Limitations of Income Statement
An income statement is a financial statement that reports a company’s financial performance over a specific accounting period.
It shows the company’s revenues, expenses, and profits over a specific period of time. The income statement can be prepared on a monthly, quarterly, or annual basis. Income statements are important because they provide insights into a company’s financial performance. They can show whether a company is generating enough revenue to cover its expenses and make a profit. They can also reveal trends over time, which can be helpful in forecasting future profitability.
While it is often compared to the balance sheet and cash flow statement, the income statement is unique in that it reflects the financial activity of a business over a specific period of time. As such, it is an essential tool for investors, analysts, and other stakeholders who are interested in assessing a company’s financial health.
Limitations of Income Statement
Even though the income statement provides many benefits to the user, it still has several limitations as follows:
- Not represent the actual cash flow in the company.
Income statement does not show the actual cash flow in the company. Cash flow is the movement of cash into and out of a business. It is important to track cash flow because it can be a good indicator of a company’s financial health.
The company may be generating profit but still have financial difficulty if they lack of cash to pay for the supplier and other parties. Many companies liquidate due to lacking of cash flow to support the operation while the bottom line is positive.
If we focus only on the income statement, we may miss some useful information such as the cash flow. The investors may be making the wrong decision if they only use the income statement.
- Easily to Manipulate
It appears that the company is trying to increase the profit by window-dressing the report. Management tries to manipulate the income statement by increasing revenue and decreasing expenses. The management team receives incentives based on the company performance which is present on the income statement.
And it is not very hard to make such kind of manipulation. The income statement is made based on the accrued basics and requires many assumptions and judgment. They can use these factors to work in their favor. For example, company can increase sales at year-end and return next year. They can delay the expense to next year. Moreover, they can reduce the depreciation expense by increasing the fixed assets’ useful life.
- Based on the assumption and company policy
As mentioned above, the income statement follows the accrued basic which the revenue and expenses record based on an occurrence rather than cash flow.
In some situations, company has to make the assumption to record the revenue and expense. They estimate the amount of revenue to be recorded in the construction project. It will be the same for the cost as well. The depreciation and amortization expenses will depend on the company policy. The accrued expense will depend on the management estimation.
With these kinds of assumptions and estimations, there is always room for errors.
- Not include the true costs
Some expenses such as depreciation and amortization may not reflect with the actual cost. Due to the estimation, it can be far different from reality. The fixed assets may be able to use for more than the expected useful life.
- Ignore the non-financial factors
The income statement takes into account only the financial figure which is the revenue and expense. These are the numbers that already happened in the past. We are not sure about the future which can be a different story.
The report ignores the market share, the growth of sales, and customer satisfaction. These factors have a huge impact on the company’s performance in the future.
The company needs to spend a huge time preparing such kind of report. It may be easy to just extract the report from the accounting software but in order to ensure the truth and fairness, the income statement needs to be reviewed by quality auditors. The process is very time-consuming and costly for small businesses.