What is the Limitation of Accounting?
From the management of the company to the management of other stakeholders, financial accounting is highly important. The process of management is greatly dependent on the financial statements. These statements provide management with a comprehensive idea about the financial status of the company, its investment, position, and transaction. However, it is important to understand that there are certain limitations of financial accounting which do not reveal the true balance sheet of the firm. This article is going to discuss those limitations for a better understanding of accountancy.
The Various Limitations of Accounting
Besides studying accounting, it is also important to understand the limitations of accounting. These limitations have been discussed below:
Historical Costs - To measure the values, accounting considers historical costs. However, this process does not allow considering important areas of accounting like inflation, price changes and similar things as such. Further, this reduces the importance of accounting information and records. Hence, historical costs are considered to be one of the important limitations of accounting.
Estimates - Another important limitation of accounting is estimation. The reason behind is that not all accounting can be done to establish the exact amount and hence it is essential to estimate. But the drawback in such a scenario is that the accountant makes the estimation based on his or her judgment. This estimation is extremely subjective as they are based on the assumption of future events. Such estimation results in doubtful debts and often at times leads to depreciation.
Verifiability - The correctness of the financial statement or for that matter an audit, cannot be guaranteed. The verification of the statements depends only on the judgment and ability of the auditor and hence creates plenty of limitations in accounting.
Measurability - Events or things that do not have monetary value cannot be measured in accounting. Such events or things include management, reputation, loyalty, and dedication which cannot be expressed in money and therefore has no place in accounting. These important qualities are responsible for the growth of the organization but they cannot be measured and put in financial statements. Thus it becomes one of the important limitations of financial accounting.
No Future Assessments - The financial statements prepared are based on the date or the period of preparation. But when it reaches the authorities of the company to assess the future position of the firm it does not have any clarification as it does not provide the record of the present. All businesses are dynamic and change is inevitable. To understand more about this limitation, the student can refer to the limitations of accounting Class 11.
Errors and Frauds - These two limitations are the most common ones in accounting. Error is ought to happen as the financial statements are prepared by humans and not machines and fraudulency occurs whenever there is the involvement of manipulation or similar other external or internal factors. These factors are very hard to recognize and rectify at the same time. Thus, this limitation is highly dangerous for any business or firm.
Accounting Policies - Though mentioned last, this is one of the most common problems that is faced by all organizations across the world. The reason is that every accounting department follows a different form of accounting policy. While Indians follow the global accounting standards, Americans follow the GAAP. However, if a multinational company operates in more than one country it is prone to create confusion and conflict. This is the reason why there is a sheer need for uniform accounting policies to eradicate this limitation from accounting. The student will be able to learn more about accounting by referring to the right tutorial site which can help them develop a clear understanding of the chapter.
What are the Two Major Drawbacks of Historical Accounting?
Two of the major drawbacks of historical accounting are as follows:
Depreciation is charged
Price changes are not considered
Why Choose Vedantu?
There are numerous reasons why students may want to choose Vedantu over other tutorial sites. Some of the reasons have been listed below:
If you are a student you can avail any information, solution, and guide from the site.
Best curated teachers come together at Vedantu fulfilling the objective of interactive and comprehensive learning.
It is the only tutorial site that provides master classes for a student from class 6 to class 12 and also prepares the student for IIT JEE
This is a site not only meant for students but teachers. There are career options as well which an individual can explore.
FAQs on Limitations of Accounting: Key Challenges
1. What are the main limitations of accounting that students should be aware of?
Accounting, while essential, has several inherent limitations. For a student of Commerce, the key challenges to understand are:
- Ignores Qualitative Elements: Accounting only records transactions that can be measured in monetary terms, ignoring crucial factors like employee morale, management skills, and brand reputation.
- Based on Historical Cost: Assets are recorded at their purchase price. This value does not reflect current market prices, which can be misleading, especially during periods of inflation.
- Prone to Personal Bias: Accountants must make estimates (e.g., for doubtful debts or asset depreciation), which can be influenced by personal judgement, affecting the final profit or loss figure.
- Allows for 'Window Dressing': The flexibility in accounting principles can be exploited to manipulate financial statements to show a more favourable position than what is real.
- Ignores Price Level Changes: Financial statements are prepared assuming a stable monetary value, which is unrealistic as the purchasing power of money constantly changes.
2. How does the 'Historical Cost' principle make financial statements less useful?
The Historical Cost principle dictates that assets must be recorded on the balance sheet at their original purchase price. This becomes a significant limitation because it does not account for changes in the asset's market value over time. For example, a piece of land bought for ₹5 lakhs 20 years ago will still be shown at ₹5 lakhs, even if its current market value is over ₹1 crore. This makes the balance sheet an unrealistic representation of the company's true financial worth and can mislead stakeholders about the real value of its assets.
3. Why is accounting often criticised for providing an incomplete picture of a business?
Accounting is criticised for providing an incomplete picture primarily due to the Money Measurement Concept. This concept restricts accounting to only record events and transactions that can be expressed in monetary terms. Consequently, vital non-monetary or qualitative aspects of a business are completely omitted from the financial reports. Important factors like the quality of the management team, the skill and morale of the workforce, customer satisfaction, and the company's public reputation are not reflected, despite their significant impact on a firm's long-term success and profitability.
4. What is meant by 'window dressing' in accounting and how does it exploit the system's limitations?
'Window dressing' refers to the practice of manipulating financial accounts to make a company's performance and financial position appear better than they actually are. It exploits accounting's limitations, particularly personal bias and the flexibility in choosing accounting policies. For instance, management might postpone a necessary large expense to the next accounting period or overvalue closing stock to artificially inflate the current year's profit. This is not illegal fraud but an unethical manipulation that misleads investors, creditors, and other users of the financial statements.
5. How can personal bias affect accounting records even when all rules are technically followed?
Even when following Generally Accepted Accounting Principles (GAAP), several areas require professional judgement and estimation, which can be influenced by personal bias. For example:
- Depreciation Method: Choosing between the straight-line method and the written-down value method for depreciation can significantly alter the reported profit.
- Provision for Doubtful Debts: The percentage set for potential bad debts is an estimate, and a biased accountant can set it lower to show higher profits.
- Valuation of Inventory: The choice between methods like LIFO and FIFO for valuing stock can change the cost of goods sold and, therefore, the gross profit.
These choices, while permissible, show that financial statements are not always precise or free from the subjective influence of the accountant or management.
6. If accounting is based on historical data, how does it fail to help with future forecasting?
A major limitation of accounting is its historical nature. Financial statements report on what has already happened—past events and transactions. While this historical data is useful for analysis, it is not always a reliable guide for the future. The business environment is dynamic, affected by rapid changes in technology, competition, economic policies, and customer preferences. Relying solely on past performance can be misleading for forecasting future profits and performance, as historical trends may not continue.
7. How do businesses and financial analysts overcome the limitations of accounting information?
To get a more accurate view, businesses and analysts use several methods to supplement standard financial statements:
- Ratio Analysis: By calculating and comparing various financial ratios over time and against industry benchmarks, analysts can identify underlying trends and issues not obvious from the statements alone.
- Cash Flow Statement: This statement is crucial as it shows the actual movement of cash, which is less susceptible to manipulation than accrual-based profit figures.
- Management Discussion & Analysis (MD&A): Companies often include a narrative report that discusses the financial results and provides context on qualitative factors and future outlooks.
- Notes to Accounts: The detailed notes accompanying financial statements explain the specific accounting policies used, helping analysts understand how the figures were derived.
