There are three main components of the financial statements which are balance sheet, income statement, and cash flows. Balance sheet provides the information on the sources of capital, income statement provides information about operational expenses and revenues, and cash flow statement focuses on the financial liquidity (Weiss, 2000). Organizations are often under pressure to post high sales figures and achieve record profits through economies of scale and operational efficiency. Management compensation is often tied to certain performance benchmarks and investors watch sales and profitability figures closely. Accounting standards recognize revenue at the point of service and not when payment is received. The same rule applies to recognition of profits as well.
In order to boost sales, organizations may extend credit aggressively. Even though this will allow the organizations to report high sales and profitability figures, the same will not be true of liquidity. Even profitable firms can go out of business if they are unable to meet day-today expenses. Profitability is not the same as liquidity. The management will record account receivables as an asset in addition to profits in the income statement in the current fiscal year, but the firm may not receive the actual cash before the current fiscal year ends. Thus, on the paper an organization may be profitable and highly efficient with strong sales, in reality its very existence may be in danger due to low liquidity. Because some of the receivables will turn into bad debts, the firm’s original expenses would turn out to be underestimated and its income figures overstated. The most important factor that causes misalignment of costs with productivity is the mismatch between sales of good or provision of service and the actual receipt of the payment for the goods and the services.