Income Statement Shows the True Profit of an Entity

Topics: Generally Accepted Accounting Principles, Depreciation, Income statement Pages: 5 (1739 words) Published: February 8, 2011
An income statement is part of the three main financial statements (balance sheet and cash flow statement) companies are obliged to produce by law. It is dependent upon by stakeholder to show a true and fair view for decision making. For instance, a potential investor that is willing to invest in a particular company. But, the question arises as to 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, an economist might argues that profit should be seen as – ‘terse, obvious, and mathematically demonstrable’ (Mac Neal, 1970) in the accounts. This essay discusses the different point of views regarding to which extent true profit of an entity is shown in the income statement. Firstly, it will clarify why accountants and economist view on profit proves to be different. Furthermore, this essay will discuss and explore a balance argument as to whether true profit is shown by the income statement or not. Finally, arising from the discussion will be a conclusion.

The profit figure of an income statement is usually derived after some subjective judgement(s) being made in the statement. ‘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 number of concepts involved usually depends on the complexity of the entity. In addition to the accountants and economist views, another perspective in according to 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). Therefore, 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 income statements 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). The timings based on accruals in the income statement can cause a huge difference in the profit projected. As a result, this would allow 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. For example, the realisation of sales could vary from entity to entity because of the complexity involved in showing 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 which could result in inflated profit figure for the period. 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). Due to the different recognition period there will be an inconsistency in the Income statement if it is heavily relied on accruals concept as there is huge ambiguity regarding when the realisation actually occurred. Other examples include long-term contracts,...
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