Importance of Income Statement in Financial Reporting
Every entity has to prepare the financial statements, on a regular basis, to communicate the financial results of the business operated by it. These financial statements contain the summarised information expressed in financial terms about all the transactions and events that are entered into during the course of business. All the financial information that helps the readers to assess the financial health of business of an entity is compiled in the financial statements and shared with the intended users by the way of annual report. There are primarily three types of financial statements that are prepared by almost every business entity. They are: Income Statement, Balance Sheet and Cash Flow Statement. All these financial statements convey different but related information about the business. Therefore, it is important for the users of financial reports of the company to study all the three financial statements to evaluate the performance of the business. Preparation and presentation of financial statements is called the financial reporting function which is performed by the entities to comply with the corporate governance requirements as applicable to the entities. The basic objective behind the following the practices of financial reporting is to disseminate the relevant and necessary financial information about the business to allow the key stakeholders to make sound economic decisions relating to the reporting entity.
The first and foremost financial statement that is required to be prepared by the entities is the income statement which is traditionally termed as profit and loss account. This statement mainly reflects the profitability position of the reporting entity. It is mainly composed of two important elements of the business i.e. income and expense. Income is something that the business earns over a period of time. There are various types of income that forms part of income statement of the entity such as sales revenue, interest and dividend income etc. On the other side expenses of the business are the costs that are incurred in the course of business over a period of time. The examples of expenses of the business are: depreciation, rent, salaries and wages, interest and tax payments. The income statement enables the users to determine whether the company has made profits or losses during the reported period in the course of business. The expenses that are reported in the income statement are charged against the revenues generated in the concerned period by following the matching principle of accounting. Income statement represents the financial performance of the business during a period of time and not at a particular moment of time (Van Auken & Carraher, 2013). The income statements render the important portion of financial reports of the entity as they form an important basis in the preparation of statement of financial position since net profit is earned during the year by the entity is transferred to the general reserves of the company that becomes the key component of its statement of financial position. Not only operating incomes and expenses are reported in the income statement of an entity but also the non-operating incomes and expenses (De Franco, Kothari & Verdi, 2011).
Components of Income Statement
Income statement of an entity possesses various features that make it an important document to assess the financial position of the business. They provide detailed information about the ways in which net profits of the business are ultimately derived as it not only covers the information of revenues earned by the business but also the information regarding the cost of goods sold and other expenses that are incurred while operating the business. Moreover, the income statements help the owners to determine their tax obligation on the profits earned as a part of business. There are various parties for whom income statement act as an ideal source of information to make various economic decisions such as the potential investors, lenders of finance, governmental agencies etc. (Boundless Finance, n.d.)
The Earning per share as depicted by the income statements of the entity enables the potential investors to evaluate the return potential of the reporting entity. It shows them the current return that the company is paying to its existing investors and the potential of the company to pay them the desired returns in the subsequent periods (Penman & Penman, 2007). Further, the net income shown in the income statement helps the lenders of finance such as bank and financial institutions to assess the profitability position of the business that will in turn allow them to decide as to whether they should provide the company the required financial assistance or not. Furthermore, the net income reflected in the income statement allows the tax regulatory bodies to calculate the tax obligations of the reporting entity on the basis of such book profits (Hanlon, 2003). In spite of these many uses of income statement, such statements suffer from certain limitations that affect their usefulness for the intended users. Such limitations are discussed in the further section.
There are multiple types of profits reported in the income statement such as gross profit and net profit and these profits have different interpretations. Since each profit reflected in the income statement carries different meaning it becomes tough for the readers to understand and interpret each profit separately and to identify the reasons for the differences in the values of different sort of profits. In order to evaluate the overall profitability of the business, the readers are therefore required to possess requisite knowledge of all the concepts of business profits (Accounting Coach, 2018). Further, the income statements of any entity are usually prepared on the accrual basis and hence it reports all the transactions that are entered into, by the business managers in the normal course of business, irrespective of the involvement of cash in such transactions. The preparation of income statement on accrual basis does not allow the closing cash balance of business to match with the net profits earned over the period of time. The amount of revenue from sales shown in the income statement includes those amounts also that are not even collected till the end of reporting year and also the amounts that are actually not paid during the reporting period. Even the non-cash expenses such as goodwill amortisation expenses, depreciation expenses and so on are reported in the income statements to determine the true picture of profitability of the business. The free cash flow of the business cannot be ascertained through the income statements. The reporting of all such items in the income statement sometimes leads to misrepresentation of true profitability of the reporting entity (Spathis, 2002). Moreover, though the income statement contains the information regarding the earning per share but at the same time it does not contain information that helps the readers to gauge the future growth prospects of the business. Therefore, it is necessary for the readers to make use of other financial statements before reaching the ultimate decision making (Maine & McDaniel, 2000).
Uses of Income Statement for Key Stakeholders
Once the income statements of the business of the entity are prepared, the accountants have to take next step of preparing statement of financial position which is conventionally known as the balance sheet. Balance sheet of an entity contains the summaries of the current financial position of all the assets and liabilities carried by the business along with the information regarding the equity of the owners. Assets, liabilities and the owner’s equity are the integral components of any business (Edupristine, 2015). Assets are those properties of the business that are owned and controlled by the business entity such as inventory, trade receivables, plant and machineries, goodwill etc. Liabilities are those items that the business entity owes to any other party. The trade payables, bank loan, debentures, share capital and so on. The balance sheet typically contains the information about the total assets financed through the use of internal and external sources of finance such as retained earnings, borrowings from banks and financial institutions, issue of debentures or shares. Unlike, the income statement, the data and information that constitutes the balance sheet of an entity provides the clear insights about the financial position of the company at a particular point of time (Myers, n.d.). It basically reflects the valuable resources that are controlled and possessed by the entity as well as the information about how such resources are financed in the business. The statement of financial position helps the intended users to assess the liquidity position of the business as well the degree of efficiency used by entity to manage its debts and total assets. The analysts use the balance sheet to identify the ability of the company to pay off its short term and long term financial obligations and to distribute its profits among the shareholders. Banks and other financial institutions assess the balance sheet of the company to determine the credit worthiness and the current financial exposure of the business (Young, 2006).
The income statement and the statement of financial position are connected in the sense that the net profit earned in the current financial year becomes the part of the owner’s capital of the firm. If the owner does not invest or withdraw the profits of the business then it is quite likely that owner’s capital and net income will remain same. The double entry system of accounting establishes the relationship between the income statement and balance sheet of the firm. Though the balance sheet serves as the fundamental financial statement of an entity that facilitates evaluation of overall financial position of the business at a particular point of time, it suffers from certain pitfalls that impact its relevance for the users of financial reports (Barth, 2006). Such pitfalls will be discussed further.
Limitations of Income Statement
The figures on which the some of the assets and liabilities of the business of the entity are carried at the historical costs and not at their respective fair market values while some other items are measured on the basis of fair values of such items prevailing in the market. Therefore, it becomes difficult to instil uniformity in the financial statements (Chea, 2011). The measurement method that is used to measure the key items of assets and liabilities affects the amount with which they are reflected in the statement of financial position. The balance sheet does not contain the information that helps the readers to analyse the growth prospects of the business (Analyst Prep, 2016). The balance sheet does not reflect the strategies and policies of the company. Further, it is also not possible to carry out the comparative study of the financial performance of the business using income statements and statement of financial position (Analyst Prep, 2016).
The third most fundamental financial statement that is prepared by almost all the entities is the statement of cash flows of the business. This statement covers all the information relating to the inflow and outflows of cash to and from the business of the reporting entity. The major advantage of this statement is that it bifurcate the cash flows in three main categories i.e. operating activities, investing activities and the financing activities. The cash flows from the operating activities cover all such transactions that are undertaken as a part of main operations of the business. These activities are the core business activities. Whereas investing activities and financing activities are those activities that are generally non-core in nature but involves significant amount of cash inflows and outflows during the course of the business. The cash flow statement helps the readers to understand the actual movement of cash in the business (Georgiou, 2010). However, there are various limitations that influence its overall value for the users. Such limitations are discussed below:
Cash flow statements fail to represent the overall profitability of the business during a particular period and also the liquidity and solvency position of business is not reflected through the cash flow statements of the entity. Further, this statement does not contain the information that helps the analysts to identify the future growth scope of business. The cash flow statement is neither the substitute of the entity’s profit and loss account nor the fund flow statement.
Importance of Balance Sheet in Financial Reporting
Conclusion:
It can now be concluded that though the financial statements plays great role in allowing various parties from within and outside the business to critically evaluate the financial performance of the business of the reporting entity. The income statement, balance sheet and the statement of cash flows reflects the information that serves different purposes but all the three statements depicts the information that is related to each other in some context. These statements provide necessary information to the stakeholders of the business so that they can take informed economic decision in the matters in which they are directly or indirectly related to the entity. Thus, these statements are commonly known as the fundamental financial statements of the company. However, there are certain features of the financial statements that makes causes them to lose their relevance for the intended users (Barth, Beaver & Landsman, 2001). The financial statements of the entity are prepared on the basis of various accounting assumptions and conventions which are not uniformly followed by all the entities of same industry. Hence it gets difficult to carry out the comparative study of the financials results of different entities of the same industry. Also, the preparation of financial statements sometimes requires application of personal judgements of the accountants of the firm which is quite objective is nature. Further, since few items are carried at their historic cost and not at their existing value in the market, therefore the results are often misleading and not accurate in nature. One of the major drawbacks of financial statements is that these statements does not recognise necessary non-financial information about the business which is material to be taken into account by the intended users to undertake decision making.
References:
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Hanlon, M., 2003. What can we infer about a firm’s taxable income from its financial statements?. National Tax Journal, pp.831-863.
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