Why Income statement is not enough?
No doubt profit figures of the entity over the year provide valuable information to ascertain entity’s performance. Information regarding financial performance let the users understand how effectively and efficiently management has used the resources at its disposal.
Financial performance is also a measure of economic resources available to the entity. Improvement in financial performance means entity’s resources has increased and is now in even better position to control more resources.
On the other hand resources generate cash and cash equivalents. If we sum up, we can safely say that any change in financial performance is the result of change in resources of the entity which also means that entity’s potential to generate cash flows is affected.
So we understand that information regarding financial performance and cash flows of the entity is important for the users of financial information and they cannot rely just on the Income statement for the following reasons:
- Income statements are prepared on accrual basis instead of cash basis i.e. income is recognized when it is earned instead of when the amount is received and expense is recognized when it is incurred instead of when amount is paid.
Due to the same reason as the amounts of expenses and incomes are not shown on cash basis i.e. actual receipt and payments thus income statement figures are not a true representation of actual cash flows.
- And as said earlier, increase in profit means increase in net assets. Net assets include non-current assets and current assets. Therefore, if the profit is increasing then it does not necessarily means that cash has increased it can be any asset. For example, when sales are made on credit basis then our profits increase as we have earned an income and on the other hand our debtors increase. This way net assets will increase but cash remains still the same. Therefore, profits calculated in the income statement do not mean equivalent increase in cash.
From the above discussion we can understand that only profitable business is not enough for the stakeholders, especially shareholders as they want these profits to be converted into cash as we profits earned but distributed through cash got no worth and to pay out such profits in the form of dividend entity needs cash. Therefore, capability of entity to generate cash and cash equivalent becomes even more important profitability.
Remember, companies become insolvent because they are no more capable to generate enough cash flows to pay out their liabilities on time and not the profitability. That is why you might have seen companies which are in losses for years but still operating whereas the ones with profits most often go bankrupt.
Understanding this IASB has issued an International Accounting Standard (IAS) 7 – Statement of Cash flows