ANSWERS TO QUESTIONS

1. The income statement is important because it provides investors and creditors with information that helps them predict the amount, timing, and uncertainty of future cash flows. It helps investors and creditors predict future cash flows in a number of different ways. First, investors and creditors can use the information on the income statement to evaluate the past performance of the enter-prise. Second, the income statement helps users of the financial statements to determine the risk (level of uncertainty) of income—revenues, expenses, gains, and losses—and highlights the relationship among these various components.

It should be emphasized that the income statement is used by parties other than investors and creditors. For example, customers can use the income statement to determine a company’s ability to provide needed goods or services, unions examine earnings closely as a basis for salary discussions, and the government uses the income statements of companies as a basis for formulating tax and economic policy.

2. Information on past transactions can be used to identify important trends that, if continued, provide information about future performance. If a reasonable correlation exists between past and future performance, predictions about future earnings and cash flows can be made. For example, a loan analyst can develop a prediction of future performance by estimating the rate of growth of past income over the past several periods and project this into the next period. Additional information about current economic and industry factors can be used to adjust the trend rate based on historical information.

3. Some situations in which changes in value are not recorded in income are:

a) Unrealized gains or losses on available-for-sale investments, b) Changes in the market values of long-term liabilities, such as