Limitations of the Income Statement

Income statements have several limitations stemming from estimation difficulties, reporting error, and fraud.

Learning Objective

Demonstrate how the limitations of the income statement can influence valuation

Key Points

Income statements include judgments and estimates, which mean that items that might be relevant but cannot be reliably measured are not reported and that some reported figures have a subjective component.
With respect to accounting methods, one of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands.
Income statements can also be limited by fraud, such as earnings management, which occurs when managers use judgment in financial reporting to intentionally alter financial reports to show an artificial increase (or decrease) of revenues, profits, or earnings per share figures.

Terms

LIFO
Method for accounting for inventory. LIFO stands for last-in, first-out, and assumes that the most recently produced items are recorded as sold first.
FIFO
Method for for accounting for inventories. FIFO stands for first-in, first-out, and assumes that the oldest inventory items are recorded as sold first.
matching principle
According to the principle, expenses are recognized when obligations are (1) incurred (usually when goods are transferred or services rendered, e.g. sold), and (2) offset against recognized revenues, which were generated from those expenses, no matter when cash is paid out. In cash accounting—in contrast—expenses are recognized when cash is paid out.

Full Text

Income statements are a key component to valuation but have several limitations: items that might be relevant but cannot be reliably measured are not reported (such as brand loyalty); some figures depend on accounting methods used (for example, use of FIFO or LIFO accounting); and some numbers depend on judgments and estimates. In addition to these limitations, there are limitations stemming from the intentional manipulation of finances.

One of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands. This could be due to the matching principle, which is the accounting principle that requires expenses to be matched to revenues and reported at the same time. Expenses incurred to produce a product are not reported in the income statement until that product is sold. Another common difference across income statements is the method used to calculate inventory, either FIFO or LIFO.

Income statement

Accounting for inventory can be done in different ways, leading to differences in statements.

In addition to good faith differences in interpretations and reporting of financial data in income statements, these financial statements can be limited by intentional misrepresentation. One example of this is earnings management, which occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports in a way that usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures.

The goal with earnings management is to influence views about the finances of the firm. Aggressive earnings management is a form of fraud and differs from reporting error. Managers could seek to manage earnings for a number of reasons. For example, if a manager earns his or her bonus based on revenue levels at the end of December, there is an incentive to try to represent more revenues in December so as to increase the size of the bonus.

While it is relatively easy for an auditor to detect error, part of the difficulty in determining whether an error was intentional or accidental lies in the accepted recognition that calculations are estimates. It is therefore possible for legitimate business practices to develop into unacceptable financial reporting.

[ edit ]

Prev Concept

Uses of the Income Statement

Effects of GAAP on the Income Statement

Next Concept