 Hello and welcome to the session in which we will start to discuss the income statement. This topic is typically covered in a Chapter 3 or Chapter 4 Intermediate Accounting course and also this topic is heavily covered on the CPA exam. Therefore I call this FAR Boot Camp Income Statement Part 1. It's going to be Part 1 of 7 part. In this part, we would look at the usefulness and limitation of the income statement and we'll cover the other parts in subsequent lectures in order to fully understand the income statement. The income statement is a topic that is very important whether you are an accounting student or a CPA candidate. So whether you are either or, I suggest you take a look at my website farhatlatchers.com. I don't replace your CPA review course. I'm a useful addition. I can explain the material differently. 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Take a look at my LinkedIn recommendation, like this recording, share it with other connect with me on Instagram, Facebook, Twitter and Reddit. So the first thing we're going to do, part one is look at the usefulness and limitation of the income statement. The first is we need to know what is the purpose of the income statement? What is the use of the income statement? Why do we have the income statement? Well, simply put, income statement provide past performance. Well, what is that past performance? It tells you whether the company was profitable or whether the company is incurring a loss, but notice the word past. So if it is past, well, how useful to us? Well, if we can look at the past and look at revenues and expenses and determine that income, and there's more to the income statement than revenues and expenses, but this is basically a simplification to start the process. We're going to see the income statement will have much, many, many more component than those two. We'll look at revenues and expenses. And as a result, what we can do, we can predict. We can help us predict future performance. So we're going to look at past performance to predict the future profitability of the company. For example, if Ford Motor Company is increasing sales 10% year after year or increasing profit 10% year after year, giving everything else is equal. We can predict that trend to continue unless we have new information, new economic information. But if that's their past performance, it will help us predict the future. Why would it help us? Why is that useful? Well, that's useful for investors and creditors because as an investor or as a creditor, you're interested in income. Actually, you're interested specifically in cash. Income is a predictor of cash. If the company is making a profit, you would expect the company to turn that profit into cash. And that's all what investors are interested in. When you evaluate a company, you want to look at their future cash flow. Well, where do cash flow comes from? From their sales. Sales, then they deduct their expenses. What's left is profit. If I see that profit is growing and I can also measure if they are converting that profit into cash flow, then I have some certainty that their cash will be coming in future years. So it shows us, all what it shows us, year over year profit or loss. But that's important. Now that's important, but the income statement will have many limitations we have to be aware of. Some limitations are not all performance items are measured reliably on the income statement. So not everything that affects our earnings is measured on the income statement as well as our expenses. Certain unrealized holding gains and losses, they are not listed on the income statement. They might be listed somewhere else, but they're not on the income statement. Company reputation, if the company has a good reputation, that's going to improve our net income, which eventually will improve our cash flow. But that's not on the income statement. It's important, but not on the income statement. Customer service, if we have a good customer service department, that's also going to help our income. It's going to help our revenues. It's going to help our reputation. So they all feed into each other. But unfortunately, we cannot show that number on the income statement in any way, shape, or form. So that's some of the limitation. Other limitation will be different accounting method used by different companies. When you're evaluating Pepsi versus Coke, guess what? If they're using two different methods, then you're going to have to kind of do a little bit of work to determine the true profitability of the company. So one company could be using FIFO. The other company could be using LIFO. One company could be using the completed contract method to measure revenue. Another company could be using the percentage of completion method. Now, if you don't know what these methods are, just know if two different companies are using two different methods, they might come up with different numbers. So we have to make adjustments. That's another limitation of the income statement. Because different methods are used, you have to be careful on how you evaluate income. Because one company could be using the completed contract method generating income, the same company could be using a different method and generating a loss. Well, it doesn't mean the company generating a loss is not good. It all depends on the method that they are using. So you have to be aware of that. And the income statement doesn't tell you the full picture. Other limitation, the use of estimates and judgment. And that's something inherent in accounting. We make many estimates and many judgments, such as bad debt. When we estimate bad debt, it's an estimate. We estimate bad debt expense. When we estimate our warranty, again, the word estimate is there. Well, if it's an estimate, it means we can overestimate or underestimate. Depreciation figures, well, when we estimate the life of the usefulness of the asset, when we estimate their salvage value, even the depreciation itself, the depreciation method is a form of estimate. So notice those different accounting method and different estimates, including not all items are captured on the income statement, will give us some serious limitation for the quality of earnings on the income statement. What is the quality of earnings? How good or how reliable are your figures, the figures that you are reporting? Remember, we have different accounting methods, estimates, judgments, which in turn will affect the method. Now you have to understand management have incentives, have incentives to do what? To manipulate the numbers. And these accounting, different accounting methods, estimates and judgment, it gives management room. Options to manage, to smooth income, to either meet Wall Street expectation, meet the market expectation, meet the investor's expectation, meet the creditor expectation, or manipulate the numbers to earn their compensation package. For example, if management wants to earn a certain figure, because based on that certain figures, they can exercise their stock options and they can make profit for themselves, they might manipulate the numbers, they might manipulate earnings. So we have to be aware of this as we are evaluating the income statement. So the quality of earnings is important. And in the real world, accounting irregularities are penalized heavily. Simply put, when investors find out that the company somehow is manipulating earnings, cooking the books, even stretching their accounting method, guess what? The stock price will suffer heavily because once that reputation is lost, because all what investors rely on is your accounting figures. Once they lose that trust, they can no longer trust you. Therefore, your stock will suffer. Then your stock will sell at a discount. If the creditors want to lend you money, they're gonna require you to pay more in interest expense to compensate the risk, because they cannot rely on your figures. You want the quality of earnings to be very high. How is the quality of earnings high? Well, be conservative. Don't fudge the numbers. Report the numbers as accurately as possible. So if the numbers cannot be relied on on the income statement, the whole usefulness of the predictive value of the income statement that we talked about, it lost its purpose. Remember, at the beginning, we said the purpose of the income statement is to help us predict future earnings as a result, future cash flow. Well, if I cannot rely on that prediction, if I cannot rely on your income statement, I have some reservations. If I wanna buy your stock, I wanna buy it at a discount. Why? Because I'm taking risk. I wanna buy it at a cheaper price, not at the current price that it's trading at. Therefore, the price will suffer. If I want to lend you money, again, I want to be compensated heavily because I'm taking more risk because I cannot truly rely on your figures. So any accounting irregularity, especially on the income statement, especially with revenues, is penalized heavily. Therefore, the quality of earnings is an extremely important component of reporting. So company will have to report objective numbers, reliable numbers, accurate numbers. Guys, remember that we talked about the conceptual framework. They have to follow all these rules. At the end of the day, I'm gonna remind you whether you're an accounting student or a CPA candidate to take a look at my website, farhatlectures.com. Once again, I don't replace your CPA review course. I'm a useful addition. I explain the material differently, help you understand the material, which in turn will help you pass the CPA exam. In the next session, we would look at the second topic that we're gonna be working with, and that's gonna be elements of the income statement. What goes on the income statement? And that's important to understand the elements. The CPA is worth it. Study hard, good luck, and invest in yourself. Thank you.