What are the Financial Statements?
Financial statements refer to a detailed record of an organisation that contains financial information on every business aspect of a company. These are evaluated based on past, present and projected future performances.
Financial statements generally include three elements – balance sheets, income statements and cash flow statements.
These statements are analysed using quite a few procedures, which include horizontal analysis, vertical analysis, ratio analysis, trend analysis, etc. However, students must note, there are also quite a few limitations of financial statement analysis. These must also be learnt to understand this topic thoroughly.
Limitations of Financial Statements
While financial statements are vital to understanding associated prospects of a company, these have significant limitations too. Consequently, students of commerce must learn these limitations to get a complete idea of these statements. Additionally, understanding the limitations of conventional financial statements also helps a user to note devaluation or otherwise of invested capitals.
Too Much Dependence on Historical Costs: A significant issue that comes up with the reliance on financial statements is that of excessive reliance on historical costs. While every enterprise records their transactional details, the intrinsic value of assets changes over time.In the case of securities, these are generally modified according to market changes, though that is not the case for fixed assets. As a result, balance sheets and other records might turn out to be ambiguous since these are dependent on historical costs.
Effect of Inflation: Related to the above mentioned disadvantage of financial statements, inflation has an immense impact on the cost and value of assets. However, with a dependence on historical costs, most fixed assets are not re-evaluated as per current market conditions. Commonly, that leads to transactional estimations that are inordinately lower when compared to current standards. This issue is mostly related to long-term assets.
Lack of Accurate Records on Intangible Assets: Business enterprises have numerous intangible assets like brand value, Research & Developments, etc. Typically, these assets are recorded in expenditures. However, they are intangible and financial statements do not shed any light on such assets, therefore being quite misleading in this aspect. This can be a significant issue, especially for smaller enterprises that have generated intellectual assets without having adequate sales exposure.
Time-specific: Financial reports like balance sheets, cash flow statements, income statements, etc. are extremely time-specific for every functional business enterprise. As a result, any individual looking at one of these reports might have a biased understanding of the financial standing of a company since a single report might vary vastly from the aggregate trend of an institution.As a limitation of financial statements, it is a particularly problematic issue. However, it can still be handled by getting detailed statements of extended periods.
Subject to Fraud: There is always a chance of fraudulent activities on the part of a company to project their financial statements in a fashion that fits their ulterior motives. Often done by skewing results and doctoring aspects of these financial statements, these can be very misleading. These are done sometimes to avail payouts and bonuses that are subject to specific business numbers and revenue generations.
Aggregate Information: Among the limitations of financial statements, a recurrent issue is that of aggregate data. Often, companies record their expense and revenue related statements on an aggregate basis, rather than that of a detailed entry. While this is not misleading in the first glance, lack of details can effectively project a financial condition that is far removed from reality.
Missing of Data: Related to this issue mentioned above, often detailed data is not recorded by enterprises. Furthermore, data related to end of agreements, loss of markets or ventures etc. are not mentioned in financial statements. Consequently, that can be a severe hindrance in evaluating the current value of a business.
Prevalent Conventions: Accounting conventions that are involved in the recording of financial statements also bring about certain inherent limitations of financial statements. In the event of liquidation or any such movement, many assets do not reach their declared value owing to their old records not accounting for depreciation.
Interim Reports with no Predictive Value: Profit and loss statements and other similar statements are restricted to a specific time frame and do not represent the revenue-generating capability of an enterprise. Understandably, such a financial statement does not adequately represent future projections or aid in its estimation.
Much like financial statements and their limitations, there are many topics in standard 10 + 2 curricula for commerce students that are vital and complex. Consequently, Vedantu offers detailed study materials on all these topics, which help students understand them in detail. Furthermore, students can also assess themselves with questionnaires provided by Vedantu, which cover every important topic.
In case a student has some doubt, he/she can also attend Vedantu’s live classes for a clear understanding of these chapters.
FAQs on Limitations of Financial Statements
1. What are financial statements and what is their primary purpose?
Financial statements are formal records that provide a structured overview of a business's financial activities and position. Their primary purpose is to convey the financial performance and health of an enterprise to a wide range of stakeholders, including investors, creditors, management, and government agencies. The main financial statements are the Balance Sheet, the Profit and Loss Account (Income Statement), and the Cash Flow Statement.
2. What are the key limitations of financial statements for a business?
Financial statements, while crucial, have several inherent limitations that can affect their accuracy and usefulness. The key limitations include:
- Historical Cost Basis: Assets are recorded at their purchase price, which may not reflect their current market value.
- Ignores Qualitative Elements: They only record monetary transactions, ignoring non-monetary factors like employee skill, management quality, or customer loyalty.
- Prone to Personal Bias: The choice of accounting methods (e.g., for depreciation) can be influenced by the personal judgement of the accountant, affecting reported profits.
- Risk of "Window Dressing": Management might manipulate financial data to present a more favourable picture than what is real.
- Incomplete Information: They represent interim reports and do not show the full picture of a company's long-term earning potential.
3. How does the historical cost concept become a major limitation of financial analysis?
The historical cost concept requires assets to be recorded on the balance sheet at their original purchase price. This becomes a major limitation because it ignores the effects of inflation and changes in market value. For example, a piece of land bought for ₹1 lakh decades ago would still be shown at that value, even if its current market worth is over ₹1 crore. This can lead to a significant understatement of the company's asset value, providing a misleading picture of its true financial position and making it difficult to assess the real worth of the business.
4. Why do financial statements often ignore important qualitative information, and what is the consequence?
Financial statements ignore qualitative information like the quality of management, employee morale, or brand reputation because of a core accounting principle called the "Money Measurement Concept." This principle dictates that only transactions and events that can be expressed in monetary terms are recorded. The consequence is that the statements provide an incomplete picture of the company's overall health and future prospects. A company might have excellent financial numbers but be on the verge of collapse due to poor management or labour strikes, factors that are not visible in the balance sheet.
5. Can you provide an example of how 'window dressing' can manipulate financial statements?
'Window dressing' refers to the practice of manipulating financial figures to make a company's performance look better than it actually is. For example, just before the end of the financial year, a company might delay recording large expenses until the next period or record sales for goods that haven't been delivered yet. This artificially inflates the reported profit for the current year. While not illegal, it misleads stakeholders by presenting a deceptively rosy picture of the company's profitability and financial health.
6. How do the limitations of financial statements affect the decisions of different stakeholders, like investors and managers?
The limitations of financial statements affect stakeholders differently. For investors, reliance on historical cost can obscure the true value of their investment, while window dressing can lead them to make poor decisions based on inflated profits. For management, while they have access to more internal data, the inability to quantify qualitative factors like brand strength can make strategic planning difficult. Creditors might be misled about a firm's liquidity, and employees might get a false sense of job security based on manipulated financial reports.
