Limitations of the Income Statement

Most of the limitations of the income statement are caused by the periodic nature of the
income statement. At any particular financial statement date, buying and selling will be in
process, and some transactions will be incomplete. Therefore, net income for a period
necessarily involves estimates, and these estimates affect the company’s performance for the
period.
Limitations that reduce the usefulness of the income statement for predicting amounts, timing
and uncertainty of cash flows include:
• Net income is an estimate that reflects a number of assumptions.
• Income numbers are affected by the accounting methods used. For example, differences in
methods of depreciation cause differences in amount of depreciation expense during each
year of an asset’s life. A lack of comparability between and among companies results from
these differences in accounting methods.
• Income measurement involves judgment. For example, the amount of depreciation expense
recorded during a period is dependent upon estimates regarding the useful lives of the assets
being depreciated.

• Items that cannot be measured reliably are not reported in the income statement. For
instance, increases in value due to brand recognition, customer service, and product quality
are not reflected in net income.
• The income statement is limited to reporting events that produce reportable revenues and
expenses. Generally, revenues and gains are not recognized Until they can be reliably
measured and are realizable. “Reliably measured” means they can be converted into a known
amount of cash or claims to cash. “Realizable” Generally means that the company has
completed all of its obligations relating to the sale of the product, and the collection of the
receivable is assured beyond reasonable doubt. Delaying the recognition of revenue until it is
realizable is a means of dealing with the
periodic nature of the income statement. However, some gains such as holding gains on
available for-sale debt securities are realizable but are not reported on the income statement.
The Available for-sale debt securities could be sold immediately at the market price, but
holding gains and losses on them are excluded from net income, though they are reported in
accumulated other comprehensive income in the equity section of the balance sheet. (The
preceding information about securities will be explained in this volume in the topic
Investments.)

Limitations of the Balance Sheet

A balance sheet reports a company’s financial position, but it does not report the company’s
value, for the following reasons:
• Many assets are not reported on the balance sheet, even though they do have value and will
generate future cash flows. Examples of these assets include the company’s employees, or its
human resources, its processes and procedures, and its competitive advantages.

• Values of certain assets are measured at historical cost, not market value, replacement cost,
or their value to the firm. For example, property, plant and equipment are reported on the
balance sheet at their historical cost minus accumulated depreciation, although the assets’
value in use may be significantly greater.

• Judgments and estimates are used in determining many of the items reported in the balance
sheet. For example, estimates of the amount of receivables the company will collect are used
to value the accounts receivable; the expected useful life of fixed assets is used to determine
the amount of depreciation; and the company’s liability for future warranty claims is
estimated by projecting the number and the cost of the future claims.

• Most liabilities are valued at the present value of cash flows discounted at the rate that was
current when the liability was incurred, not at the present value of cash flows discounted at
the current market interest rate. If market interest rates increase, a liability that carries a fixed
interest rate that is below market increases in its value to the company. If market rates
decrease, a liability that is payable at a fixed interest rate that is higher than the market
interest rate sustains a loss in value. Neither of these changes in values is recognized on the
balance sheet.

Limitations of the Statement of Cash Flows

The statement of cash flows shows only how much cash was received and paid out for
operating, investing, and financing activities. In order for this information to be fully utilized,
it often needs to be combined with other information in the financial statements.
For example, the statement of cash flows alone would not show that a positive operating cash
flow was achieved by not paying payables when due. The existence of past-due payables is
important information for a user to have in interpreting the statement of cash flows and for
analyzing the financial condition of the company. In order to recognize something like past-
due payables, the balance sheet and income statement are needed. For that reason, the
statement of cash flows needs to be interpreted in the context of the other financial
statements.
The indirect method of preparing the operating cash flows section of the SCF has an
additional limitation: it does not show the sources and uses of operating cash individually, but
instead shows only adjustments to accrual-basis net income. Because of this limitation, a user
can have difficulty in using the information presented. For this reason, the direct method is
preferable even though both methods are acceptable. The indirect method is more commonly
used, however, because it is easier to prepare.