Limitations of Financial Statements

Financial statements have often been criticized by business, accountants and others for their inherent deficiencies or shortcomings. An attempt has been made here to highlight some of the significant limitations:

1.    Historical Cost:

Financial statements are primarily prepared on the basis of historical cost – a principle of accounting which requires that information on financial statements be presented in terms of items at original cost, in money terms, to the business entity. The only adjustment is by way of depreciation. Thus no attempt is made to reflect all changes in the market value of some assets between the dates of their purchase and sale. This fact may make the financial statements misleading especially in respect of assets the values of which are always increasing.

2.    Use of estimates:

In some cases the figures in respect of certain items are based on estimates which can range from reasonably pessimistic to reasonably optimistic. Further there is no scientific basis of recognizing some costs for the current period and their postponement for future e.g., unexpired insurance, deferred revenue expenditure on advertisement etc.. In short, most of the capital expenditure and deferred revenue expenditure have to be arbitrarily distributed over a number of years during which is benefit of the expenditure is likely to arise.

3.    Use of different procedures:

In many cases the financial statements of various firms which are in the same industry and very much alike cannot be compared because generally accepted accounting principles are not very rigid and permit different treatments for identical operating situations. The net effect of such flexibility is that two sets of financial statements may not be comparable with respect to some important aspects of the business unit.

4.    Omissions:

Accounting reflects only those variables which can be expressed in money terms because of objectivity. In this process some qualitative aspects of business units are omitted from the accounting records and consequently from the financial statements. Examples are common to find and include quality of the management, training and skill of the work-force, the firm’s ability to develop new products, cordial management-labor relations and so on.

5.    Intangible Assets:

Allied to the preceding limitation, the business unit cannot record certain intangible assets which are not acquired in exchange transactions with outside parties, that is, for which no payment has been in terms of money. Thus when assets such as company goodwill, secret processes, patents and trade marks are developed gradually over many years of operations but are not specifically purchased, either they are not reflected in the financial statements or they are shown at nominal sums.

6.    Every item shown in the assets side of the balance sheet is not an asset in the sense of inflow of resources.

7.    Management policies:

The net income shown in the Income-Statement is not absolute but relative and dependent on the management policies. The management may deliberately understate the profits by manipulating accounting conventions because of more than one reason stated as:

(i)    to avoid high rates of taxation;

(ii)    indifference to new responsibilities and risks;

(iii)    to escape the charge of profiteering since high profits are linked with the price inflation;

(iv)    to resist the demand for higher wages;

(v)    to avoid to impression that the business entity has developed the monopolistic tendencies;

(vi)    to show unwillingness to expand due to future uncertainties.

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