Question

18) The Statement of cash flows provides information that may be useful in predicting future cash flows, evaluating financial flexibility, assessing liquidity, and identifying a company's financial needs. It is not, however, the best financial statement for learning about a firm's financial performance during a period. Information about a company's financial performance is provided by the income statement. Two basic principles-the revenue recognition principle and the matching concept-work to distinguish the income statement from the statement of cash flows. (a) Define the revenue recognition principle and the matching concept. (b) Briefly explain how these two principles work to make the income statement a better report regarding a firm's periodic financial performance than the statement of cash flows.

Answer 1

a. Revenue recognition principle states that revenue must be recognized when it is realized or is realizable or it is earned. Revenue must be recognized irrespective of cash it received or not and must be recorded as and when it is accrued. Revenue must be recognized when the ownership or title is transferred.

Matching concept : It states that expenses must be matched with the revenues incurred in the period under consideration. The revenues and expenses are recognized and matched on a accrual basis.

b. In both the concepts, revenues and expenses are recorded in books on a accrual basis irrespective of whether cash is realized or paid. This reveals the actual net income / loss of a business i.e. what the company has actually made whereas in the statement of cash flows the actual payments and receipts of cash are shown and hence the actual cash position may not be the profit earned by the company. The cash flow statement does not consider what is to be paid or received in the future which may present a skewed financial position of the firm.