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CHAPTER
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 how it is related to a balance sheet
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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
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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
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Operating Cycle
Buys Merchandise
Sells Merchandise
Collects Cash
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Merchandise Inventory
Sales
Cost of inventory sold
+160,000
-100,000
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Cost of goods sold expense is the original acquisition cost of the inventory that a company sells to customers during the reporting period
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Accountants record revenue as a company earns it, and they record expenses as the company incurs them
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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
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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
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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
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Applying Matching
The following transaction records depreciation expense
Assets Store Equipment = Liabilities + Owners Equity = Retained Earnings
-100
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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
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(2) Assets
(3) Assets
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Time
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Cash Dividends
Cash dividends
Are distributions of some of the companys assets (cash) to stockholders Reduce Cash and Retained Earnings Are not expensesthey are transactions with stockholders
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Cash Dividends
Cash dividends of $50,000 are disbursed to stockholders
Assets Cash
Declaration and payment of cash dividends
-50,000
-50,000 (dividends)
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Cash Dividends
A cash dividend involves three important dates:
Declaration datethe date on which the board declares the dividend Record datestockholders owning the stock on this date receive the dividend Payment datethe date on which the corporation pays the dividend
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Cash and Retained Earnings are two entirely separate accounts, sharing no necessary relationship Retained earnings is a residual claim, not a pot of gold
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A net loss (negative net income) is subtracted from the beginning balance of retained earnings Negative retained earnings is called an accumulated deficit
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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
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$176,000
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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
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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
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EPS tells investors how much of a periods net income belongs to each share of common stock Investors should predict a companys future EPS before deciding whether to buy the companys common shares
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The P-E ratio measures how much the investing public is willing to pay for a chance to share the companys potential earnings A high P-E ratio indicates that investors predict the companys net income will grow rapidly
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Dividend-Yield Ratio
Dividend-Yield Ratio = Common dividends per share 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
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Dividend-Payout Ratio
Common dividends per share Dividend-Payout Ratio = 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
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The FASB and the IASB must choose rules whose decision-making benefits exceed their costs
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Feedback Value
Relevance
Decision Usefulness
Reliability
Neutrality
Timeliness
Comparability
Validity
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