|




 
  

Learning Objectives
 Explain how accountants measure income.

 Use the concepts of recognition, matching, and cost

recovery to record revenues and expenses.

 Prepare an income statement and show how it is related to a

balance sheet.

 Calculate operating cash flows and show how cash flow

differs from income.

 Account for cash dividends and prepare a statement of

retained income.

 Compute and explain earnings per share, price-earnings

ratio, dividend-yield ratio, and dividend-payout ratio.
Ontroduction to Oncome
Measurement
 Oncome is a measurement of accomplishment or a means of
evaluating performance.

 Performance is indicated by profitability, which is the

excess of sales over expenses.

0 All income should be measured in the same

way following a common set of rules.

0 Using a common set of rules allows decision

makers to compare the performance of one
company with that of other companies
because measurement is the same in all
companies.
Operating Cycle
 !perating cycle - the time span during which cash
is used to acquire goods and services, which in
turn are sold to customers, who in turn pay for
their purchases, with cash.

Buy Sell
Cash Merchandise Accounts
$100,000 Onventory Receivable
$100,000 $160,000

Collect
he Accounting ime Period
 Companies need a way to measure performance
over discrete time periods.

 Calendar year is the most popular time period for

measuring performance.

0 -owever many companies use a period for

measuring income which is not the calendar year
but a year that ends on a date other than
December 31, and is called a fiscal year

0 Usually Fiscal year end date is a low point in

annual business activity.

0 Companies also prepare statements

for interim periods, generally on a
quarterly or monthly basis.
Revenues and Expenses: he key
components for measuring income
 ºevenue and expenses are inflow and outflow of
assets that occur during a business¶s operating
cycle
 ºevenues/ Sales ºevenue/Sales ±increases in
owners¶ equity arising from
increases in assets received in
exchange for the delivery of
goods or services to customers
 Expenses - decreases in owners¶ equity that arise
because goods or services are delivered to
customers
Revenues and Expenses
 Oncome/ Profit/ Earnings - the excess of
revenues over expenses

ºevenues - Expenses = Profit

0 ºevenues increase owners¶ equity.

0 Expenses decrease owners¶ equity.

 he total, cumulative owner¶s equity

generated by income or profits is called
ºetained earnings or ºetained Oncome
 Assets = Liabilities + Owner¶s Equity

Assets = Liabilities + Paid up Capital + Retained Earnings

Assets = Liabilities + Paid up capital + Revenues - Expenses

Methods of Measuring
Oncome:

Accrual Basis
Vs
Cash Basis
Accrual Basis and Cash Basis
 he most common ways of measuring income are
the accrual basis and the cash basis.

 Accrual basis - recognizes the impact of

transactions for the time periods when
revenues and expenses `
 even if no cash
changes hands

 Cash basis - recognizes the impact of

transactions only when cash is received or
disbursed
 Accrual Basis and Cash Basis
 Under the accrual basis:

0 ºevenues are recorded when earned.

For example, a sale on credit is recorded as revenue
when the transaction takes place even though the
seller receives no cash at that moment.

0 Expenses are recorded when incurred.

For example, a purchase on credit is recorded as an
expense when the transaction takes place even though
the buyer disburses no cash at that moment.
Accrual Basis and Cash Basis
 Under the cash basis:
0 ºevenues are recorded when a sale is made
for cash at the time when the cash changes
hands.
0 Expenses are recorded when a purchase is
made for cash at the time when the cash
changes hands.
E.g.: Sales= Rs.1,00,000(50% on credit), Cost of
Goods Sold =Rs.60,000 (20% unpaid), Other
Expenses =Rs.30,000(10% unpaid)

Accrual Cash Basis

Basis
Sales 1,00,000 50,000
Less: C! S 60,000 48,000
Less: Expenses 30,000 27,000
Net Profit/Loss 10,000 (25,000)
|
 

 

Oncome Statement is prepared on Accrual basis

Cash Flow Statement is prepared on Cash basis

Recognition of Revenues
 ºecognition - a test to determine whether
revenues should be recorded in the
financial statements for a given period or
not.
 o be recognized, revenue must be:
0 Earned - goods are delivered or a service is
performed
0 ºealized - cash or a claim to cash is received
in exchange for goods or services
Recognition of Revenues
 For most retailers, revenue recognition is
straightforward ± revenue is earned and
realized at the point of sale, which is
when the customer pays and takes
possession of the goods.
Recognition of Revenues
 Forother companies, revenue may
be earned and realized at different
times.
0 Magazine subscriptions are received in
advance, but the revenue is not earned until
the issues are delivered.

0 Supplies are sent to customers throughout the

month, but the cash is not received until the
customer formally promises to accept the
supplies and pay for them.
Oncome can arise from 3 sources‰

1. Sale of oods

2. ºendering of Services
-Proportionate completion method
- Complete service contracts method

3. Use of enterprise resources by others

(revenue earned in the form of interest, royalties
and dividends)
ypes of Expenses/ Costs

 Productcosts - those linked with

revenue earned in the same period
0 Cost of goods sold or sales commissions
Without sales there is no cost of goods sold
or sales commissions.

 Periodcosts - those linked with the

time period itself
0 ºent or other administrative expenses
ºent is paid even if no sales are made.
Matching Of Costs with Revenues
W-EN S-!ULD -E EXPENSES BE

ºEC! NO
ED?????????????????

 Matching - recording of expenses in the same

time period as the related revenues are
recognized

 Product Costs are recognized when respective

revenues are produced.

 Period costs are recognized in the period in

which they occur.
 Expired Cost
- Ot is an expense

Cost/
Expense

Unexpired Cost
-Ot is an asset
-Ot becomes an expense
when it gets expired
Cost Recovery

 Costrecovery - concept by which

some purchases of goods or
services are recorded as assets and
³expired´ later because the costs are
expected to be recovered in future
periods

0 An example is rent paid in advance

Matching and Cost Recovery
 Another example of matching and cost recovery
is depreciation.

0 Depreciation - the systematic allocation of the

acquisition cost of long-lived assets or fixed
assets to the expense accounts of particular
periods that benefit from the use of the assets

0 Land is not subject to depreciation

0 Assets wear out or are used up over a period

of time, so more and more of their original
costs are transferred from asset accounts to
expense accounts

Recognition of Expired Assets
 Assets such as inventory, prepaid rent, and
equipment may be considered costs that are
stored to be carried forward to future periods and
recorded as expenses in the future.

0 Of these costs are used up immediately, they are

expensed immediately rather than being carried
as assets for such a short period of time.
Recognition of Expired Assets

Acquisition
Assets Expiration
(Unexpired costs Expenses
such (such as COGS,
as inventory, rent, deprecation,etc
prepaid rent,
equipment)
Recognition of Expired Assets
 he income statement is really just a way of
explaining changes that occur between one
balance sheet date and another.

 he balance sheet equation can be

manipulated to show that revenues and
expenses are subparts of owners¶ equity.

0 he income statement collects the

changes and combines them in one
place.
 Oncome Statement
or
Statement of Earnings
or
Operating Statement
or
Profit and Loss Account
he Oncome Statement
 Oncome Statement - a report of all revenues and
expenses pertaining to a specific time period

 Net income/ net earnings/Net profit - the remainder

after all expenses (including income taxes) have
been deducted from revenue
0 !ften called the ³B!!M LONE´

 Sales are called !P LONE

 Net loss - the excess of expenses over revenues

 he Oncome Statement
DANOELS C!MPANY
Oncome Statement
for the Year Ended December 31, 2008

Sales $98,600

Expenses:
C! S $45,800
ºent expense 12,000
Wage expense 6,500
Depreciation expense 5,000
otal expenses 69,300
Net Oncome $29,300
==============
he Oncome Statement
 he income statement must always indicate the
exact period covered (month ended, quarter
ended, year ended) because statements are often
prepared for different time periods.

 Decision makers inside and outside the company

use the income statement to assess the
company¶s performance over a span of time.

0 By tracking net income from period to period,

decision makers can evaluate the success of
the period¶s operations.
Relationship Between Oncome
Statement and Balance Sheet
 he balance sheet provides a snapshot of an
entity¶s financial position at an instant in time.

 he income statement ?` 

`?

` ` ? ` 
 and explains the
changes that have taken place between balance
sheet dates.
Relationship Between Oncome
Statement and Balance Sheet

Balance Sheet on Balance Sheet on

31st Dec, 2006 31st Dec, 2007

Oncome Statement for

the year ended Dec 31,2007


 
 Accounting for Dividends
and Retained Oncome
 ºevenues and expenses are recorded
in the ºetained Oncome account.

0 Net income increases retained income

Net losses decrease retained income.

Cash Dividends
 Cash dividends - distributions of cash to
stockholders (owners)  
 
 `

0 Companies pay dividends to provide
stockholders a return on their investments.

 Although cash dividends decrease

retained income, they are `   
?
Cash Dividends
 Cash dividends are limited by the amount of cash
on hand or available.

 Some companies do not pay cash dividends.

0 hese companies retain the cash for financing
future growth.

 he board of directors decides if and when cash

dividends will be paid to stockholders.

 Distribution of cash dividends decreases

retained earnings
Statement of Retained Oncome
Ot lists the beginning balance in ºetained Oncome,
followed by a description of any changes that
occurred (usually net income and dividends)
during the period covered by the statement, and
the ending balance in ºetained Oncome
Statement of Retained Oncome
0 his statement can be anchored to the balance
sheet equation as follows‰

Assets = Liabilities + Paid-in Capital + ºetained Oncome

Beginning
Balance + Revenues - Expenses - Dividends
Statement of Retained Oncome
DANOELS C!MPANY
Statement of ºetained Oncome
for the Year Ended December 31, 2008

ºetained income, Jan 1, 2008 $108,600

Add: Net income for the year 29,300

otal $137,900
Less: Cash dividends declared 10,000

ºetained income, Dec 31, 2008 $127,900

===============
Statement of Retained Oncome

the statement of retained

 !ften,
income is added to the bottom of an
income statement to produce the
Statement of Oncome and ºetained
Oncome.
Statement of Oncome and Retained Oncome
DANOELS C!MPANY
Statement of Oncome and ºetained Oncome
for the Year Ended December 31, 2008
Sales $ 98,600
Expenses:
C! S expense $45,800
ºent expense 12,000
Wage expense 6,500
Depreciation expense 5,000 69,300
Net income $ 29,300
ºetained income, Jan 1, 2008 108,600
otal $137,900
Dividends declared 10,000
ºetained income, Dec 31, 2008 $127,900
==============
Financial Ratios/ Ratio Analysis

ºatio analysis involves methods of

calculating and interpreting financial
ratios to analyze and monitor a firm¶s
performance.

 Net Profit of WOPº! Company is ºs.10 Million????????

 Onfosys declared a dividend of ºe.1 per share?????????
Four Popular Financial Ratios
 Literally hundreds of ratios can be calculated
from a set of financial statements.

 Four widely used financial ratios:

0 Earnings per Share (EPS)
0 Price-Earnings (P-E) ºatio
0 Dividend-Yield ºatio
0 Dividend-Payout ºatio
Earnings per Share (EPS)
 Earnings per share is the net income per common
share of stock outstanding during a period.

 
 ë

u 

   
 
 u
Price-Earnings (P-E) Ratio
 heP-E ratio measures how much
investors are willing to pay for a
chance to share the company¶s
potential earnings.

  
 a

  
 ë

 a  a


 

 A high P-E ratio indicates that investors predict that the
company¶s net income will grow rapidly.

 he ratio is determined by the marketplace because the

market price of the stock is used to compute the ratio.
 Since it uses Market price of share, hence this ration keeps
on varying throughout a given year
Dividend-Yield Ratio
 he dividend-yield ratio measures
dividends paid for a period
compared to the market prices of the
stock on a given day.
Dividend-      a

ë
Yield Ratio 
 
   a

D



 he dividend-payout ratio measures
the percentage of earnings per share
distributed in the form of dividends.

Dividend- ë   



aa

Payout 
 a
a

Ratio
Some Basic Accounting Concepts

Œ
 
 

   
 

  

  
 

   


!