In this article, we will learn in-depth about the top 9 disadvantages or limitations of financial statements and much more.
Limitations of Financial Statements
Financial statements reveal a variety of information about the business. The demand for and application of this information is growing all the time.
On the other hand, financial statements have some limitations, and it is necessary to be aware of these limitations.
Financial statements have the following limitations:
1.Unable to disclose exact financial position:
The common misconception about financial statements is that they accurately reflect a company’s financial situation. However, this theory isn’t always correct.
According to the historical price principle, the business entity records its assets in the accounts book. After the purchase of any asset, the exact purchase price is shown in the book of accounts year after year.
If an asset was purchased for $1 million ten years ago, it is still listed in the financial statements at that price. However, its current value could be $5 million or more, or it could lose value if it becomes obsolete.
The current market value of fixed assets does not reflect the financial statements, which does not reveal its exact financial condition.
However, there are problems with the revaluation of fixed assets every year. As a result, the problem of valuing fixed assets is a significant flaw in financial statements.
2. Maintaining accounts based on historical cost:
The transactions in an accounting year are recorded in the books of accounts based on historical expenses, i.e., actual expenses.
A big assumption of accounting is that the value of money remains unchanged in an accounting year. As a result, the net profit or net loss determined at the end of the accounting year is considered accurate and reliable.
However, the reality is not that. The value of money fluctuates in almost all countries of the world.
The net profit or net loss calculated by accountants for economic instability is not accepted as accurate, reliable, and realistic.
3. Absence of qualitative information:
The financial results and financial condition of any business organization depend on two types of factors. These two factors are:
- Quantitative factor and
- Qualitative factor
Quantitative factors can be expressed in numbers, but qualitative factors cannot be expressed in numbers.
Financial statements express the financial results and financial condition of a business organization. However, it does not realize the actual state of the business.
The role of qualitative factors in determining the net profit, net loss, and financial condition of a business organization is not minor.
For example- the reputation of business organization, product quality, the use of advanced and skilled human resources, dynamic management, excellent and professional behavior of sales staff, improved worker-owner relationships, application of advanced technology, the solidarity of officers and employees towards organization all play an essential role in increasing the income of the organization and improving the financial condition.
However, since these critical issues do not reflect in the financial statements, the accounting information users cannot know about the business organization’s overall condition.
4. Lack of future information:
Many account information users, especially current and potential investors and creditors, are interested in knowing about the business organization’s future business situation.
The financial statements provide no information about the future state of the business.
The main reason for this is that financial statements are prepared using information from previous transactions and expenses. As a result, the financial statements do not include any guidance on the company’s prospects.
5. Cannot serve data quickly:
Interim accounting data is required to make business policy decisions such as borrowing, expanding, or contracting a business.
In these cases, financial statements fail to provide the necessary interim information. Because preparing the financial statements at the end of the accounting year takes a long time.
It’s a good idea to use it after preparing the financial statements and receiving the audit report.
The process of preparing interim financial statements has been introduced in many industrialized countries around the world to overcome this limitation.
6. Influenced by personal opinions:
Personal opinions of accountants or professional accountants have an impact on financial statements at the time of preparation. Despite universally accepted accounting principles, this effect is observed.
For example, accounting differs in determining depreciation, valuing inventories, determining the amount of distributable profits, dividing capital and profit into revenue income and expenditure, and determining the amount of different types of reserves.
As a result, different organizations’ financial statements differ in information, and various questions arise about the acceptability of the financial statements.
7. Creation of private reserve:
In many cases, business organizations increase or decrease the amount of assets and liabilities and do not correctly divide capital and revenue transactions to hide the business’s actual financial condition from competitors, resulting in financial statements that show less than the correct amount of net profit.
Again, financial results are skewed by creating a large number of private reserves, which makes financial statements unreliable for business decisions in many cases.
8. Possibility of window decoration:
Many business organizations use deceptive tactics to hide the business’s actual financial condition. It presents a favorable financial situation to improve its reputation and ensure the reasonable market value of its shares in the stock market.
The financial statements prepared as a result of purposefully windowed beds do not reveal the business organization’s exact financial position. Financial statements like these aren’t acceptable.
9. Relative comparisons are not possible:
Users of accounting information use financial statement information for a variety of purposes. Investors often decide to invest in companies with relatively good financial conditions by analyzing different business organizations’ financial conditions.
When businesses are different, and their accounting methods are different. It is complex and confusing for investors to make the right investment decision by analyzing their financial statements.
Nothing in today’s commercial world is innocent or blameless. Despite the many limitations of financial statements, their practical importance is far greater.
Its acceptability will increase hundreds of times if its limitations in terms of reality and practical importance can be mainly overcome.
You can also read:
- What are financial statements? and What are the elements of Financial Statements?
- Everything about Income Statement.
- Short questions and answers- Financial Statements
- Assets and their classification
