Relationship Between Income Statement and Balance Sheet
•	A balance sheet shows the financial position of the company at a discrete point in time 
•	An income statement explains the changes that take place between those points in time
Relationship Between Income Statement and Balance Sheet
Cash Dividends
•	Cash dividends 
–	Are distributions of some of the company’s assets (cash) to stockholders 
–	Reduce Cash and Retained Earnings
–	Are not expenses—they are transactions with stockholders
Cash Dividends
Cash Dividends
•	A cash dividend involves three important dates:
–	Declaration date—the date on which the board declares the dividend
–	Record date—stockholders owning the stock on this date receive the dividend
–	Payment date—the date on which the corporation pays the dividend
Retained Earnings and Cash
•	In order to pay a cash dividend, a corporation needs
–	Cash
–	Retained Earnings
•	Cash and Retained Earnings are two entirely separate accounts, sharing no necessary relationship
•	Retained earnings is a residual claim, not a pot of gold
Statement of Retained Earnings
•	The statement of retained earnings consists of the

•	A net loss (negative net income) is subtracted from the beginning balance of retained earnings
•	Negative retained earnings is called an accumulated deficit
Statement of Retained Earnings
•	Some companies add the statement of retained earnings to the bottom of the income statement
•	The next slide shows a combined statement of income and retained earnings

Statement of Retained Earnings
Statement of Retained Earnings
•	Note how the combined statement of income and retained earnings is anchored to the balance sheet equation

The Entity Concept
•	An accounting entity is an organization that stands apart from other organizations and individuals as a separate economic unit
•	Personal transactions are not recorded by a business entity
The Reliability Concept
•	Reliability is the quality of information that assures decision makers that the information captures the conditions or events it purports to represent
•	Reliable data can be verified by independent auditors
•	Only certain types of events can be reliably recorded as accounting transactions
Going Concern Convention
•	The going concern (continuity) convention is the assumption that an entity will continue to exist indefinitely
•	For a going concern, it is reasonable to
–	Use historical cost to record long-lived assets
–	Report liabilities at the amount to be paid at maturity

Materiality Convention
•	The materiality convention asserts that an item should be included in a financial statement if its omission or misstatement would tend to mislead the reader of the financial statements under consideration 
•	Many acquisitions that a company theoretically should record as assets are immediately written off as expenses because they are not material
Cost-Benefit Criterion
•	The cost-benefit criterion states that a system should be changed when the expected additional benefits of the change exceed its expected additional costs
•	The FASB safeguards the cost-effectiveness of its standards by
–	Assuring that a standard does not impose costs on the many for the benefit of a few
–	Seeking alternative ways of handling an issue that are less costly and only slightly less efficient
Stable Monetary Unit
•	The ability to use historical cost accounting depends on a stable monetary unit
•	A stable monetary unit is one that is not expected to change in value significantly over time
•	With low levels of inflation, changes in the value of the monetary unit do not hinder accounting rules
Earnings Per Share (EPS)
•	EPS tells investors how much of a period’s net income “belongs to” each share of common stock
•	Investors should predict a company’s future EPS before deciding whether to buy the company’s common shares
Price-Earnings (P-E) Ratio
•	The P-E ratio measures how much the investing public is willing to pay for a chance to share the company’s potential earnings
•	A high P-E ratio indicates that investors predict the company’s net income will grow rapidly
Dividend-Yield Ratio
•	The dividend-yield ratio gauges dividend payouts
•	Investors in common stock who seek regular cash returns of their investments pay particular attention to dividend-yield ratios
Dividend-Payout Ratio
•	The dividend-payout ratio shows what proportion of net income a company elects to pay in cash dividends to its shareholders
•	Many companies elect to pay a reasonably constant dollar amount in dividends, even if this means variations in its dividend-payout ratio
Cost-Benefit Criterion and 
Accounting Regulation
•	Accounting information is 
–	A benefit or economic good
–	Costly to produce
•	The FASB and the IASB must choose rules whose decision-making benefits exceed their costs
Aspects of Decision Usefulness
•	Relevance and reliability are the two main qualities that make accounting information useful for decision making
•	Reliability is a quality of information that captures the conditions or events it purports to represent
•	Relevance refers to whether the information makes a difference to the decision maker
Aspects of Decision Usefulness
•	Accounting is filled with trade-offs between relevance and reliability
•	Historical cost is reliable, but not very relevant
•	The current value of land is more relevant than historical cost, but estimates of the current value are subjective and may not be reliable

Aspects of Decision Usefulness
•	For information to be relevant, it must help decision makers predict the outcomes of future events (predictive value) or confirm or update past predictions (feedback value)
•	Relevant information must also be available on a timely basis
Aspects of Decision Usefulness
•	Reliability is characterized by verifiability for objectivity, neutrality, and validity
•	Verifiability means that information can be checked to make sure it is correct
•	Validity (also called representational faithfulness) means the information provided represents the events or objects it is supposed to represent
Aspects of Decision Usefulness
•	Neutrality, or freedom from bias, means that information is objective and is not weighted unfairly
•	Comparability requires all companies to use similar concepts and measurements
•	Consistency requires conformity within a company from period to period with unchanging policies and procedures
Aspects of Decision Usefulness