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Limitations Of Financial Statements
Although often not mentioned, the financial statements of a company are the backbone of success. By keeping records of the company’s financial conditions, the accountants not only save the financial mechanism a company follows but also find out whether the company is profitable and working in the right direction. Therefore, financial statements are an indispensable part of the business.
Financial statements are prepared by following a certain mechanism and the mechanism is based on appropriate business-oriented tools that help businesses become profitable and perform well enough. Therefore, these financial statements are considered to be unavoidable by businesses.
Limitations of Financial Statements
However, there are some distinct disadvantages of financial statements that make them unfavourable for businesses. Here are ten such factors.
Historical Costs: Financial reports are reported on historical costs. When we check a financial statement, it is not reported according to the current position of the company. Therefore, when we judge the performance or other factors of a company, there is always a historical cost involved in the process, which is misleading because we want the reports to be in their current position. Therefore, financial statements do not provide the current value of assets and liabilities which is a big limitation of them.
Inflation not adjusted: In financial statements, the assets and liabilities recorded are not inflation adjusted. Inflation is the price rise that occurs for a bucket of selected goods at a certain point in time. Missing high inflation value means items are recorded at lower costs. Such records can be misleading for the readers because they will take the price of items at a lower rate than actual when inflation is not adjusted in the financial statements.
Personal Bias: There is always a personal bias attached to the formation of financial statements. The assets and liabilities are usually determined by individuals or a group who have their own judgments which are applied to the formation of financial statements. Therefore, the amortization of assets, depreciation methods, etc., are prone to the personal judgment of the person using those assets. In order to prepare the assets, therefore, the people who prepare the assets depend on personal judgments. As personal judgment often leads to judgemental errors, financial statements are usually erroneous in nature.
Reporting for a specific period: Financial reports are usually prepared for a specific period of time and they become unusable in other periods. For example, financial statements made for the current year may not be usable after five years of time. As changes keep occurring in various specific time periods, users of financial statements should be aware of the changing nature of business over the years. In fact, financial statements may become useless after a certain period of time. Therefore, analysts who study a company’s performance must take as many references as possible to make a judgment about the company’s future.
Exclusion of intangible assets: It is a major limitation of financial statements. Financial statements usually do not include intangible assets and hence many of the items get excluded from the coverage of financial statements in the case of the financial performance of a company. For example, the goodwill of a company is not reflected in the balance sheet of the company. This creates a particular gap in the case of start-ups who create great goodwill depending on their domain knowledge but cannot show this on financial statements. Therefore, a lot of value may be lost when there is no inclusion of intangible assets of a company in the financial statements.
Comparability: Investors and analysts often compare two companies in the same industry or sector using their financial statements. However, as the accounting practices used, valuation of the company, personal judgment, etc. are different for different companies, they are often not comparable to one another. Therefore, the use of financial reports and statement for comparing the performance of two companies is often an ardent task for analysts.
Fraudulent Practices: Financial statements are prone to fraudulent practices and hence must be carefully observed before taking a call on any of them. There may be many motives for the financial managers to skew the company's reports to show the company is healthy when its actual condition is not so. There have been many reports of mishandling the financial processes and inflating or deflating the financial statements. The financial reports are just pieces of accounting practices and so they can easily be manipulated. Although it is impossible to manipulate books forever, there are chances of fraud in accounting. Therefore, one must be vigilant for fraudulent cases in the case of financial statements.
Ignorance of non-financial issues: It is a major concern for the stakeholders that financial reports do not discuss non-financial issues like environmental, social, and governance concerns. They do not also consider the steps taken by the company to improve the conditions too. These issues are being discussed increasingly in the current period of time, and there is an increased awareness among the stakeholders However, the financial statements do not provide any information or discussion over the same.
Non-verifiability: Although auditors can audit financial reports, they are usually of no use to the readers because they cannot verify them. The financial statements, once prepared, act as the final call on the financial statute of the company. Non-verifiability is a major concern because it often offers accountants the power to manipulate the books. However, one can use the nature of non-verifiability as an act of responsibility to prepare the financial statements responsibly which can increase the faith of stakeholders in that particular company.
Cannot predict the future: Although many analysts and many investors use many tools to use the financial statement to predict the future, it is impossible to do so. There has been no financial policy that can predict the future with full compatibility and competence. The non-predictability of the future is the rule of nature and financial statements cannot supersede it.
Despite having some super qualities that aid businesses in becoming organized and profitable, financial statements also have some notable limitations. Knowing these limitations is invaluable for business owners as well as managers and accountants. Some of these limitations are surprising in nature because many won’t ever consider them to be so. For example, personal bias, non-verifiability, and non-predictability of the future are some of them. Knowing the limitations of the financial statement is therefore very useful and practically valuable in nature.
Q1. What is the issue of personal bias in the case of financial statements? Briefly illustrate.
Ans. There is always a personal bias attached to the formation of financial statements. The assets and liabilities are usually determined by individuals or a group who have their own judgments which are applied to the formation of financial statements. Therefore, the amortization of assets, depreciation methods, etc., are prone to the personal judgment of the person using those assets.
Q2. Can financial statements predict the future? Illustrate.
Ans. Although many analysts and many investors use many tools to use the financial statement to predict the future, it is impossible to do so. There has been no financial policy that can predict the future with full compatibility and competence. The non-predictability of the future is the rule of nature and financial statements cannot supersede it.
Q3. What is meant by the non-comparability of firms according to financial statements?
Ans. Investors and analysts often compare two companies in the same industry or sector using their financial statements. However, as the accounting practices used, valuation of the company, personal judgment, etc. are different for different companies, they are often not comparable to one another. Therefore, the use of financial reports and statement for comparing the performance of two companies is often an ardent task for analysts.
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