Limitations of the Income Statement What You Should Pay Attention to
The income statement also has limitations that you should pay attention to, if you don't want your business to fall into the abyss of losses.
Don't let the business go bankrupt because you ignore the limitations of an income statement. CAREFUL! Because if you do not pay attention to the limitations that I will describe in this article, it is not impossible You think having a 'good' profit is actually driving you to the brink of bankruptcy.
We have discussed the income statement several times, if you want to know how important the income statement is, please CLICK HERE right away. The income statement presents a measure of the success of the company's operations over a certain period of time.
Through the income statement, investors can find out the level of profitability generated by the investee. Also through the income statement, the creditor can consider the creditworthiness of the debtor. Earnings measures describe management's performance in generating profits to pay creditor interest, investor dividends, and government taxes.
Earnings information is also used to estimate the company's ability to generate profits in the future, to interpret the risk in investing, and others.
Besides the usefulness of the 'powerful' income statement, users must also be aware of some of the limitations that exist in it. Net income as a result of matching expenses and revenues, is an estimate and reflects a number of assumptions. That's why we have to be careful. Here are some limitations of the income statement that you should pay attention to.
3 Limitations of the Income Statement What You Should Pay Attention to
1. Items that cannot be measured accurately are not reported.
Current practice prohibits the recognition of certain items when determining profit, even though these items have a significant impact on the company's performance. For example, when there is a temporary change in value (market price), unrealized gains and losses should not be recorded in the income statement.
This is due to the uncertainty regarding the realization of the change in value until it is actually sold.
Another example, when a company experiences an increase in company value due to brand image recognition, service quality improvement, product quality improvement, or product innovation, all of these things are not reported as a result of the company's performance in the income statement. This is because there is no framework that can be used to identify and report these types of values.
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2. Profit is influenced by the accounting method used.
As mentioned in several previous articles, one of the components of profit is expenses. And an item will be comparable with the same accounting method, meaning that it has a uniform method in recording and reporting the item. This is one of the weaknesses of accounting, which is too indulgent for financial statement makers by providing various alternative accounting methods.
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One example is the method used in calculating asset depreciation. Even though the assets are the same, due to differences in the depreciation method used, it is certain that the amount of depreciation is different. Companies that use the straight-line depreciation method will generate greater profits than companies that use the accelerated depreciation method.
3. Earnings are also influenced by estimation factors (involving management's subjective judgment).
In practice, management often has to use subjective judgment to determine the size of the estimate for an accounting event. Based on generally accepted accounting principles, these estimates can be determined subjectively and rationally.
An example is an estimate of the residual value and useful life of a fixed asset. In this case, the use of different estimates will of course also result in different depreciation expense and profit.
Another example is the use of estimates in measuring product warranty expense and bad debts expense.
It turns out that even though your method is correct, the income statement You can still output different inputs. By using different accounting methods, and/or subjective estimates, your operating profit can be different.
Therefore be careful!!! Pay attention to the three limitations of the income statement when you view the financial statements of your business, or when you You as a potential investor see the financial statements of a company.
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