Measuring Income to Assess Performance 2006 Prentice Hall

Measuring Income to Assess Performance © 2006 Prentice Hall Business Publishing CHAPTER Introduction to Financial Accounting, 9/e 2 Horngren/Sundem/Elliott/Philbrick

Learning Objectives 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 it is related to a balance sheet © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 2

Learning Objectives After studying this chapter, you should be able to 5. Account for cash dividends and prepare a statement of retained earnings 6. 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, priceearnings ratio, dividend-yield ratio, and dividendpayout ratio 8. Explain how accounting regulators trade off relevance and reliability in setting accounting standards © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 3

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 4

Operating Cycle Starts with Cash $100, 000 Buys Merchandise Inventory $100, 000 Sells Merchandise Accounts Receivable $160, 000 Collects Cash © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 5

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 6

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) © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 7

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 8

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 9

Revenues and Expenses Sales on open account for the entire month of January amount to $160, 000. The cost of the inventory sold is $100, 000 Assets Accounts Receivable Sales = Liabilities + Owners’ Equity Merchandise Inventory +160, 000 Cost of inventory sold © 2006 Prentice Hall Business Publishing -100, 000 Retained Earnings = +160, 000 (sales revenues) = -100, 000 (cost of goods sold expenses) Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 10

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 11

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 12

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 13

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 14

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 15

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 16

Applying Matching The following transaction records depreciation expense Assets = Liabilities + Owners’ Equity Store Equipment = Recognize depreciation expense © 2006 Prentice Hall Business Publishing -100 = Introduction to Financial Accounting, 9/e Retained Earnings -100 (increase depreciation expense) Horngren/Sundem/Elliott/Philbrick 17

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 18

Recognition of Expired Assets Acquisition Assets (Unexpired costs, such as Inventory, Prepaid Rent, Equipment) © 2006 Prentice Hall Business Publishing Expiration Instantaneously Or Eventually Become Introduction to Financial Accounting, 9/e Expenses (Expired costs, such as Cost of Goods Sold, Rent, Depreciation, Other Expenses) Horngren/Sundem/Elliott/Philbrick 19

Expanded Balance Sheet Equation (1) Assets = Liabilities + Stockholders’ Equity (2) Assets = Liabilities + Paid-in Capital + Retained Earnings (3) Assets = Liabilities + Paid-in Capital + Revenues - Expenses © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 20

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 21

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 22

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 23

Relationship Between Income Statement and Balance Sheet December 31 20 X 1 Balance Sheet February 28 20 X 2 Balance Sheet January 31 20 X 2 Income Statement For January Income Statement For February Balance Sheet March 31 20 X 2 Income Statement For March Time Income Statement for Quarter Ended March 31, 20 X 2 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 24

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 25

Cash Dividends Cash dividends of $50, 000 are disbursed to stockholders Declaration and payment of cash dividends Assets = Liabilities + Stockholders’ Equity Cash = -50, 000 = © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Retained Earnings -50, 000 (dividends) Horngren/Sundem/Elliott/Philbrick 26

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 27

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 28

Statement of Retained Earnings • The statement of retained earnings consists of the Beginning balance + Addition of net income - Deduction of dividends = Ending balance • A net loss (negative net income) is subtracted from the beginning balance of retained earnings • Negative retained earnings is called an accumulated deficit © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 29

Statement of Retained Earnings Retained earnings, January 31, 20 X 2 Add: Net income for February Total Less: Dividends declared Retained earnings, February 28, 20 X 2 $ 57, 900 63, 900 $121, 800 50, 000 $ 71, 800 • 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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 30

Statement of Retained Earnings Sales Deduct expenses: Cost of goods sold $110, 000 Rent 2, 000 Depreciation 100 Net income Retained earnings, January 31, 20 X 2 Total Less: Dividends declared Retained earnings, February 28, 20 X 2 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e $176, 000 112, 100 $ 63, 900 57, 900 $121, 800 50, 000 $ 71, 800 Horngren/Sundem/Elliott/Philbrick 31

Statement of Retained Earnings • 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] Ending Retained Earnings Balance = $71, 800 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 32

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 33

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 34

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 35

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 36

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 37

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 38

Earnings Per Share (EPS) Net Income EPS = Average number of shares outstanding • 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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 39

Price-Earnings (P-E) Ratio P-E Ratio = Market price per share of common stock Earnings per share of common stock • 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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 40

Dividend-Yield Ratio Common dividends per share Dividend-Yield Ratio = Current market price of stock • 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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 41

Dividend-Payout Ratio = Common dividends per share Earnings per share • 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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 42

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 43

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 44

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 45

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 46

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 47

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 © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 48

Aspects of Decision Usefulness Predictive Value Feedback Value Consistency Relevance Timeliness © 2006 Prentice Hall Business Publishing Decision Usefulness Comparability Introduction to Financial Accounting, 9/e Verifiability Reliability Neutrality Validity Horngren/Sundem/Elliott/Philbrick 49