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.

In Question 18, our authors focus on the Revenue Recognition and Matching Principles to distinguish between the Income Statement and the Cash Flow Statement. Is there another way to think of the Cash Flow Statement? What type of statement might it be?

Answer 1

(a) Revenue recognition principle is a Generally Accepted Accounting Principle (GAAP) which states that a business must record the revenue when it has been earned and not when the cash is collected. No amount of revenue should be recognized unless the amount of consideration & actual realization of the consideration is reasonably certain. It is related to one of the fundamental assumptions of accounting ,accrual basis of accounting which states transactions are recognized as soon as they occur, whether or not cash or cash equivalent is actually received or paid. For example- A sale is recognized in accounts on the completion of delivery of goods or service to customer and not when the customer actually pays cash.

Matching concept - As per this concept, all expenses matched with the revenue of that period should only be considered for calculating profit or loss. In financial statements, if any revenue is recognized, then expenses incurred to earn that revenue should also be recognized. This concept is based on accrual concept as it considers the occurrence of expenses and income and do not concentrate on actual inflow or outflow of cash. This leads to adjustment of certain items like prepaid and outstanding expenses, unearned or accrued incomes. For example- When a sale is recognized as an income, any selling expenses incurred to complete that sale must also be recognized as an expense.

(b) The above concepts ensures better matching between revenue and cost and profit/loss obtained on this basis reflects the actual activities of the enterprise during an accounting period, rather than cash flows generated by it. Cash flow statement has limited usage as it does not disclose net income/financial performance of an organisation. It is of little use when used in isolation without Balance Sheet and Profit & loss Statement. For example, cash flow statement may show increase in cash and cash equivalents during the year but this can be due to the receipt of cash from outstanding receivables at the beginning of the period and not from the sales made during the year thus, it is not that reliable. Mainly, cash flow does not follow accrual concept and hence it does not provide provision for the expenses incurred during the year for which payment is made in next year thus not showing the actual performance of the business.