CHAPTER 3:
Measuring and
Evaluating
Financial
Performance
© 2007 by Nelson, a division of Thomson Canada Limited.
1
CHAPTER 3
Measuring and Evaluating Financial Performance
Main topics in Chapter 3:






Some relevant history, particularly about the development of
stock markets and the resultant interest in evaluating financial
performance
Introduction to the income statement and RE statements
Format of income and RE statements
More on the underlying accounting mechanisms, including
accrual adjustments
Introductory interpretation and analysis of the income statement
Some comments on earnings management and other actions by
management to influence what the income statement reports
© 2007 by Nelson, a division of Thomson Canada Limited.
2
History
 In the mid 1600’s companies began selling shares
(stocks) to private investors
 The stock market emerged as business grew in size and
complexity
 Investors wanted updated
reports on how well their
companies were doing. They
demanded accurate summaries of
the financial position and
performance of the company
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3
Emergence of Corporations
Separation of
management
from
ownership
Increase in the
number of
owners
(shareholders)
Need to audit
financial statements
Longer life
than
proprietorship
and joint
ventures
Need for periodic
financial statements
 Income statements began to evolve when
legislation required that dividend payments
made to shareholders come out of the yearly
income (Revenue – Expenses)
 The income statement was proof for
corporations that they had performed well
enough to permit the distribution of dividends or
the issuance of more shares
 By 1920, annual financial statements for public
companies were mandatory in Canada
Demand for Regulation of Financial Accounting
Complexity and diversity in
accounting methods
Corporate
failures
Difficulty to analyze
financial statements
Need for consistency in
accounting methods
TENSION
Self-regulation by the
accounting profession
Regulation of the profession
by government
Generally Accepted Accounting Principles
The Generally Accepted Accounting Principles are
the conceptual structures behind financial
accounting
Includes rules, standards, and common practices that
companies are expected to follow
CICA handbook began about 30 years ago as a successful
attempt by the Canadian Institute of Chartered Accountants to
develop more rigorous accounting and auditing standards for
Canada.
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7
Some Regulators
CANADA
• CICA Handbook
• Ontario Securities Commission (OSC)
UNITED STATES
• Financial Accounting Standards Board (FASB)
• Securities and Exchange Commission (SEC)
INTERNATIONAL
• International Accounting Standards Committee (IASC)
GLOBALIZATION
• Economic globalization, therefore pressure to harmonize
accounting standards internationally
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8
Financial Position
Financial Performance
Balance Sheet as at Dec.31, 2005
Income Statement for the year 2006
Events during 2006 affecting
only the balance sheet
Balance Sheet as at Dec.31, 2006
Statement of Retained Earnings
for the year 2006
What is Income?
 Income is the ability to generate new resources through
day-to-day operations
 Income is the “bottom line” measure of performance
 Income is based on accrual accounting’s broad,
judgmental (though constrained) framework
 Net Income (or the per-share version, EPS) is the mostquoted accounting number
Defined by: Income = Revenues - Expenses
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10
What is Income?
Revenues are increases in the company’s wealth arising from the
provision of services or sale of goods to customers. Wealth
increases because customers either pay cash, promise to pay cash, or
pay with other forms of wealth.
Expenses are decreases in the company’s wealth that are incurred in
order to earn revenues. A major expense category is the cost of
goods sold (COGS) expense. COGS is the cost to the enterprise of
the goods given up to generate the revenue.
Payments of returns to owners (withdrawals by proprietors and
partners and dividends to shareholders) are not included in
expenses. Income is measured before such payments.
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11
What is Income?
Revenues
Expenses other than income tax
Income before
tax
Revenues
Expenses other than income tax
Income
tax
expense
© 2007 by Nelson, a division of Thomson Canada Limited.
Net Income
12
Why does the Income Statement Exist?
Purpose is to measure the financial performance of
an organization over a period of time (net income)
Displays the components of income (Revenues
minus Expenses) – this would be messy if it were
done in the Equity section of the balance sheet
Provides data for analyzing financial
performance (the balance sheet focuses on
financial position)
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13
Why does the Statement of Retained Earnings Exist?
It connects (“articulates”) the income statement to
the balance sheet
 It shows any non-operating items affecting
retained earnings (especially dividends)
© 2007 by Nelson, a division of Thomson Canada Limited.
14
Income and Retained Earnings Statements’ General
Format
Income Statement
(for a specified period)
Retained Earnings
Statement
Revenues
(for a specified period)
Deduct Expenses
Beginning Balance
=Income before Income tax
Add net income
Deduct income tax expense
Deduct dividends
declared
=Net income
=Ending Balance
To Balance Sheet
Features of the Income Statement
 For a specific period of time
 Revenues first, then expenses
 Income before tax is shown explicitly
 Then income tax expense
Income(loss) from discontinued operations and
extraordinary items comes next
Net Income
 EPS equals Net Income/ # of shares outstanding
© 2007 by Nelson, a division of Thomson Canada Limited.
16
Features of the Statement of Retained Earnings
For a specific period of time (over the same time
period as the income statement)
 Not necessarily a separate statement (can be at
the bottom of the income statement)
Usually done only for corporations
Dividends declared are deducted
Sometimes other non-operating items
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17
Features of the Income and Retained Earnings
Statements
The statements cover a period of time ending at balance sheet date.
As for balance sheet, explanatory notes are referred to & appended.
The income statement is broken up into several different sections,
starting with “ordinary” income and expenses, then moving on to
items such as “extraordinary” or “discontinued operations”.
The net income from the income statement is carried down to the
statement of retained earnings.
The statement of retained earnings starts with the beginning balance,
adds the net income from the income statement, and deducts the
dividends declared.
© 2007 by Nelson, a division of Thomson Canada Limited.
18
Content of the Income and Retained Earnings
Statements’- Canadian Pacific Railway Inc.
CPR’s revenue increased from 2003 to 2004, as it increased to
$3,902.9 million from $3,660.7 million.
Total expenses increased by a relatively lower amount - $183.3
million - causing Operating Income to increase from 2003 to 2004.
Since CPR is a service company, it is impossible to calculate a gross
margin. Employee compensation and fuel are two the of the most
important expenses.
In looking at interest expense, it can be seen that the company’s net
cost of borrowing stayed the same, at $218.7 mil in 2003 and $218.6
mil in 2004. The overall interest expense has been netted against
interest income.
© 2007 by Nelson, a division of Thomson Canada Limited.
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Content of the Income and Retained Earnings
Statements’- Canadian Pacific Railway Inc.(cont.)
Since we have both the income tax amount and net income, we can
deduce the company’s tax rate as 25.8% in 2004 ($143.3/$556.3) and
9.4% in 2003 ($41.6/$442.9).
Below the net income figure is the earning per share (EPS) ratio. It
is calculated as net income divided by the average # of common shares
outstanding for the year. The first figure is for the current number of
outstanding shares and the second, diluted figure, accounts for any
stock options the company has issued that have yet to be exercised.
In the retained earnings statement, CPR paid out dividends on two
kinds of shares. The ordinary shares are related to the spin-off from
the former CP. Dividends applicable to CPR’s new shares are listed
under common shares.
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20
“What if”analysis- CPR
Scenario: “what if” CPR discovered that a $1 million freight sale
wasn’t recorded until the 2004 fiscal year, but should have been
recorded in 2003. The accompanying expense was recorded in 2003.
What would recording this sale properly in 2003 do to:
a) 2003 continuing income before income tax
b) 2003 net income
by $906,000 (after deducting 9.4% income tax)
c) 2003 ending working capital
d) 2003 ending retained earnings
e) 2004 revenue
by $1 million
by $1 million
by $906,000 (the increase in NI)
by $1 million
© 2007 by Nelson, a division of Thomson Canada Limited.
21
Format of the Income Statement
Revenue
Operating expenses (COGS
may be disclosed separately)
Operating income
Nonoperating items
Ordinary items
Any unusual items separately disclosed
Continuing income before income tax
Income tax expense (current
and future/deferred portions)
Income from continuing operations
Any discontinued operations, net of income tax
Any extraordinary items, net of income tax
Net income for the year
(goes to the statement of RE)
© 2007 by Nelson, a division of Thomson Canada Limited.
$XXXX
XXXX
$XXXX
$XXXX
XXXX
XXXX
$XXXX
XXXX
$XXXX
$XXXX
XXXX
XXXX
$XXXX
22
Format of the Income and Retained Earnings
Statements’
The income statement begins with the more ordinary, regular
revenues and expenses, and separates those from significant nonordinary accounts shown further down.
There may be ordinary items that are unusual in size and so
may be disclosed separately.
To signal the company’s ability to generate income, most income
statements report a subtotal called Income before income tax, or
Continuing income before income tax.
Income tax expense, which includes amounts payable currently
and amounts estimated in the future (called future or deferred) is
deducted next. Including both current and future tax is called
interperiod tax allocation.
© 2007 by Nelson, a division of Thomson Canada Limited.
23
Format of the Income and Retained Earnings
Statements’
The nonordinary items are added or deducted next. Since income
tax has already been deducted, these items should be net of income
tax. The 2 main nonordinary items shown at the bottom of the income
statement are discontinued operations and extraordinary items.
The income statement’s “bottom line” is the net income, which is the
income from continuing operations plus or minus any discontinued
operations or extraordinary items.
Earnings per share (EPS) is usually shown both before and after
extraordinary and discontinued items.
Net income from the income statement is transferred to the
statement of retained earnings.
© 2007 by Nelson, a division of Thomson Canada Limited.
24
Format of the Retained Earnings Statement
Retained earnings as reported
at the end of the prior period
Any adjustments to beginning balance
for error corrections or accounting policy
changes, net of income tax
Revised beginning retained earnings
Add net income (or deduct net loss)
from income statement
Add or deduct any adjustments from
transactions with shareholders, net of tax
Deduct dividends declared during the period
Ending retained earnings
(not from IS)
$XXXX
XXXX
$XXXX
XXXX
XXXX
XXXX
$XXXX
(goes to the balance sheet)
© 2007 by Nelson, a division of Thomson Canada Limited.
25
Sequence of Reporting
2005
Events in 2006
2007
Income
statement
Beginning
balance sheet
(Dec. 31, 2005)
Retained
earnings
Ending
balance sheet
(Dec. 31, 2006)
MEGALOMANIA INC.
Account Balances at August 31, 2005
Accounts (millions of dollars)
Name
1) Bank balance
2) Bank loan due on demand
3) Beginning retained earnings
4) Cash on hand
214
4
5) Common shares issued
130
6) Cost of goods sold
317
7) Amortization this year
8) Amortization accum. to date
$
21
42
Statement
B/S R/E I/S
19
68
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27
MEGALOMANIA INC.
Account Balances at August 31, 2005
Accounts (millions of dollars)
Name
9) Dividends declared
10) Income tax not yet paid
11) Expenses paid in advance
12) Factory building
17
187
13) Factory equipment
123
$
12
6
14) Tax on this year’s income
15
15) Interest incurred on debts
16) Land under factory
13
50
© 2007 by Nelson, a division of Thomson Canada Limited.
Statement
B/S R/E I/S
28
MEGALOMANIA INC.
Account Balances at August 31, 2005
Accounts (millions of dollars)
Name
17) Administrative expenses
18) Marketing expenses
19) Mortgage payable
20) Operating expenses
58
124
21) Owing by customers
112
22) Payable to suppliers
87
23) Sales revenue
24) Supplies on hand
$
60
41
Statement
B/S R/E I/S
610
11
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29
MEGALOMANIA INC.
Account Balances at August 31, 2005
Accounts (millions of dollars)
Name
$
25) Unsold goods on hand
103
26) Unusual gain
10
27) After-tax loss on disc. operations 22
28) After-tax extraordinary gain
27
29) Deduction from RE (prior error)
5
30) Still owing on dividends
4
© 2007 by Nelson, a division of Thomson Canada Limited.
Statement
B/S R/E I/S
30
MEGALOMANIA INC.
Income Statement for the Year ended August 31, 2005 (millions)
Sales revenue
Expenses:
Cost of goods sold
Amortization
Operating, marketing, and administration
Interest incurred
Unusual gain
Continuing income before income tax
Income tax expense
Income from continuing operations
Loss on discontinued operations (after-tax)
Extraordinary gain (after-tax)
Net income for the year
$610
$317
19
225
13
($22)
27
574
36
10
$46
15
$31
5
$36
(goes to the statement of RE)
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31
MEGALOMANIA INC.
Statement of Retained Earnings for the Year ended August 31, 2005 (millions)
Beginning balance
Deduct: Prior period error
Revised beginning retained earnings
Add net income for the year
Deduct dividends declared during the the year
Ending balance
$214
5
$209
36
245
12
$233
(goes to the balance sheet)
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32
MEGALOMANIA INC.
Balance sheet as at August 31, 2005 (millions)
Assets
Current assets:
Cash on hand and in bank
Accounts receivable
Inventory
Supplies
Prepaid expenses
Non-current assets:
Land
Factory building
Factory equipment
Less: accum. amortization
TOTAL
$25
112
103
11
17
$268
$50
187
123
(68)
$292
$560
Liabilities and Equity
Current liabilities:
Demand bank loan
Accounts payable
Dividends payable
Income taxes payable
Non-current liabilities:
Mortgage payable
Shareholders' equity:
Share capital
Retained earnings
TOTAL
© 2007 by Nelson, a division of Thomson Canada Limited.
$42
87
4
6
$139
58
$197
$130
233
$363
$560
33
CappuMania Inc.
Balance Sheet as at March 31, 2006
Assets
Current assets:
Cash
$3,200
Inventory of unsold food 800
Inventory of supplies
2,350
$6,350
Non-current assets:
Equipment
$9,200
(1,500)
Accum. Amortization
$7,700
Liabilities and Shareholders' Equity
Current liabilities:
Owing to suppliers
$1,550
Sales and other taxes owing
100
$1,650
Non-current liabilities:
Loan to buy equipment
3,900
$5,550
Shareholders' equity:
Share capital contributed
$4,100
Retained earnings
4,400
$8,500
$14,050
$14,050
© 2007 by Nelson, a division of Thomson Canada Limited.
34
Journal Entries- CappuMania
1. Revenue
DR Cash (assets increased)
DR Accounts receivable (assets increased)
CR Revenue (equity increased)
85,250
4,490
2. General expenses
DR General expenses (equity decreased)
CR Cash (assets decreased)
CR Accounts payable (liabilities increased)
67,230
2,120
© 2007 by Nelson, a division of Thomson Canada Limited.
89,740
65,110
35
Journal Entries- CappuMania
3. Using up of inventories
DR General expenses (equity decreased)
CR Inventory of unsold food (assets decreased)
DR General expenses (equity decreased)
CR Inventory of supplies (assets decreased)
250
250
610
4. Amortization of equipment
DR Amortization expense (equity decreased)
2,380
CR Accumulated amortization (assets decreased)
© 2007 by Nelson, a division of Thomson Canada Limited.
610
2,380
36
Journal Entries- CappuMania
5. Estimated income tax expense
DR Income tax expense (equity decreased)
4,460
CR Sales and other taxes owing (liabilities increased) 4,460
6. Dividend declared
DR Retained earnings (equity decreased)
CR Dividend payable (liabilities increased)
1,000
7. Collections of accounts receivable
DR Cash (assets increased)
CR Accounts receivable (assets decreased)
3,330
© 2007 by Nelson, a division of Thomson Canada Limited.
1,000
3,330
37
Journal Entries- CappuMania
8. Payments of accounts payable
DR Accounts payable (liabilities decreased)
CR Cash (assets decreased)
9. Payments toward income tax
DR Sales and other taxes owing
(liabilities decreased)
CR Cash (assets decreased)
10. Payment toward dividend
DR Dividend payable (liabilities decreased)
CR Cash (assets decreased)
© 2007 by Nelson, a division of Thomson Canada Limited.
59,420
59,420
3,000
3,000
800
800
38
CappuMania Inc.
March 31, 2006 Trial Balance
Cash
Accounts receivable
Inventory of unsold food
Inventory of supplies
Equipment cost
Accumulated amortization
Accounts payable
Sales and other taxes owing
Dividend payable
Loan to buy equipment
Share capital contributed
Retained earnings
Revenue
General expenses
Amortization expense
Income tax expense
Total
26,440
1,160
550
1,740
9,200
(3,880)
(7,240)
(1,560)
(200)
(3,900)
(4,100)
(3,400)
(89,740)
68,090
2,380
4,460
0
CappuMania Inc.
Income Statement for the Year Ended
March 31, 2006
Revenue
Expenses:
General
Amortization
Income before income tax
Estimated income tax expense
Net income for the year
$89,740
$68,090
2,380
© 2007 by Nelson, a division of Thomson Canada Limited.
70,470
$19,270
4,460
$14,810
40
Closing Entry- CappuMania
DR Revenue
CR General expenses
CR Amortization expense
CR Income tax expense
CR Retained earnings (the net income)
89,740
68,090
2,380
4,460
14,810
CappuMania Inc.
Statement of Retained Earnings
For the Year Ended March 31, 2006
Retained earnings, beginning of year
$ 4,400
Add net income for the year
14,810
$19,210
Deduct dividends declared during the year
1,000
Retained earnings, end of year
$18,210
CappuMania Inc.
Balance Sheet as at March 31, 2006
Assets
Current assets:
Cash
Accounts receivable
Inventory of unsold food
Inventory of supplies
$26,440
1,160
550
1,740
$29,890
Non-current assets:
Equipment cost
$9,200
Accumulated amortization (3,880)
$5,320
$35,210
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
$7,240
Sales and other taxes owing 1,560
Dividend payable
200
$9,000
Non-current liabilities:
Loan to buy equipment
3,900
$12,900
Shareholders' equity:
Share capital contributed
$4,100
Retained earnings
18,210
$22,310
$35,210
© 2007 by Nelson, a division of Thomson Canada Limited.
42
Tanya’s Footwear Ltd.
Balance Sheet as at December 31, 2005
Assets
Current assets:
Cash & ST investments
Accounts receivable
Unsold inventory
Prepaid expenses
$25,090
25,130
98,200
15,320
$163,740
Non-current assets:
Buildings
$80,890
Less: Accum. amortization (40,510)
$40,380
$204,120
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
$85,010
Wages payable
15,345
$100,355
Non-current liabilities:
Bank loan payable
12,590
$112,945
Shareholders' equity:
Share capital contributed $62,010
Retained earnings
29,165
$91,175
$204,120
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43
Journal Entries- Tanya’s
1. Payments of wages payable
DR Wages payable (liabilities decreased)
CR Cash (assets decreased)
2. Recognize cost of goods sold
DR Cost of goods sold
CR Unsold inventory
3. Dividend declared
DR Retained earnings (equity decreased)
CR Dividend payable (liabilities increased)
© 2007 by Nelson, a division of Thomson Canada Limited.
7,420
7,420
22,750
22,750
3,450
3,450
44
Journal Entries- Tanya’s
4. Issuance of new shares
DR Cash (assets increased)
4,700
CR Share capital contributed (equity increased)
4,700
5. Purchase of supplies
DR Supplies (assets increased)
CR Accounts payable (liabilities increased)
2,000
2,000
6. Collections of accounts receivable
DR Cash (assets increased)
CR Accounts receivable (assets decreased)
26,210
© 2007 by Nelson, a division of Thomson Canada Limited.
26,210
45
Journal Entries- Tanya’s
7. Receipt and use of bank loan for expansion
DR Cash (assets increased)
CR Bank loan payable (liabilities increased)
DR Buildings (assets increased)
CR Cash (assets decreased)
15,000
15,000
15,000
15,000
8. Amortization of building
DR Amortization expense (equity decreased)
CR Accum. amortization (assets decreased)
6,000
9. Payment of dividend
DR Dividend payable (liabilities decreased)
CR Cash (assets decreased)
3,450
© 2007 by Nelson, a division of Thomson Canada Limited.
6,000
3,450
46
Journal Entries- Tanya’s
10. Incurred selling & admin. costs
DR Selling and admin. expenses (equity decreased) 61,965
CR Cash (assets decreased)
17,000
CR Accounts payable (liabilities increased)
36,045
CR Prepaid expenses (assets decreased)
8,920
11. Payment of accounts payable
DR Accounts payable (liabilities decreased)
CR Cash (assets decreased)
12. Revenue
DR Cash (assets increased)
DR Accounts receivable (assets increased)
CR Revenue (equity increased)
© 2007 by Nelson, a division of Thomson Canada Limited.
43,000
43,000
73,450
71,320
144,770
47
Journal Entries- Tanya’s
13. Estimated income tax expense
DR Income tax expenses (equity decreased)
14,660
CR Sales and other taxes payable (liab. increased)
14,660
14. Purchase of inventory
DR Unsold inventory (assets increased)
CR Cash (assets decreased)
15. Accrued wage expense
DR Wage expense (equity decreased)
CR Wages payable (liabilities increased)
© 2007 by Nelson, a division of Thomson Canada Limited.
21,040
21,040
3,500
3,500
48
Tanya’s Footwear Ltd.
Trial Balance at December 31, 2006
Cash & ST investments
Accounts receivable
Unsold inventory
Supplies
Prepaid expenses
Buildings
Cost of goods sold expense
Amortization expense
Selling and admin. expenses
Income tax expense
Wage expense
© 2007 by Nelson, a division of Thomson Canada Limited.
DR
37,540
70,240
96,490
2,000
6,400
95,890
22,750
6,000
61,965
14,660
3,500
417,435
49
Tanya’s Footwear Ltd.
Trial Balance at December 31, 2006
Accum. amortization
Accounts payable
Wages payable
Sales and other taxes payable
Bank loan payable
Share capital contributed
Retained earnings
Revenue
© 2007 by Nelson, a division of Thomson Canada Limited.
CR
46,510
80,055
11,425
14,660
27,590
66,710
25,715
144,770
417,435
50
Tanya’s Footwear Ltd.
Income Statement for the Year Ended December 31, 2006
Revenue
Expenses:
Cost of goods sold
Selling and administration
Amortization
Wages
Income before income tax
Estimated income tax expense
Net income for the year
$144,770
$22,750
61,965
6,000
3,500
© 2007 by Nelson, a division of Thomson Canada Limited.
94,215
$50,555
14,660
$35,895
51
Closing Entry- Tanya’s
DR Revenue
CR Cost of goods sold expense
CR S & A expenses
CR Amortization expense
CR Income tax expense
CR Wage Expense
CR Retained earnings (the net income)
144,770
22,750
61,965
6,000
14,660
3,500
35,895
Tanya’s Footwear Ltd.
Statement of Retained Earnings
For the Year Ended December 31, 2006
Retained earnings, beginning of year
Add net income for the year
$29,165
35,895
Deduct dividends declared during the year
Retained earnings, end of year
3,450
$61,610
Tanya’s Footwear Ltd.
Balance Sheet as at December 31, 2006
Assets
Current assets:
Cash & ST investments
Accounts receivable
Unsold inventory
Supplies
Prepaid expenses
$37,540
70,240
96,490
2,000
6,400
$212,670
Non-current assets:
Buildings
$95,890
Less: Accum. amortization (46,510)
$49,380
$262,050
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
$80,055
Wages payable
11,425
Sales and other taxes payable 14,660
$106,140
Non-current liabilities:
Bank loan payable
27,590
$133,730
Shareholders' equity:
Share capital contributed
$66,710
Retained earnings
61,610
$128,320
$262,050
© 2007 by Nelson, a division of Thomson Canada Limited.
53
Adjustments
ongoing
events
in the
world
Transactions
are
recorded
(journalized)
Posting to
accounts
(ledger)
Accounts
are
adjusted
Financial
statements
are
prepared
Adjusting entries do not normally involve cash. Their
purpose is to augment the transaction-based figures, to
add to the story told by the transactional records.
They implement accrual accounting.
Why are Adjustments Needed?
For correction of errors.
To overcome limitations of transactional base (implementation of
routine accruals). These include revenues earned but not yet
collected, expenses incurred but not yet paid, and amortization of
assets.
To recognize non-routine events or estimates needed to bring the
financial statements in line. An example is the “writing down” of
assets whose economic value has been impaired.
© 2007 by Nelson, a division of Thomson Canada Limited.
55
How are they Done?
Adjustments are completed in the journal entry format as we
have already seen (Debits = Credits).
The key is to judge whether an adjustment is needed. Is the
adjustment appropriate given the situation?
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56
What Accrual Accounting Adjustments Do
 Accrual adjustments affect both balance sheet (assets and
liabilities) and income statement (revenues and expenses)
 There are four kinds of accrual accounting connections:
Balance Sheet
Liabilities
Assets
Income Statement
Revenue
Expenses
Equity
Net Income
© 2007 by Nelson, a division of Thomson Canada Limited.
57
1)Assets and Revenues,
2)Assets and Expenses,
3)Liabilities and Revenues, and
4)Liabilities and Expenses.
Balance Sheet
Liabilities
Assets
Income Statement
Revenue
Expenses
Equity
Net Income
Articulation
The resulting net income goes into equity (retained
earnings), completing the articulation of the
statements.
Balance Sheet
Liabilities
Assets
Income Statement
Revenue
Expenses
Equity
Net Income
Pelforth Retail Inc.
Preliminary Trial Balance
Cash
Accounts receivable
Inventories
Prepaid expenses
Land
Building
Furniture and fixtures
Investment in Reddy Ware Corp.
Cost of goods sold expense
Operating expenses
Amortization expense
Interest expense
Income tax expense
© 2007 by Nelson, a division of Thomson Canada Limited.
DR
23,000
78,000
216,000
6,000
80,000
240,000
110,000
60,000
409,000
114,000
35,000
18,000
11,000
1,400,000
60
Pelforth Retail Inc.
Preliminary Trial Balance
Accumulated amortization
Bank loan
Accounts payable
Mortgage payable
Share capital
Retained earnings (prior to closing)
Revenue
© 2007 by Nelson, a division of Thomson Canada Limited.
CR
180,000
70,000
112,000
150,000
75,000
193,000
620,000
1,400,000
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Journal Entries- Pelforth
1. To reduce prepaid expenses from $6,000 to $4,000
DR Operating expenses
CR Prepaid expenses
2,000
2,000
2. To write the investment down to market of $25,000
DR Loss on investment (expense)
35,000
CR Investment in Reddy Ware
35,000
3. To record estimated accrued mortgage & bank interest
DR Interest expense
2,000
CR Accrued interest liability
2,000
4. To recognize revenue earned on special contracts
DR Accounts receivable
CR Revenue
© 2007 by Nelson, a division of Thomson Canada Limited.
15,000
15,000
62
Journal Entries- Pelforth
5. To recognize the COGS for entry (4)
DR Cost of goods sold expense
CR Inventories
7,000
7,000
6. To record estimated warranty expense arising this year
DR Warranty expense
3,000
CR Warranty liability
3,000
7. To write off a receivable that will never be collected
DR Bad debt expense
CR Accounts receivable
1,000
8. To reduce tax expense and record estimated refund
DR Income tax receivable
CR Income tax expense
8,000
© 2007 by Nelson, a division of Thomson Canada Limited.
1,000
8,000
63
Pelforth Retail Inc.
Adjusted Year-End Trial Balance
Cash
Accounts receivable
Income tax refund receivable
Inventories
Prepaid expenses
Land
Building
Furniture and fixtures
Investment in Reddy Ware Corp.
Cost of goods sold expense
Operating expenses
Amortization expense
Bad debts expense
Warranty expense
Interest expense
Loss on investment
Income tax expense
© 2007 by Nelson, a division of Thomson Canada Limited.
DR
23,000
92,000
8,000
209,000
4,000
80,000
240,000
110,000
25,000
416,000
116,000
35,000
1,000
3,000
20,000
35,000
3,000
1,420,000
64
Pelforth Retail Inc.
Adjusted Year-End Trial Balance
Accumulated amortization
Bank loan
Accounts payable
Accrued interest
Estimated warranty liability
Mortgage payable
Share capital
Retained earnings (prior to closing)
Revenue
© 2007 by Nelson, a division of Thomson Canada Limited.
CR
180,000
70,000
112,000
2,000
3,000
150,000
75,000
193,000
635,000
1,420,000
65
Pelforth Retail Inc.
Year-End Income Statement
Revenue
Expenses:
Cost of goods sold
Operating
Amortization
Bad debts
Warranty
Operating income
Other expenses:
Interest
Loss on investment
Income before income tax
Income tax
Net income
$635,000
$416,000
116,000
35,000
1,000
3,000
$20,000
35,000
© 2007 by Nelson, a division of Thomson Canada Limited.
571,000
$64,000
55,000
$9,000
3,000
$6,000
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Closing Entry- Pelforth
DR Revenue
CR Cost of goods sold
CR Amortization expense
CR Operating expenses
CR Income tax expense
CR Bad debt expense
CR Warranty expense
CR Interest expense
CR Loss on investment
CR Retained earnings (the net income)
635,000
416,000
35,000
116,000
3,000
1,000
3,000
20,000
35,000
6,000
Retained Earnings Statement
Retained earnings, beginning
Add net income for the year
Retained earnings, ending
$193,000
6,000
$199,000
Pelforth Retail Inc.
Balance Sheet at Year-End
Assets
Current assets:
Cash
Accounts receivable
Income tax refund receivable
Inventories
Prepaid expenses
Non-current assets:
Investment in Reddy Ware Corp.
Land
Building
Furniture and fixtures
Accumulated amortization
$23,000
92,000
8,000
209,000
4,000
$336,000
$25,000
80,000
240,000
110,000
(180,000)
$275,000
$611,000
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
$112,000
Accrued interest
2,000
Estimated warranty liability
3,000
Bank loan
70,000
$187,000
Non-current liabilities:
Mortgage payable
150,000
$337,000
Shareholders' equity:
Share capital
$75,000
Retained earnings
199,000
$274,000
© 2007 by Nelson, a division of Thomson Canada Limited.
$611,000
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Kim’s Sporting Goods
Preliminary Trial Balance at August 31, 2006
Cash
Accounts receivable
Prepaid expenses
Inventories
Store equipment
Accum. amortization
Accounts payable
Bank loan
Share capital contributed
Retained earnings
Revenue
Cost of goods sold expense
SG & A expenses
DR
17,000
10,400
8,800
21,600
20,900
CR
2,700
7,800
4,600
18,300
12,300
305,000
216,000
56,000
350,700 350,700
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Journal Entries- Kim’s Sporting Goods
1. Write off a receivable that will never be collected
DR SG & A expenses (Bad debt expense)
2,200
CR Accounts receivable
2,200
2. Several items in the store were stolen and will never be
recovered
DR SG & A expenses (Loss on theft
of inventory)
5,000
CR Inventories
5,000
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70
Journal Entries- Kim’s Sporting Goods
3. Recognize used-up portion of prepaids
DR SG & A expenses
CR Prepaid expenses
1,100
1,100
4. Recognize uncollected revenue mistakenly not recorded
DR Accounts receivable
6,000
CR Revenue
6,000
(Assume the COGS for this revenue was already recorded.)
© 2007 by Nelson, a division of Thomson Canada Limited.
71
Journal Entries- Kim’s Sporting Goods
5. Recognition of amortization for the year
DR Amortization expense
CR Accum. amortization
1,320
6. To estimate the income tax for the year
DR Income tax expense
CR Income tax payable
5,200
© 2007 by Nelson, a division of Thomson Canada Limited.
1,320
5,200
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Journal Entries- Kim’s Sporting Goods
7. Record dividend declared that is to be paid later
DR Retained earnings
5,500
CR Dividends payable
5,500
8. To estimate the warranty expense for the year
DR SG & A expenses (warranty expense)
3,200
CR Estimated warranty liability
3,200
© 2007 by Nelson, a division of Thomson Canada Limited.
73
Kim’s Sporting Goods
Adjusted Trial Balance at August 31, 2006
Cash
Accounts receivable
Prepaid expenses
Inventories
Store equipment
Accum. amortization
Accounts payable
Bank loan
Share capital contributed
Retained earnings
Revenue
Cost of goods sold expense
SG & A expenses
Amortization expense
Income tax expense
Income tax payable
Dividends payable
Estimated warranty liability
DR
17,000
14,200
7,700
16,600
20,900
CR
4,020
7,800
4,600
18,300
6,800
311,000
216,000
67,500
1,320
5,200
5,200
5,500
3,200
366,420 366,420
Kim’s Sporting Goods
Income Statement for the Year-Ended August 31, 2006
Revenue
$311,000
Expenses:
Cost of goods sold
$216,000
SG & A
67,500
Amortization
1,320 284,820
Income before income tax
$26,180
Estimated income tax expense
5,200
Net income for the year
$20,980
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75
Closing Entry- Kim’s Sporting Goods
DR Revenue
CR SG & A expenses
CR Amortization expense
CR Income tax expense
CR Cost of goods sold expense
CR Retained earnings (the net income)
311,000
67,500
1,320
5,200
216,000
20,980
Kim’s Sporting Goods
Statement of Retained Earnings
For the Year Ended August 31, 2006
Retained earnings, beginning of year
Add net income for the year
$12,300
20,980
Deduct dividends declared during the year
Retained earnings, end of year
5,500
$27,780
Kim’s Sporting Goods
Balance Sheet as at August 31, 2006
Assets
Current assets:
Cash
Accounts receivable
Prepaid expenses
Inventories
Non-current assets:
Store equipment
Accumulated amortization
$17,000
14,200
7,700
16,600
$55,500
$20,900
(4,020)
$16,880
$72,380
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
$7,800
Estimated warranty liability
3,200
Dividends payable
5,500
Income tax payable
5,200
$21,700
Non-current liabilities:
Bank loan
4,600
$26,300
Shareholders' equity:
Share capital
$18,300
Retained earnings
27,780
$46,080
$72,380
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77
Managers, Investors, and Managing Earnings
Earnings are important
Earnings announcements
Income smoothing
The Big Bath
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78
Earnings Management
What is it?

A company chooses accounting methods that alter
the size or interpretation of its net income
Why does it happen?


Users of financial information place great
importance on a company’s earnings or net income
Increasing pressure on managers to “perform” and
meet expectations of analysts and the stock
markets
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Income Smoothing

Managers create stable income numbers from
year to year
 Creates less variability in performance
Variable
Smoothed
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“Big Bath”

In a bad year, a company chooses
accounting methods to make a loss look
even worse
 Eliminates all the bad news at one time and
helps future earnings
 Could occur after a new CEO takes over
 Examples include large restructuring
charges or investment write-downs
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Write-offs of Consolidated Goodwill





A type of “Big Bath” strategy
Goodwill is an asset created when two companies
merge and the price paid for the company is more
than the value of its assets
If this value has declined, the value of the goodwill
is written down or written off to expense
**the write-down or write-off may dramatically
reduce net income but has no effect on cash
AOL Time Warner First Quarter 2001 incurred a
loss of $54.2 billion after taking a goodwill writedown
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EBITDA & Pro Forma Earnings
 Earnings before interest, tax, depreciation and
amortization (EBITDA)
The company reports only operating income that
leaves out large expenses and one-time charges
such as high amortization expenses on large
assets
Shows a clearer picture of the company’s
operating performance(??)
 Pro forma earnings
Focus on how the company will supposedly
perform in the future
© 2007 by Nelson, a division of Thomson Canada Limited.
83
Stock Option Compensation

Options give an individual the right to buy or
sell a stock at a certain price
 Companies offer this type of compensation to
executives
 Currently, it seldom has to be reported as an
expense on the income statement
 Allows companies to give large potential
payoffs to execs or employees without reducing
net income
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84