Intermediate Accounting I Lesson 9 Income Statement

What can the income statement be used to assess?

Creditworthiness The business and investment community uses the income statement to determine profitability, investment value, and creditworthiness. Creditworthiness is the measure that a company has sufficient income to cover its expenses. Both revenue and expenses are found on the income statement

What limitation of an income statement occurs when one company uses an accelerated depreciation method while another company uses straight-line depreciation?

Income numbers are affected by the accounting methods employed. Depreciation is an accounting method. If one company uses accelerated depreciation while another uses straight-line, comparing the income of the statements for the two would be affected.

How can the Income Statement help users of financial statements predict future cash flows?

1) Evaluate the past performance of the company. Examining revenues and expenses indicates how the company performed and allows comparison of its performance to its competitors. For example, analysts use the income data provided by Ford to compare its performance to that of Toyota. ------------------------------------------------------------------ 2) Provide a basis for predicting future performance. Information about past performance helps to determine important trends that, if continued, provide information about future performance. For example, General Electric at one time reported consistent increases in revenues. Obviously, past success does not necessarily translate into future success. However, analysts can better predict future revenues, and hence earnings and cash flows, if a reasonable correlation exists between past and future performance. ------------------------------------------------------------------- 3) Help assess the risk or uncertainty of achieving future cash flows. Information on the various components of income—revenues, expenses, gains, and losses—highlights the relationships among them. It also helps to assess the risk of not achieving a particular level of cash flows in the future. For example, investors and creditors often segregate IBM's operating performance from other non-recurring sources of income because IBM primarily generates revenues and cash through its operations. Thus, results from continuing operations usually have greater significance for predicting future performance than do results from non-recurring activities and events. ------------------------------------------------------------------- In summary, information in the income statement—revenues, expenses, gains, and losses—helps users evaluate past performance. It also provides insights into the likelihood of achieving a particular level of cash flows in the future.

What does the income statement reveal about an organization?

Net earnings (net income) of the organization for a period of time The income statement reports net earnings (net income) for a period of time, such as month or a year.

What are the Limitations of the Income Statement?

Because net income is an estimate and reflects a number of assumptions, income statement users need to be aware of certain limitations associated with its information. Some of these limitations include: 1. Companies omit items from the income statement that they cannot measure reliably. Current practice prohibits recognition of certain items from the determination of income even though the effects of these items can arguably affect the company's performance. For example, a company may not record unrealized gains and losses on certain investment securities in income when there is uncertainty that it will ever realize the changes in value. In addition, more and more companies, like Cisco Systems and Microsoft, experience increases in value due to brand recognition, customer service, and product quality. A common framework for identifying and reporting these types of values is still lacking. ----------------------------------------------------------------- 2. Income numbers are affected by the accounting methods employed. One company may depreciate its plant assets on an accelerated basis; another chooses straight-line depreciation. Assuming all other factors are equal, the first company will report lower income. In effect, we are comparing apples to oranges. ------------------------------------------------------------------- 3. Income measurement involves judgment. For example, one company in good faith may estimate the useful life of an asset to be 20 years, while another company uses a 15-year estimate for the same type of asset. Similarly, some companies may make optimistic estimates of future warranty costs and bad debt write-offs, which result in lower expenses and higher income. ------------------------------------------------------------------- In summary, several limitations of the income statement reduce the usefulness of its information for predicting the amounts, timing, and uncertainty of future cash flows.

What is true about the information provided in the income statement?

It helps in evaluating the past performance of the enterprise. Examining revenues and expenses indicates how the company performed and allows comparison of its performance to its competitors.

Quality of Earnings

So far, our discussion has highlighted the importance of information in the income statement for investment and credit decisions, including the evaluation of the company and its managers. Companies try to meet or beat Wall Street expectations so that the market price of their stock and the value of management's stock compensation packages increase. As a result, companies have incentives to manage income to meet earnings targets or to make earnings look less risky. The SEC has expressed concern that the motivations to meet earnings targets may override good business practices. This erodes the quality of earnings and the quality of financial reporting. As indicated by one SEC chairperson, "Managing may be giving way to manipulation; integrity may be losing out to illusion." As a result, the SEC has taken decisive action to prevent the practice of earnings management.

Income Statement

The income statement is the report that measures the success of company operations for a given period of time. (It is also often called the statement of income or statement of earnings.) The business and investment community uses the income statement to determine profitability, investment value, and creditworthiness. It provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows. - the central element of the objective of financial reporting

Earnings Management

The planned timing of revenues, expenses, gains, and losses to smooth out bumps in earnings. In most cases, companies use earnings management to increase the income in the current year at the expense of income in future years For example: they prematurely recognize sales in order to boost earnings. Companies also use earnings management to decrease current earnings in order to increase income in the future. The classic case is the use of "cookie jar" reserves. Companies establish these reserves by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges, and warranty returns. The companies then reduce these reserves in the future to increase reported income in the future. Such earnings management negatively affects the quality of earnings if it distorts the information in a way that is less useful for predicting future earnings and cash flows. Markets rely on trust. The bond between shareholders and the company must remain strong. Investors or others losing faith in the numbers reported in the financial statements will damage U.S. capital markets. We need heightened scrutiny of income measurement and reporting to ensure the quality of earnings and investors' confidence in the income statement.

What does the business investment community use the income statement for?

To determine profitability, investment value, and creditworthiness It provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows