ANSWERS TO QUESTIONS
The income statement is important because it provides investors and creditors with
information that helps them predict the amount, timing, and uncertainty of future cash
flows. It helps investors and creditors predict future cash flows in a number of different
ways. First, investors and creditors can use the information on the income statement to
evaluate the past performance of the enter-prise. Second, the income statement helps
users of the financial statements to determine the risk (level of uncertainty) of income—
revenues, expenses, gains, and losses—and highlights the relationship among these
It should be emphasized that the income statement is used by parties other than investors
and creditors. For example, customers can use the income statement to determine a
s ability to provide needed goods or services, unions examine earnings closely
as a basis for salary discussions, and the government uses the income statements of
companies as a basis for formulating tax and economic policy.
Information on past transactions can be used to identify important trends that, if continued,
provide information about future performance. If a reasonable correlation exists between
past and future performance, predictions about future earnings and cash flows can be
made. For example, a loan analyst can develop a prediction of future performance by
estimating the rate of growth of past income over the past several periods and project this
into the next period. Additional information about current economic and industry factors can
be used to adjust the trend rate based on historical information.
Some situations in which changes in value are not recorded in income are:
a) Unrealized gains or losses on available-for-sale investments,
b) Changes in the market values of long-term liabilities, such as bonds payable,
c) Changes (increases) in value of property, plant and equipment, such as land, natural
resources, or equipment,
d) Changes (increases) in the values of intangible assets such as customer goodwill, brand
value, or intellectual capital.
Note that some of these omissions arise because the items (e.g., brand value) are not
recognized in financial statements, while others (value of land) are recorded in financial
statements but measurement is at historical cost.
Some situations in which application of different accounting methods or estimates lead to
comparison problems include:
Inventory methods—LIFO vs. FIFO,
Depreciation Methods—straight-line vs. accelerated,
Accounting for long-term contracts—percentage-of-completion vs. completed-contract,
Estimates of useful lives or salvage values for depreciable assets,
Estimates of bad debts,
Estimates of warranty returns.