CHAPTER 2
Measuring Income to Assess Performance
LEARNING QUESTIONS EXERCISES PROBLEMS OTHER
OBJECTIVES
LO1: Explain how 1,2,3,4,26,27 32, 36 45,49,51 67
accountants measure
income.
LO2: Determine when a 5,6 31 45,46,49,51,61 67
company should record
revenue from a sale.
LO3: Use the concept of 7,8,9 34, 36 45,47,48,50,
matching to record the 52,53,54,56
expenses for a period.
LO4: Prepare an 10,11,12 30,35,36,37,38,39, 45,47,48,50,52, 65,66,67
income statement and 40,41 53,54,55,
show how it is related to 56,57,58
a balance sheet.
LO5: Account for cash 13,14,15, 28 33,35, 38, 54,55,57,58 65,66
dividends and prepare a 39,40
statement of
stockholders’ equity.
LO6: Compute and 17,18,19,20,29 42,43 59, 60 64,66
explain earnings per
share, price-earnings
ratio, dividend-yield
ratio, and dividend-
payout ratio.
LO7: Explain how the 21,22,23 62
conceptual framework
guides the standard
setting process and how
accounting regulators
trade off relevance and
faithful representation
in setting accounting
standards.
LO8: Explain how the 16,24,25,26 44 63
following concepts affect
financial statements:
entity, going concern,
materiality, stable
monetary unit,
periodicity and
reliability.
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, CHAPTER 2
2-1 The length of the operating cycle depends on the nature of the company. It is the time it
takes the company to use cash to acquire goods and services, to sell those goods and
services to customers, and to collect cash from the sales.
2-2 A fiscal year is the year used for financial reporting. It may be the same as a calendar
year, but often it is not. Many companies elect to begin and end a fiscal year at the low
point in their annual business activity.
2-3 Expenses are reductions in stockholders’ equity; thus they may be described as negative
stockholders’ equity accounts.
2-4 The cash basis fails to match accomplishments with efforts in a single accounting period.
In particular, the cash basis fails to match revenues and expenses properly. Inventory may
be bought and paid for in one period, and sold in the second with the collection from
customers in a third period. Accrual accounting matches revenue and cost of goods sold
in the second period, although the cash outlay occurred in the first and the collection was
made in the third.
2-5 The two criteria for revenue recognition are earning and realization (realized or
realizable).
2-6 Revenue recognition is delayed when a company sells a magazine subscription because
the company does not recognize revenue until it is earned by delivery of the magazines.
Revenue recognition is also delayed if collection of the account receivable is not reasonably
certain, which means that it is not realized or realizable. This may happen with
speculative land sales.
2-7 Product costs are naturally linked to revenues, while period costs support a company’s
operations for a given period. Product costs become expenses when the company recognizes
the related revenue. Period costs become expenses in the period in which the y are incurred.
2-8 In theory, all expenses are goods and services that were first purchased as assets and that
have now been consumed or used in the conduct of operations.
2-9 Managers acquire assets (goods and services) that are then either used instantaneously or
at a later time. When the assets are used, they become expenses.
2-10 The balance sheet is a financial picture of a company at one point in time, like a snapshot.
In contrast, an income statement shows activity over a period of time. It shows the series
of events that take a company from one “snapshot” (balance sheet) to another, just as a
moving picture shows movement from one position to the next.
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,2-11 Synonyms for the income statement include statement of earnings, statement of
operations, and operating statement. A major reason to learn accounting is to be able to
read real financial statements. Such statements contain a variety of terms that may differ
from the one first leaned in an introductory accounting course. To be able to read and
interpret the financial statements, users need to understand the terminology, including
synonyms used for the major accounting terms.
2-12 Managers are often optimistic and feel that things are bound to get better, so they do not
like to report bad news. In addition, they may have bonuses or possible promotions that
depend on the financial results, so they want the reports to be as good as possible.
Finally, financial reports are often the “scorecard” for business success, and competitive
managers want to report a high score.
2-13 Cash dividends are not necessary in the conduct of revenue-producing operations.
Therefore, they are not expenses but are voluntary distributions of assets to owners.
These distributions are made possible because of profitable operations, but are not part of
the profitable operations.
2-14 Retained earnings is a stockholders’ equity account (a residual claim against assets), and
not an asset account. It is a claim against resources, not a resource itself.
2-15 The statement of stockholders’ equity provides information on what caused the stockholders’
equity accounts to change during a given period. The three main items that affect
stockholders’ equity are net income, transactions with stockholders (sale of stock,
distribution of dividends), and other comprehensive income—a catch-all category of all
equity changes that are neither part of net income nor arise from transactions with
owners.
2-16 No. An accounting entity can be a part of an organization, such as a division or
department. It can also be an entire economy, such as national income accounting for the
United States or another country.
2-17 No. One financial ratio, earnings per share (EPS), is presented on the income statement.
2-18 A high P-E ratio suggests that investors expect future earnings to significantly exceed
current earnings. This is likely to be true for fast growing companies.
2-19 Two dividend ratios are as follows:
• Dividend-yield ratio—The amount of dividends paid per dollar invested in a stock
at the current market price. The dividend-yield ratio is computed as Dividends per
share ÷ Market price per share.
• Dividend-payout ratio—The percentage of a company’s earnings that is paid out in
dividends The dividend-payout ratio is computed as Dividends per share ÷ EPS.
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, 2-20 No. A high dividend-payout ratio may be a bad sign. Companies with a high dividend-
payout ratio tend to be slow-growing companies. They return a larger percentage of their
income to shareholders because they do not have profitable opportunities in which to
invest.
2-21 Yes, accountants make many trade-offs between relevance and faithful representation.
Although both are desirable characteristics, sometimes it is necessary to sacrifice some
of one to gain much of the other. A major trade-off is between market values, which are
often more relevant but may raise questions about faithful representation, and historical
costs, which faithfully represent an event but may be less relevant.
2-22 The two main characteristics that make accounting information relevant are predictive
value—meaning that it helps users form their expectations about the future—and
confirmatory value—meaning that it can confirm or contradict existing expectations.
2-23 These criteria support faithful representation. They help ensure that information truly
captures the economic substance of the transactions, events, or circumstances it
describes.
2-24 Reliable data require convincing evidence that can be verified by independent auditors.
Accountants must make sure that data reported in the financial statements can be
measured with enough accuracy to be useful to users of the statements.
2-25 Materiality means that items that are not large enough to influence users’ decisions can be
omitted from the financial statements. Thus, you do not find pencils or paper clips listed
separately among a company’s assets. Cost-benefit means, for example, that if the cost of
measuring an item is greater than the value from knowing it, the item can be omitted. Thus,
the financial statements of a division of a company may not include an expense for any
portion of the company president’s salary, even though the president spends time
overseeing the division’s activities. It would simply be too costly for the president to
account for each minute spent on each different activity he or she undertakes, and there is
little benefit to attempting to allocate the president’s salary to individual divisions.
However, in the corporate financial statements, the president’s salary would be treated as
an operating cost assigned to the corporation as a whole.
2-26 A year is a long time to wait for new information about a company’s performance.
Preparing full financial statements is time consuming and costly. Quarterly financial
disclosures are less complete than annual ones, but they represent a balanced answer to
how often and how complete information should be. Within companies, managers get
financial reports daily, weekly, or monthly depending on their needs. In different
countries the tradition and the identity of investors have led to different customs. The
United States relies on public ownership of companies and needs a system to keep large
numbers of investors adequately informed. In countries where more of the ownership is
closely held and more of the liabilities are bank financed, there is less need for frequent
public disclosure.
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