Question

Which of the following is considered to be a limitation of income statements?

Select one:

a. Income statements depend on accounting methods selected.

b. Income statements evaluate past performance.

c. Income statements predict future performance.

d. Income statements assess uncertainties of achieving future cash flows.

Answer 1

The limitation of income statement is that (a.) Income statements depend on accounting methods selected

Accounting is an art. The data of income statements depends on the choice of method adopted by the accountant . There are different methods of depreciation. Depreciation is equal in all years by following straight line method of depreciation. The amount of depreciation declines each year by following written down value method of depreciation. Profit displayed by income statement in different years does not gets affected by depreciation when straight line method of depreciation is followed. Profit displayed by income statement is less in initial years of purchase of asset when written down value method of depreciation is followed. There are different accounting methods for valuing closing inventory on the income statement. First in First Out method of valuation of inventory values inventory at latest prices. It is assumed in this method that inventory which comes first is sold first. Last in first out method of valuation of inventory values inventory at the old prices. It is assumed in this method that inventory which comes last is sold first. Weighted average method of valuation of closing stock is also used.The freedom in selection of accounting methods is sometimes misused by the firm to do window dressing of accounts. Sometimes the motive of window dressing is to evade taxes by reducing profit displayed by income statement. Sometimes the motive of window dressing of accounts is to take loan from bank by showing inflated figures of assets. Fixed assets may be overvalued to convince the bank to give the loan. A company which wants to raise money by issuing shares may inflate its profits on the income statement. The presence of different methods of accounting provides an opportunity to manipulate the accounts. The accounts can be manipulated according to the desires of management. The price of shares may be changed by window dressing of accounts to facilitate insider trading. Different methods adopted by different firms in making their income statements make comparison of income statements of two firms difficult. This makes the decision of investor difficult.