Chapter 2

Measuring Income to
Assess Performance
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.
Introduction to Income
Measurement
 Income is a measurement of accomplishment or a means of
evaluating performance.

 Performance is indicated by profitability, which is the

excess of sales over expenses.

– All income should be measured in the same

way following a common set of rules.

– 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
 Operating cycle/ Cash 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 Inventory Receivable
$100,000 $160,000

Collect
The Accounting Time Period
 Companies need a way to measure performance
over discrete time periods.

 Calendar year is the most popular time period for

measuring performance.

– However 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

– Usually Fiscal year end date is a low point in

annual business activity.

– Companies also prepare statements

for interim periods, generally on a
quarterly or monthly basis.
Revenues and Expenses: The key
components for measuring income
 Revenue and expenses are inflow and outflow of
assets that occur during a business’s operating
cycle.
 Revenues/ Sales Revenue/Sales/ Turnover –gross
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
 Income/ Profit/ Earnings - the excess of revenues over
expenses
Profit = Revenues - Expenses

– Revenues increase owners’ equity.

– Expenses decrease owners’ equity.

 The total, cumulative owner’s equity generated by income or

profits is called Retained earnings or Retained Income.
 Assets = Liabilities + Owner’s Equity

Assets = Liabilities + Paid up Capital + Retained Earnings

Assets = Liabilities + Paid up capital + Revenues - Expenses

Revenues and Expenses
 A sales transaction has two phases, a revenue phase, and an
expense phase.
– Requires two new accounts, Accounts Receivable and
Cost of Goods Sold Expense

 Accounts receivable: Amounts owed to a company

by customers as a result of the company’s delivering
goods or services and extending credit in the ordinary
course of business
– Also known as trade receivables or receivables
or debtors.

 Cost of Goods Sold: Original acquisition cost of the

inventory that a company sells to customers during
the reporting period
– Also known as cost of sales or cost of revenue
Revenues and Expenses

Assets = Liabilities + Stockholders’ Equity

Accounts Merchandise
Receivable Inventory
Sales on open account +160,000 = + 160,000
(Sales Revenue)
Cost of merchandise
inventory sold –100,000 = –100,000
(Cost of Goods Sold Expense)
Methods of Measuring
Income:

Accrual Basis
Vs
Cash Basis
 Accrual Basis and Cash Basis
 The 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 occur 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:

– Revenues 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.

– 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:
– Revenues are recorded when a sale is made
for cash at the time when the cash changes
hands.
– Expenses are recorded when a purchase is
made for cash at the time when the cash
changes hands.
E.g.: Sales Revenue= Rs.1,50,000(50% on credit),
Cost of Goods Sold expense=Rs.60,000 ,
Other Expenses =Rs.30,000 (10% unpaid)

Accrual Cash Basis

Basis
Sales 1,50,000 75,000
Less: COGS 60,000 60,000
Less: Expenses 30,000 27,000
Net Profit/Loss 60,000 -12,000
Companies use both the methods:

Income Statement is prepared on Accrual basis

Cash Flow Statement is prepared on Cash basis

 Recognition of Revenues

 Recognition - a test to determine whether

revenues should be recorded in the
financial statements for a given period or
not.
 To be recognized, revenue must be:
– Earned - goods are delivered or a service is
performed
– Realized - 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
 For other companies, revenue may
be earned and realized at different
times.
– Magazine subscriptions are received in
advance, but the revenue is not earned until
the issues are delivered.

– 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.
Types of Expenses/ Costs

 Product costs - those linked with

revenue/ that can be linked to the
products being sold.
– Cost of goods sold or sales commissions
• Without sales there is no cost of goods sold
or sales commissions.

 Period costs - those linked with the

time period itself
– Rent or other administrative expenses
• Rent is paid even if no sales are made.
Some examples of Expenses
 Cost of goods sold expenses (COGS)/ Cost of
Sales Expense
 Salary expenses
 Rent expenses
 Insurance expenses
 Advertising expenses
 Depreciation/ Amortisation expenses
 Administrative Expenses
 Interest expenses
Matching of Expenses/ Costs with Revenues

WHEN SHOULD THE EXPENSES BE

RECOGNIZED ?

 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.
Recognition of Expired Assets
 Expenditures are first recorded as assets.
 Subsequently, they are expensed when the
assets are used.
Recognition of Expired Assets
Sl No Asset Expired in the form of:

1 Inventory Cost of Goods Sold expense (COGS)/ Cost of

sales expense

2 Prepaid Rent Rent Expense

3 Equipment Depreciation expense

Recognition of expired assets/ Cost
Recovery

 A concept by which some purchases

of goods or services are recorded as
assets and “expired” later because
the costs are expected to be
recovered in future periods

– An example is prepaid rent / rent

paid in advance
Prepaid Rent/ Rent paid in advance

 Rent paid for a quarter in advance

Assets = Liabilities + Stockholders’ Equity

Cash Prepaid Rent
Pay rent in advance –6,000 +6,000

 At the end of one month, rent used is expensed

Assets = Liabilities + Stockholders’ Equity
Cash Prepaid Rent
Expiration of rental services –2,000 = –2,000
(Rent Expense)
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Matching and Cost Recovery
 Another example of matching and cost recovery
is depreciation.

– 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

– Land is not subject to depreciation

– 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.

– If 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
 The income statement is really just a way of
explaining changes that occur between one
balance sheet date and another.

 The balance sheet equation can be manipulated to

show that revenues and expenses are subparts of
owners’ equity.

 Balance sheet equation has universal

applicability!!!!!!!

– The income statement collects the changes and

combines them in one place.
 Expanded Balance Sheet Equation

(1) Assets = Liabilities + Stockholders’ Equity

(2) Assets = Liabilities + Paid-in Capital + Retained Earnings

(3) Assets = Liabilities + Paid-in Capital + Cumulative - Cumulative

Revenues Expenses

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 Income Statement
or
Statement of Earnings
or
Statement of Operations
or
Statement of Profit and Loss
The Income Statement
 Income 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
– Often called the “BOTTOM LINE”

 Sales Revenue is called TOP LINE

 Net loss - the excess of expenses over revenues

 The Income Statement
DANIELS COMPANY
Income Statement
for the year ended December 31, 2022

Sales $98,600

Expenses:
COGS $45,800
Rent expense 12,000
Salary expense 6,500
Depreciation expense 5,000
Total expenses 69,300
Profit Before Tax $29,300
Less: Tax @ 30% 8790__
Profit After Tax/ Net Income 20,510
The Income Statement
 The 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.

– By tracking net income from period to period,

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

 The income statement provides a moving picture

of events over a span of time and explains the
changes that have taken place between balance
sheet dates.
Relationship between Income
Statement and Balance Sheet

Balance Sheet on Balance Sheet on

31st March 2022 31st March, 2023

Income Statement for

the year ended March 31, 2023

Accounting Period
 Accounting for Dividends
and Retained Income
 Revenues and expenses are recorded
in the Retained Income account.

– Net Income increases retained income.

• Net losses decrease retained income.

Cash Dividends
 Cash dividends - distributions of cash to
stockholders (owners) that reduce retained
income
– Companies pay dividends to provide
stockholders a return on their investments.

 Although cash dividends decrease

retained income, they are not treated as
expenses.
Cash Dividends

 Dividend payment occurs in a series of steps:

Declaration Date, Record Date and Payment Date.
 Cash dividends are limited by the amount of cash
on hand or available.
 Some companies do not pay cash dividends.
– These companies retain the cash for financing
future growth.

 The board of directors decides if and when cash

dividends will be paid to stockholders.
Statement of Retained Income
It lists the beginning balance in Retained Income,
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 Retained Income
Statement of Retained Income
– This statement can be anchored to the balance
sheet equation as follows:

Assets = Liabilities + Paid-in Capital + Retained Income

Beginning
Balance + Revenues - Expenses - Dividends
Statement of Retained Income
DANIELS COMPANY
Statement of Retained Income
for the Year Ended December 31, 2022

Retained income, Jan 1, 2022 $108,600

Add: Net income for the year 20,510

Total $129,110
Less: Cash dividends paid 10,000

Retained income, Dec 31, 2022 $119,110

===============
Financial Ratios/ Ratio Analysis

 Ratio analysis involves methods of

calculating and interpreting financial
ratios to analyze and monitor a firm’s
performance.
Four Popular Financial Ratios
 Literally hundreds of ratios can be calculated
from a set of financial statements.

 Four widely used financial ratios:

– Earnings per Share (EPS)
– Price-Earnings (P-E) Ratio
– Dividend-Yield Ratio
– Dividend-Payout Ratio
Earnings per Share (EPS)
 Earnings per share (also called Earnings Multiple)
is the net income/ profit after tax per equity share
outstanding during a period.

 EPS=
Profit after tax - Preference dividends, if any
Average number of equity shares outstanding

The numerator shows the earnings available to

equity shareholders after the payment of preference
dividends to preference shareholders.
Price-Earnings (P-E) Ratio
 P/E ratio or Price to Earnings ratio measures how much
investors are willing to pay to participate in the future profits of
the company.

 A high P-E ratio indicates that investors predict that the

company’s net income will grow rapidly.

 The 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 ratio keeps on

varying throughout a given year.
Dividend-Payout Ratio
 The dividend-payout ratio measures
the percentage of earnings per share
distributed in the form of dividends.

Dividend Payout Ratio= Dividend Per Share

Earnings Per Share
Dividend Yield ratio

 The dividend yield ratio measures how

much returns/ yield has the share
generated in terms of the dividends that
have been paid in the context of its
market price.
 Dividend yield= DPS/ MPS
= Dividend per share
Market price per share
 Basic Accounting Priciples

1. The Entity concept (separate economic unit)

2. The Reliability concept- is the quality of information
that assures decision makers that the information captures
the conditions or events it purports to represent.
3. Going concern concept
 convention assumes an entity will continue to exist indefinitely
– Reasonable to use historical cost to record long-lived assets
 The opposite view of the going concern convention is an immediate
liquidation assumption
– Values balance sheet items at amounts appropriate in case of
liquidation
 Basic Accounting Priciples
4. 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
– An item is material if its proper accounting is likely
to affect the decision of a user
5. Monetary unit - The principal means for measuring
financial statement elements
– Common denominator for quantifying the effects of
transactions
6. Stable monetary unit: A monetary unit that is not
expected to change in value significantly over time
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– Necessary for use of historical-cost accounting
Basic Accounting Principles
7. Periodicity Convention
 Related to the information characteristics of timeliness
– This convention requires a company to break up its
economic activity into artificial time periods that will
provide timely information to users.

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