Accounting: The Language of Business - Vol. 2 (Intermediate: Part 44)

I gave up accounting. I went in for about six months writing ad copy. I was fired from that, and then another guy and I did a kind of poor man's Bob and Ray kind of syndicated radio show. Then I decided to stick it out and see what happened. I'd give it a year, a year became two years, and then two years became three years, and then along came the record album.

Bob Newhart

Statements of Net Income and Comprehensive Income (Part B)

by

Charles Lamson

THE CONCEPTUAL FRAMEWORK CONNECTION:

 Usefulness and Limitations of the Income Statements

The income statements provide useful information to financial statement users in three ways:

1. Evaluate past performance. Income statements enable financial statement users to evaluate the entity's past performance. By disclosing separate components of revenues and expenses, income statements provide useful information about the entity's overall past performance (i.e., the earnings) and identify the main factors that influence performance. Income statements provide confirmatory value, which is an aspect of relevant information For example, investors are interested in whether companies meet or beat analysts' forecasts of net income as indicated by the statement of net income.

2. Predict future performance. Income statements have predictive value because they provide a basis for estimating future performance. Predictive value is an aspect of relevance. For example, a firm with a trend of earnings growth over the last 10 years may continue that growth in the future.

3. Assess risks or uncertainties of achieving future cash flows. Income statements provide information that is useful in assessing the risks or uncertainties of achieving future cash flows. Some items of income are more persistent in nature than others, making them strong indicators of future cash flows. For example, revenue from normal sales tends to persist from year to year. However, again from the sale of a specialized piece of equipment is unlikely to reoccur in the following year.

While income statements are quite important to financial statement users, there are three main limitations. Income statements

1. Exclude certain items. Companies cannot measure certain revenues, expenses, gains, and losses reliably and therefore do not report them on the income statements. Unreliable information would result in financial statements that lack faithful representation, one of the fundamental qualitative characteristics identified in the conceptual framework [The Conceptual Framework (or “Concepts Statements”) is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives (fasb.org).]. For example, assume an entity has been sued and the loss is likely. if the firm cannot reasonably estimate the loss, it would not report it on the income statement.

2. Depend on accounting methods selected. The measurement of income is dependent upon the accounting methods selected. For example, identical companies that purchase the same asset but depreciate that asset using different depreciation methods will report a different net income, resulting in reduced comparability.

3. Require extensive judgment and estimation. In general, allowing managers to use judgment when making accounting policy choices that best reflect the economic reality of a transaction will enhance the usefulness of the financial statements. However, due to significant subjectivity and estimation uncertainties involved in financial reporting management can bias their judgments to enhance the entity's financial performance by manipulating revenues, gains, expenses, and losses. Even if management is not intentionally biasing reported earnings, different judgments will lead to different income numbers, resulting in reduced comparability. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., P. 173*

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