Introduction
The international Accounting Standards (IAS), Company Law, and International Financial Reporting Standards (IFRS) provide that companies must prepare financial statements for financial reporting purposes at the end of every financial year. These financial statements include income statement (profit and loss account), balance sheet, and cash flow statement. The income statement as per IAS 1 provides a summary of the company’s revenues and expenses and the resulting income from the operations. The cash flow statement under IAS 7 provides a summary of the changes in cash and cash equivalents, indicating to the users of the information, the liquidity position of the company.
Both income statements and cash flow statements are relevant in the decision-making process as all the stakeholders will depend on the information contained therein to determine their involvement with the company. The information contained in these statements must be relevant (both in nature and material), reliable and comparable.
The requirement by the regulating authorities including IFRS, IAS, and company law on the preparation of income statements and cash flow statements has been influential in companies performance and protection of interests of the various stakeholders in the company who may include employees, lenders, and creditors, potential investors, shareholders, government, and trading partners.
The value of the statements will depend on discretion and flexibility afforded by the accounting standards (Dye and Sridhar, 2009). However, the requirement has been faced with challenges due to some factors affecting the performance of the firms not being addressed adequately. The aim of this discussion is to critically evaluate this requirement of companies to produce income statements and cash flow statements in their end-of-year financial reports.
Definition of the statements
Income Statement
In simple terms, an income statement (commonly known as a profit and loss statement) is a summary of the financial performance of an organization in terms of profit or loss generated from matching revenues and expenses for a given financial period. According to IAS 1, the face of the income statement must disclose the revenues realized, costs incurred, tax expense, profit for the period, and appropriation of profit (including minority interest, if any).
In addition, IAS 1 provides that the following items may be disclosed either on the face or as notes to the income statement; discontinuing operations, disposal of investments, disposal of non-current assets, restructuring of activities, reversals of provisions, and write-down for inventories to net realizable values and litigation settlements (Summaries of IFRS. 2009). This is also provided for under IFRS 7 which requires for certain income and expenses items to be disclosed either on the face of or as notes to the income statement (Mirza, Holt & Orrell, 2006 p. 375)
Cash Flow Statement
A cash flow statement can simply be defined as a summary of cash movement in and out of an organization within a given financial period. It is structured in a way that shows the source of funds and where the funds of the organization are applied in the course of business. According to IAS 7, the cash flow statement analyses changes in cash and cash equivalents (demand deposits and short-term investments that can be easily converted to cash with insignificant risk of changes in value) (summaries of IFRS, 2009). The information included in the cash flow statement is derived from the income statement and balance sheet for the same period of time. A cash flow statement is composed of three parts; operating, investing, and financing activities (Stolowy and Lebas, 2006)
Operating activities directly relate to the core operation of the organization. They may include cash purchase and sale of goods, cash payment of operating expenses, and cash receipts for operating income. Adjustment is made on income generated to address the non-financial expenses (such as depreciation), changes in accounts receivable, inventory, and accounts payable.
Investing activities involve changes in investments and non-operating assets through buying new ones or disposal. Cash purchase or sale of equipment, building, motor vehicle, or machinery indicate cash movement in or out of the organization, and the same is included in the cash flow statement.
Financing activities include changes in capital items, loans, and dividend payments. Of importance is the flow of cash from investors and lenders and the cash outflow to the shareholders in form of dividends, and repayment of debt liability and interest thereof.
Relevance of income statement and cash flow statement
Both income statements and cash flow statements are vital reporting documents that provide viable information to the various users/stakeholders. The information therein should reflect the truth of the performance of the organization to enhance informed decision-making from both internal and external users.
The investors will require to know whether the organization will be able to pay dividends, creditors and other lenders will be interested to know whether the company has adequate liquidity to meet their obligations as they fall due based on cash flow information, the government will be interested in tax element in the statements and employees will be interested in understanding their future in the organization. The statements should represent a cohesive financial image of the organization and disintegrate information to ease the prediction of the organization’s future cash flows.
The relevance of the information contained in these statements is enhanced by its quality and applicability in economic decision-making. The income statement should portray a true and fair view of the profit or loss of the organization for a given financial period. In addition, disclosing unusual, abnormal, and infrequent items of income and expenses in the income statement separately enhances the prediction value of the statement (IASCF & IASB, 2007, p. 19).
The nature and materiality of the income statement and cash flow statement affect the relevance of information therein in decision-making. According to IASCF & IASB (2007) materiality is a quantitative aspect of the information in financial statements, the omission or misstatement of which will affect the economic decision making. In addition, the way the information is organized enhances the usability of such information by the various users. Reporting requirement for cash flow statement calls for classification of cash receipts and expenses into homogeneous groups according to the nature and activity they present, and items to be presented in reporting currency equivalent to the foreign currency cash flow at the prevailing exchange rates.
The income statement is prepared on the accrual basis of accounting as provided for by IAS 1 and IFRS. This enhances the presentation of useful information that reflects the importance of revenue recognition and matching concepts thus giving a more reliable true and fair view of the company’s performance. However, the cash flow statement is presented on the cash basis of accounting which is appropriate in disclosing the source and application of funds in course of business.
Impact of the requirement for income statement and cash flow statement
The information contained in both the income statement and cash flow statement must always be reliable and relevant to the user of such information and must be structured in a way that is easy to understand and derive a conclusion from them.
Income statement
The income statement is prepared using the accrual basis of accounting where income is recognized when earned and expenses recognized when a service is received even if it is not paid for. In addition, revenues are matched with costs that are incurred in producing them. According to Mirza, Holt & Orrell, (2006), all financial statements in exception of cash flow statements must be prepared using the accrual basis of accounting.
This is a requirement of the IFRS and IAS that aim at ensuring the income statement portrays a true and fair view of the profit or loss of the firm. The presentation of the income statement on an accrual basis eliminates the complexity of cash recording, especially where a company has inventories and makes sales and purchases on credit terms, thus providing more reliable information that portrays the true position of the firm. The reliability of this information is beneficial to the firm in that, the users especially the lenders will have confidence in the firm as they will be able to understand the actual performance of the firm before they can decide on their involvement.
The requirement to produce an income statement is of potential benefit to all those parties who have an interest in the company in that the statement will show the direction of the firm, and only through understanding the financial position of the firm that their interest can be protected. Indeed, Chang and Most (1981) established that most investors and financial analysts depend on the information contained in the financial statement to make their buying and holding decisions of the company’s securities.
The IAS 1 specifies the income and expenses items to be disclosed either within the income statement or as a summary in the notes to the income statement. Simply put, the income statement contains a summary of revenues generated matched to the costs incurred and the realized profit or loss, which is the main expectation of all the stakeholders (Hey-Cunningham, 2002).
The company law establishes a legal basis for the preparation of the income statement and cash flow statement and the extent to which they must reflect the requirement of the IAS and IFRS. This is a positive ingredient in ensuring uniformity in the financial reporting standards and a means of streamlining the performance of the firms to protect the stakeholders’ interests. The law also requires public quoted companies and financial institutions to publish their audited accounts in the media. This is of special importance to the users of the information especially shareholders, potential investors, government agencies, and lenders as the information so displayed will not only aid in understanding the financial position of their interest but also in making informed decisions on the level of involvement to set in the firm.
The requirement of the Companies Law, IFRS, and IAS is that the produced financial statements (Income statement and cash flow statement included) must be audited by an independent auditor to establish their relevance and reliability. In addition, the statements must include disclosures on the accounting policies used in preparing them which must depict relevance and reliability (Hey-Cunningham, 2002).
The importance of auditing the financial statements is to ensure that there have been no omissions or misstatements in the financial information and that all the information affecting the firm has been brought forth for use by the various users. Failure to have this requirement will give the managers of the firm a leeway to provide misleading information on the company’s income, increasing the chances of financial misappropriation and in the process jeopardizing the agency theory.
The impact of the requirement to produce the income statement is the influence on the figure contained therein by the political and other business-related laws such as capital market legislation, tax laws, and so on. The political and tax laws may influence the reported figures due to the difference in applicability of legal standards in different countries such that some items can be taxable in one nation but not taxable in another. Therefore, compliance with accounting standards is important to enhance understanding and interpretation of the income statement.
The comparability of a firm’s performance among periods and across the industry will not be possible without the presence of an income statement. The statement also enables the analysis of various ratios which are important in establishing and reinforcing various policies affecting the operation of the firm. For instance, the level of growth in receivables relative to sales will affect the application of a collection policy or credit extension policy.
According to Tamari (1978], managers and investors rely on the profitability ratios as standard for performance judgment. Thus the requirement to prepare an income statement is of importance in establishing the basis for the company’s performance analysis. The absence of such a requirement will give the firms a leeway to present unstructured or even unreliable information that can not be easily analyzed or interpreted.
Cash flow statement
The cash flow statement is prepared on cash basis accounting and presents the changes in cash and cash equivalent items thus giving indications to the users of the information about the liquidity strength of the firm during a given accounting period. The cash flow statement is aimed at ironing out the limitations of the income statement by providing more measurable information that eliminates estimations such as depreciation.
Cash flow ratios derived from the cash flow statement are important in revealing information that is not adequately revealed by other financial statements (Aziz and Lawson, 2009). The presentation of cash information allows understanding the liquidity of the firm and whether the company will be able to meet its short-term and long-term obligations as they fall due. Therefore the requirement for this statement will aid in predicting the future financial implications of the firm and potential cases of bankruptcy and insolvency.
Failure to have this statement may result in the firm tending to swindle the stakeholders by concealing vital information on liquidity problems affecting the firm. Many companies have collapsed and disappeared with investors’ money, a situation that could have been avoided by clear guidelines and enforcement on the use of cash flow information to predict the imminent bankruptcy thus giving the investors a sign of caution.
Due to differing accounting methods across the industry, a cash flow statement is required to even out or ease the comparability of the performance of firms across the industry thus aiding in strategic planning and market positioning. Mirza, Holt & Orrell, (2006 p. 28) state that the cash flow statement enhances comparability of operating performance by various entities especially where accounting treatment differs for a similar transaction.
Challenges of the requirement
Although the requirement to produce both the income statement and cash flow statement has had a positive impact on the relevance, reliability, and comparability of the information contained therein, it is fouled for lack of clearly addressing some important factors that have a significant effect on the performance and prospects of a company. Such factors include market demand, competitor actions, human capital, and technological advancement.
These factors are influential to the decision-maker as he will rely on their future impact and the company’s strengths to cope with them. in addition, government regulations, union movements, political conflicts, and natural acts may also have an impact on the performance of the firm and therefore the regulating authorities must look for a way to enforce the inclusion of this information in periodic reports.
Despite its importance in providing information about the liquidity of a company, the cash flow statement is weak in predicting financial distress. In addition, there has been a problem in fair value measurements of disclosures leading to the inconsistent valuation of investments and other instruments, and the inclusion of the same in interim statements. However, IASB (2009) concludes clarity in fair value measurement and inclusion of fair value measurements disclosures in the interim statements as per IAS 34.
The requirement only applies to registered companies and does not support the small partnership and sole proprietorship businesses yet they also have various stakeholders with interest in the operation of those firms. In addition, IFRS for SMEs does not address this issue. (IASB, 2009)
Conclusion
The requirement for the preparation of the income statement and cash flow statement is essential to both the company and other internal and external users of the information contained in these statements. The value of the information contained therein is paramount in the decision-making process. The requirement to produce the statements during end-of-year reporting ensures that the company makes every possible effort to ensure accountability and transparency are enhanced to portray relevant and reliable information. Where the requirement to produce these statements is not enforced, a company may distort income realized and cash may be misappropriated by the management of the company without the knowledge of investors. This may lead to increased cases of collapsed companies due to mismanagement.
References
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Dye, R A, and Sridhar, S S 2008, “A positive theory of flexibility in accounting standards,” Journal of Accounting and Economics, Vol. 46, issues 2-3. Web.
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International Accounting Standards Committee Foundation, International Accounting Standards Board 2007, A guide through International Financial Reporting Standards (IFRS), Kluwer, MA.
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International Accounting Standards Board 2007, International financial reporting standards (IFRS), Kluwer, MA.
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