Limitations of Financial Statements Accounting for Managers

The balance sheet’s depiction of the financial condition is appropriate when it was made, but it does not anticipate any future changes. Asset and liabilities values must be adjusted in accordance with market inflation. Because accounting does not account for inflation, the results must accurately represent the firm’s actual status.

It is, in general, a problem for start-ups that, based on domain knowledge, create a huge intellectual property, but since they have not been in business for long cannot generate enough sales. Hence, their intangible assets are not recorded on the financial statements and are neither reflected in the sales. As the financial statements are compiled on the basis of historical costs, they fail to take into account such factors as the decrease in money value, or increase in the price level changes.

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Financial statements, therefore, need to present a true and accurate picture of the business. There is also a possibility of manipulation of accounts, and financial reports can also be obliged to be audited. One major concern is its reliance on historical data, which may not reflect current market conditions. Additionally, financial reports focus only on monetary transactions, ignoring factors like employee skills or brand value.

Notes and other statements- Notes and other statements provide additional information to explain different items of a financial statement. They may, for example, include extra information about the items in the balance sheet and profit and loss statement that is relevant to the needs of users. Other disclosures include accounting policy disclosures, segment reporting, related party disclosures, earnings per share, and so on. Financial accounting is the systematic process of documenting, categorising, summarising, analysing, and reporting a company’s business transactions. The main goal of financial accounting is to disclose a company’s profits and losses. It allows for an accurate and fair evaluation, and thus, it protects the interests of all its stakeholders.

Types of financial statements

Market volatility can cause these fair value estimates to fluctuate dramatically, sometimes leading to financial statement volatility that doesn’t reflect the underlying business performance. Similarly, when determining whether a debt will be collected, accountants must make judgments about the likelihood of payment. These judgments can vary significantly between different accountants or even the same accountant at different times. Bad debt provisions, inventory valuations, and warranty estimates all involve subjective assessments that can materially impact financial statements. Financial accounting also has limitations—typically revolving around information that is missing from, or just not included in, financial statements, which can hamper decision making.

• In financial accounting costs are not available as an aid in determining prices of the products, services, production order and lines of products.
• Looking at reports from various periods and analyzing them prudently can give a better view of the company’s performance.
• Fraud like that can arise when there is undue pressure, such as shareholders are demanding and expecting excellent results that will push the stock price higher.

Limitation # 2. Overall Performance:

While financial statements have these limitations, they remain valuable for decision-making, regulatory compliance, and financial planning. Their usefulness increases when combined with other tools like financial analysis and with an understanding of their limitations. At Vedantu, we encourage limitations of financial accounting students to balance the advantages and drawbacks when using financial statements in studies or practical scenarios. For students, recognizing the shortcomings of financial statements helps avoid mistakes in exam answers, especially when asked to list or explain limitations. In business, these limitations highlight the need for caution before making investment or lending decisions.

Limitation # 4. Distinction between Direct and Indirect Expenses:

• Cost Accounting is a branch of accounting and has been developed due to the limitations of financial accounting.
• A business concern’s financial statements are set up to show the overall profit or loss of that business concern over a given period.
• In other words, financial accounting is a way of reporting business activity and financial information to investors, creditors, and other people outside the business organization.
• Financial accounting is so limited and inadequate with regard to the information which it can provide to the management, that businessmen have been eager to adopt supplementary accounting methods like cost accounting.
• Moreover, complex accounting standards and principles can also lead to misinterpretations.

Even though financial accounting is very popular, the information that can be supplied to the management by financial accounting needs to be more constrained and insufficient. Despite new accounting devices, improved techniques, and detailed subsidiary records over the past 30 years, businesspeople have been eager to adopt additional accounting practices known as cost accounting. In financial accounting, costs are not segregated into direct and indirect costs, constant and variable costs, and controllable and uncontrollable costs. Also, it needs to provide more information for the comparison of prices. Most businesses provide their financial accounting information in a collection of all-purpose documents called annual reports. Most of the information required by outside users is contained in these statements.

Limitation # 13. Lack of Data for Decision-Making:

(7) It does not provide any information to the management about the price to be quoted for the future supply of goods and services or predetermined price. The advantages of accounting do not suggest that accounting is free from limitations. Anyone who is using accounting information should be well aware of its limitations. There is possibility of making improper assumptions either mistakenly or in order to distort the real picture.

Financial Information is Mainly Historical in Nature:

These limitations can be overcome by systematically accounting for costs apart from other financial transactions. Such system of accounting for costs and enabling effective decision making is known as cost accounting. Financial accounts of a business concern are so designed as to disclose the overall profit or loss of that business concern for a specified period. Financial accounts do not deal with the product- wise, job-wise, process-wise, department-wise profitability of the business.

One of the drawbacks of financial accounting from a manager’s perspective is that the information represents past performance. This is useful in giving out bonuses, and of course in reporting to the public, but proactive internal decisions have to come from the most current data available, and have to be tailored to the decision being considered. It is difficult to obtain, however, in part because of the uncertain nature of the information and in part because too much information could benefit competitors and harm the company. Furthermore, it is difficult to measure social performance, but this type of information is useful in evaluating organizational effectiveness as it is broadly conceived. The information supplied by the financial accounting is in reality aggregate of the financial transactions during the year.

Difficulty in Price Setting:

The profit shown by Profit and Loss Account should not be taken as a sign of success because there may be a loss on certain items which might have been compensated by the profit of certain other items. Information regarding wastages and losses is very difficult to be obtained from financial accounts and it is only Cost Accounts which makes such information available to the management. So cost accounting has emerged mainly because of certain limitations of financial accounting. When most of the changes in the prices of the company’s resources are in the same direction, the purchasing power of money is said to change. Conventional accounting statements are stated in nominal currency units—not in units of constant purchasing power.

Different countries and organizations follow different accounting standards, leading to inconsistencies. Accounting focuses only on transactions that have a monetary value, ignoring non-financial aspects that influence business success. Although there is IASC (International Accounting Standard Committee), the accountants differ in their opinion on the application of accounting principles in the same matter. Financial statements aggregate vast amounts of data into summary form, potentially losing granular details that could be essential for a comprehensive analysis.