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Chapter2,MeasuringIncometoAssessPerformance,LearningObjectives,Afterstudyingthischapter,youshouldbeableto:Explainhowaccountantsmeasureincome.Usetheconceptsofrecognition,matching,andcostrecoverytorecordrevenuesandexpenses.Prepareanincomestatementandshowhowitisrelatedtoabalancesheet.Calculateoperatingcashflowsandshowhowcashflowdiffersfromincome.,LearningObjectives,Afterstudyingthischapter,youshouldbeableto:Accountforcashdividendsandprepareastatementofretainedincome.Computeandexplainearningspershare,price-earningsratio,dividend-yieldratio,anddividend-payoutratio.,IntroductiontoIncomeMeasurement,Incomeisameasurementofaccomplishmentorameansofevaluatingperformance.Allincomeshouldbemeasuredinthesamewayfollowingacommonsetofrules.Usingacommonsetofrulesallowsdecisionmakerstocomparetheperformanceofonecompanywiththatofothercompaniesbecausemeasurementisthesameinallcompanies.,OperatingCycle,Operatingcycle-thetimespanduringwhichcashisusedtoacquiregoodsandservices,whichinturnaresoldtocustomers,whointurnpayfortheirpurchases,withcash,Cash$100,000,MerchandiseInventory$100,000,AccountsReceivable$160,000,Buy,Sell,Collect,TheAccountingTimePeriod,Companiesneedawaytomeasureperformanceoverdiscretetimeperiods.Themostpopularperiodformeasuringincomeisthecalendaryear,butmanycompaniesuseafiscalyear,whichisayearthatendsonadateotherthanDecember31,usuallyatthelowpointinannualbusinessactivity.Companiesalsopreparestatementsforinterimperiods,generallyonaquarterlyormonthlybasis.,RevenuesandExpenses,Revenues(sales)-grossincreasesinownersequityarisingfromincreasesinassetsreceivedinexchangeforthedeliveryofgoodsorservicestocustomersExpenses-decreasesinownersequitythatarisebecausegoodsorservicesaredeliveredtocustomers,RevenuesandExpenses,Income(profit)-theexcessofrevenuesoverexpensesRevenues-Expenses=ProfitRetainedincome-additionalownersequitygeneratedbyincomeorprofitsRevenuesincreaseownersequity.Expensesdecreaseownersequity.,AccrualBasisandCashBasis,Themostcommonwaysofmeasuringincomearetheaccrualbasisandthecashbasis.Accrualbasis-recognizestheimpactoftransactionsforthetimeperiodswhenrevenuesandexpensesoccurevenifnocashchangeshandsCashbasis-recognizestheimpactoftransactionsonlywhencashisreceivedordisbursed,AccrualBasisandCashBasis,Undertheaccrualbasis:Revenuesarerecordedwhenearned.Forexample,asaleonaccountisrecordedasrevenuewhenthetransactiontakesplaceeventhoughthesellerreceivesnocashatthatmoment.Expensesarerecordedwhenincurred.Forexample,apurchaseonaccountisrecordedasanexpensewhenthetransactiontakesplaceeventhoughthebuyerdisbursesnocashatthatmoment.,AccrualBasisandCashBasis,Underthecashbasis:Revenuesarerecordedwhenasaleismadeforcashatthetimewhenthecashchangeshands.Expensesarerecordedwhenapurchaseismadeforcashatthetimewhenthecashchangeshands.,AccrualBasisandCashBasis,Theaccrualbasisisthecurrentstandardforthemeasurementofincome.PresentsamorecompletesummaryofwhathappenedduringtheyearRecognizesrevenueswhentheyareearnedandexpenseswhentheyareincurredMatchescoststorevenues,RecognitionofRevenues,Recognition-atesttodeterminewhetherrevenuesshouldberecordedinthefinancialstatementsforagivenperiodToberecognized,revenuemustbe:Earned-goodsaredeliveredoraserviceisperformedRealized-cashoraclaimtocash(credit)isreceivedinexchangeforgoodsorservices,RecognitionofRevenues,Formostretailers,revenuerecognitionisstraightforwardrevenueisearnedandrealizedatthepointofsale,whichiswhenthecustomerpaysandtakespossessionofthegoods.,RecognitionofRevenues,Forothercompanies,revenuemaybeearnedandrealizedatdifferenttimes.Magazinesubscriptionsarereceivedinadvance,buttherevenueisnotearneduntiltheissuesaredelivered.Suppliesaresenttocustomersthroughoutthemonth,butthecashisnotreceiveduntilthecustomerformallypromisestoacceptthesuppliesandpayforthem.,MatchingandCostRecovery,Twotypesofexpenses:Productcosts-thoselinkedwithrevenueearnedinthesameperiodCostofgoodssoldorsalescommissionsWithoutsalesthereisnocostofgoodssoldorsalescommissions.Periodcosts-thoselinkedwiththetimeperioditselfRentorotheradministrativeexpensesRentispaidevenifnosalesaremade.,MatchingandCostRecovery,Matching-recordingofexpensesinthesametimeperiodastherelatedrevenuesarerecognizedCostrecovery-conceptbywhichsomepurchasesofgoodsorservicesarerecordedasassetsand“expired”laterbecausethecostsareexpectedtoberecoveredinfutureperiodsAnexampleisrentforoneyearpaidinadvance.,MatchingandCostRecovery,Anotherexampleofmatchingandcostrecoveryisdepreciation.Depreciation-thesystematicallocationoftheacquisitioncostoflong-livedassetsorfixedassetstotheexpenseaccountsofparticularperiodsthatbenefitfromtheuseoftheassetsAssetswearoutorareusedupoveraperiodoftime,somoreandmoreoftheiroriginalcostsaretransferredfromassetaccountstoexpenseaccounts.,RecognitionofExpiredAssets,Assetssuchasinventory,prepaidrent,andequipmentmaybeconsideredcoststhatarestoredtobecarriedforwardtofutureperiodsandrecordedasexpensesinthefuture.Ifthesecostsareusedupimmediately,theyareexpensedimmediatelyratherthanbeingcarriedasassetsforsuchashortperiodoftime.,RecognitionofExpiredAssets,Theincomestatementisreallyjustawayofexplainingchangesthatoccurbetweenonebalancesheetdateandanother.Thebalancesheetequationcanbemanipulatedtoshowthatrevenuesandexpensesaresubpartsofownersequity.Theincomestatementcollectsthechangesandcombinestheminoneplace.,RecognitionofExpiredAssets,Expansionofthebalancesheetequation:Assets=Liabilities+OwnersEquityAssets=Liabilities+Paid-inCapital+RetainedIncomeAssets=Liabilities+Paid-inCapital+Revenues-Expenses,TheIncomeStatement,IncomeStatement-areportofallrevenuesandexpensespertainingtoaspecifictimeperiodNetincome-theremainderafterallexpenses(includingincometaxes)havebeendeductedfromrevenueOftenseenasthe“bottomline”Netloss-theexcessofexpensesoverrevenues,TheIncomeStatement,DANIELSCOMPANYIncomeStatementfortheYearEndedJune30,2002Sales$98,600Expenses:Wagesexpense$45,800Rentexpense12,000Utilitiesexpense6,500Depreciationexpense5,000Totalexpenses69,300NetIncome$29,300=,TheIncomeStatement,Theincomestatementmustalwaysindicatetheexactperiodcovered(monthended,quarterended,yearended)becausestatementsareoftenpreparedfordifferenttimeperiods.Decisionmakersinsideandoutsidethecompanyusetheincomestatementtoassessthecompanysperformanceoveraspanoftime.Bytrackingnetincomefromperiodtoperiod,decisionmakerscanevaluatethesuccessoftheperiodsoperations.,RelationshipBetweenIncomeStatementandBalanceSheet,Thebalancesheetprovidesasnapshotofanentitysfinancialpositionataninstantintime.Theincomestatementprovidesamovingpictureofeventsoveraspanoftimeandexplainsthechangesthathavetakenplacebetweenbalancesheetdates.,StatementofCashFlows,Incomedoesnotmeasureanentitysperformanceingeneratingcash,especiallyiftheincomeismeasuredusingtheaccrualbasis.Inaway,accountantsuseboththeaccrualandcashbases.Theaccrualbasisisusedintheincomestatement.Thecashbasisisusedinthestatementofcashflows.,StatementofCashFlows,Statementofcashflows-reportsthecashreceiptsandcashpaymentsofanentityduringaparticularperiodItsummarizesactivityoveraperiodoftime,soitmustbelabeledwiththeexactperiodcovered.Itdetailsthechangesinthecashaccount,muchliketheincomestatementwhichshowschangesinretainedearnings.,AccountingforDividendsandRetainedIncome,RevenuesandexpensesarerecordedintheRetainedIncomeaccount.Netincomeincreasesretainedincome.Netlossesdecreaseretainedincome.,CashDividends,Cashdividends-distributionsofcashtostockholders(owners)thatreduceretainedincomeCompaniespaydividendstoprovidestockholdersareturnontheirinvestments.Althoughcashdividendsdecreaseretainedincome,theyarenottreatedasexpenses.Retainedincomecanbedescribedasthecumulativelifetimeearningsofthecompany,lessitscumulativelifetimelossesanddividends.,CashDividends,Cashdividendsarelimitedbytheamountofcashonhandoravailable.Somecompaniesdonotpaycashdividends.Thesecompaniesretainthecashforfinancingfuturegrowth.Theboardofdirectorsdecidesifandwhencashdividendswillbepaidtostockholders.,RetainedIncomeandCash,Althoughtheexistenceofcashandretainedincomeenablesthepaymentofdividends,theseaccountsarenotnecessarilyrelated.Retainedincomeisaresidualclaim.Ifthecompanywentoutofbusinessandallassetsweresoldforcash,theownerwouldreceiveonlywhatwasleftover(residual)afteralldebtsarepaid.,StatementofRetainedIncome,Statementofretainedincome-liststhebeginningbalanceinRetainedIncome,followedbyadescriptionofanychangesthatoccurred(usuallynetincomeanddividends)duringtheperiodcoveredbythestatement,andtheendingbalanceinRetainedIncome,StatementofRetainedIncome,DANIELSCOMPANYStatementofRetainedIncomefortheYearEndedJune30,2002Retainedincome,July1,2001$108,600Netincomefortheyear29,300Total$137,900Cashdividendsdeclared10,000Retainedincome,June30,2002$127,900=,StatementofRetainedIncome,Often,thestatementofretainedincomeisaddedtothebottomofanincomestatementtoproducethestatementofincomeandretainedincome.Thisstatementcanbeanchoredtothebalancesheetequationasfollows:Assets=Liabilities+Paid-inCapital+RetainedIncome,BeginningBalance,+Revenues-Expenses-Dividends,StatementofRetainedIncome,DANIELSCOMPANYStatementofIncomeandRetainedIncomefortheYearEndedJune30,2002Sales$98,600Expenses:Wagesexpense$45,800Rentexpense12,000Utilitiesexpense6,500Depreciationexpense5,00069,300Netincome$29,300Retainedincome,July1,2001108,600Total$137,900Dividendsdeclared10,000Retainedincome,June30,2002$127,900=,FourPopularFinancialRatios,Literallyhundredsofratioscanbecalculatedfromasetoffinancialstatements.Fourwidelyusedfinancialratios:EarningsperShare(EPS)Price-Earnings(P-E)RatioDividend-YieldRatioDividend-PayoutRatio,EarningsperShare(EPS),EPSisshownonthefaceoftheincomestatement.Earningspershareisthenetincomepercommonshareofstockoutstandingduringaperiod.,Price-Earnings(P-E)Ratio,TheP-Eratiomeasureshowmuchinvestorsarewillingtopayforachancetosharethecompanyspotentialearnings.,Price-Earnings(P-E)Ratio,AhighP-Eratioindicatesthatinvestorspredictthatthecompanysnetincomewillgrowrapidly.Theratioisdeterminedbythemarketplacebecausethemarketpriceofthestockisusedtocomputetheratio.,Dividend-YieldRatio,Thedividend-yieldratiomeasuresdividendspaidforaperiodcomparedtothemarketpricesofthestockonagivenday.,Dividend-YieldRatio,Dividend-PayoutRatio,Thedividend-payoutratiomeasuresthepercentageofearningspersharedistributedintheformofcashdividends.,Dividend-PayoutRatio,TheLanguageofAccountingintheRealWorld,Organizationsusedifferenttermstodescribethesameconceptoraccount.NetIncomeNetEarningsProfitRetainedIncomeRetainedEarningsReinvestedEarningsEarningsretainedforuseinthebusinessProfitemployedinthebusiness,
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