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An income statement is part of the three main financial statements (balance sheet and cash flow statement) companies are obliged to produce by law. But, the question arises of whether an income statement reports the true profit of an entity, and to what extent it can be relied on by its users. On one side, accountants view that 'profit is an increase in net wealth' (Mac Neal, 1970). While, another perspective from an economist argues that profit should be seen as - 'terse, obvious, and mathematically demonstrable' (Mac Neal, 1970).
This essay intends to discuss different point of views regarding to which extent true profit of an entity is shown on the income statement. Firstly, it will aim to clarify why accountants and economist view of profit prove to be different. Furthermore, this essay will aim to discuss and explore a balance argument as to whether true profit is shown by the income statement or not. Supporting quotes and different perspective will be used to support the arguments. Finally, arising from the discussion will be my own conclusion based on the discussion.
An income statement profit involves an amount of subjectivity judgements. 'A Company's profit after tax (or Net income) is a quite arbitrary figure obtained after assuming certain accounting hypotheses regarding expenses and revenues'(Fernandez, 2008)
Accounting concepts are also imbedded as part of the profit's calculation; the amount of concepts involved usually depends on the complexity of the entity. In addition to the accountants and economist views, another perspective view of the significance of profit states that - 'the reported profit of a company seldom gives the true indication of its value' (actuaries, 2004). Although, a definition does not give the guarantee to the validity of the figure on the income statement (net profit). Subjectivity that arises in the statement could be the huge focus to be blamed for the different views on profit. Therefore, what is seen as true profit seems rather unclear in the financial world.
The concept of accruals used in the income statement could claim that a true indication of profit is shown. The accrual concept aims to match revenue and expenses to the period it belongs to, regardless of payments or receipts transactions (Tiron, 1990). To an extent true profit is shown, because sales and expenses recognition are allocated to the period it belongs to rather than when receipts and payments are collected or paid (cash accounting). Automatically allowing the business to observe revenues and expenditures for that period compared to the concept of cash accounting. It can therefore be argued that a more accurate profit is shown in all periods under accruals.
Although, accruals concept could also be a potential manipulating mechanism for entities in order to influence profit to their own advantage. Realisation of sales could vary from entity to entity, because of complexity involved in when to show that a sale has occurred. Sales on credit are examples that give entities more control on the influence over profit earned in periods. An entity might decide to record a sale as it occur, another might recognise it in the following period when the sale is finally finalised. Claims from one side that states sales should be recognised when it occurred whereas it can also be argued that it should be recognised when sales is fully completed (excluding receipts). Therefore, there will be an inconsistency in the Income statement if it is heavily relied on accruals concept as there is huge ambiguity regarding when there is realisation. Further example is the spread of depreciation shown in the income statement. The timings based on accruals in the income statement can cause a huge difference in the profit projected.
The recognition for amortisation (depreciation) in the income statement enhances the accuracy the profit figure. Although it is non-cash expense, the acknowledgment of depreciation illustrates the loss (decline) in fixed assets value (About, 2010). It is charged against gross profit, which helps give an edge in the precision to the net income reported. Following Ben (2007) Income statement profit is relied on for the computation of tax, dividends and investment policies making it more convincing that it shows the truth in the entity's performance. The Keating (1999) journal further expands on the essential of depreciation recognition on the profit, stating that it gives a more effective 'internal decision making and control' within the entity.
While Scot (2004) argues that 'The depreciation/amortization method, the useful life and the salvage value are all subjective decisions.' Although this is true; however, depreciation accounts for an insight into what cannot be physically seen but is known to affect profit.
Overall, Dickinson concluded that - 'in other words, every appreciation of assets is a profit & every depreciation is a loss' (Mac Neal, 1970). Dickinson gives the impression that the physical and non-physical changes in assets, has to be recognised to affect profit.
On the other hand, depreciation could potentially present false profit if realism fails to be reflected on the income statement. Discretionary items such as - provision for bad debts, depreciation, and bad debts can manipulate profits, as they can be itemised using different policies or methods. 'Discretionary expenses are those which the business owner may control in order to decrease the reported profits' (Ohio State University, 2009). Depreciation policies are more likely to differ from entity to entity because of the subjectivity issue that surrounds it. E.g. over a particular fixed asset, one entity can pursue the straight line while another entity believes the reducing balance depreciation method is more suitable. A dissimilar net income will arise due to the different depreciation method. Thus, 'they may be manipulated to either reduce or overstate the reported earnings before tax of a company' (Ohio State University, 2009). Therefore, net profit can be viewed as false as it can be easily influence with opinionated believes.
Finally, there is a strong belief in the income statement as a decisive tool by banks when offering loans, due to its conservatism mechanism (Wooseok, 2007) & (Ben, 2007).
Ball and Shivakumar suggested that- 'In the case of debt contracts, timelier income statement recognition means that the income statement provides more useful information in a loan agreement'. This asserts the huge relevance and reliance found on the firm's projected profit in income statement figures. Because of the dependency on bank loans, firms therefore could still continue trading during tough periods (Wooseok, 2007). Resulting in a higher importance and delicacy towards income statements produced, in order to maintain regular finances during critical times. Ball and Shivakumar (B&S) therefore, concluded that - 'In other words, timelier recognition implies higher financial reporting quality' (Wooseok, 2007). Banks can reasonably assume that the profit figure in the income statement must reflect the firm's performance, according to B&S.
In conclusion, I believe it is a controversial decision as to whether the income statement reflects true profit or not. The discussion explores the attempts to include discretionary items in the income statement in order to give a better accuracy to profit. But, because of the amount of subjectivity judgements involved in these items, it becomes more difficult to convince users about the validity of the net profit.
In supplement to Wooseok, It can be considered that banks take a blind risk. It demonstrates that net profit on the income statement is worth rendering loans to an entity.
Due to the uncertainty in the business world, some judgements that are known not to be fully accurate still have to be reflected in the income statement somehow, but realistically. The exclusion of subjectivity judgements from the income statements will no doubt present untrue profit figure of the entity. This exclusion claims that discretionary items do not impact on the entity's profit, which Dickinson opposes against in the discussion.
Although, Income statement does not show the true profit of an entity, but so far it is the most accurate way of measuring an entity's financial performance in this day and age.