In this article we will discuss about the limitations of financial statements of a company.
Financial statements are based on historical costs and as such the impact of price level changes is completely ignored. They are interim reports. The basic nature of financial statements is historic. These statements are neither complete nor exact.
They reflects only monetary transactions of a business. The statements furnish only information and that too in the form of figures. Figures won’t speak in themselves and it is the duty of the analyst to make these figures speak of good or bad of the business affairs.
Generally the following limitations may be noted:
1. The financial position of a business concern is affected by several factors—economic, social and financial, but only financial factors are being recorded in these financial statements. Economic and social factors are left out. Thus the financial position disclosed by these statements is not correct and accurate.
2. The profit revealed by the Profit and Loss Account and the financial position disclosed by the Balance Sheet cannot be exact: they are essentially interim reports. Exact position can be known when the business is liquidated i.e., after it has put down its shutters.
3. Facts which have not been recorded in the financial books are not depicted in the financial statements. Only quantitative factors are taken into account. But qualitative factors—such as reputation and prestige of the business with the public, the efficiency and loyalty of its employees, integrity of management etc. which are equally important for the business success, are not capable of being translated in terms of money, and as such, they do not appear in the financial statements.
4. The rupee of 1995, as for example, does not mean the same as the rupee of 2000 or the rupee of 2004. The existing accounting system results in over-statement of profits in times of inflation and under-statement in depression. The existing historical accounting is based on the assumption that the value of monetary unit, say rupee, remains constant and accordingly assets are recorded by the business at the price at which they are acquired and the liabilities are recorded at the amounts at which they are contracted for.
But monetary unit is never stable under inflationary conditions. This instability has resulted in a number of distortions in the financial statements and is the most serious limitation of historical accounting. The price level changes are not taken into account and as such financial statements prepared on a historical cost basis fail to give realistic and correct picture of the state of affairs of a firm.
5. Many items are left to the personal judgement of the accountant. For instance, provision of depreciation, stock valuation, bad debts provision etc. depends on the personal judgement of accountant.
6. On account of convention of conservation the income statement may not disclose true income of the business since probable losses are considered while probable incomes are ignored.
7. The fixed assets are shown at cost less depreciation on the basis of “going concern concept.” But the value placed on the fixed assets may not be the same which may be realised on their sale.
8. The data contained in the financial statements are dumb; they do not speak themselves. It is also worthwhile to note that human judgement is always involved in the interpretation of statements. It is the analyst or user who provides tongue to those data and makes them to speak. It rarely happens that the users of financial statements may have the same opinion and meaning in respect of a particular accounting figure.
9. Information conveyed by these statements may not be comparable on account of difference between dates of preparation of these statements. Different methods of accounting followed by different concerns or difference in the nature of business of different concerns etc. may render the financial statements of two concerns impossible or difficult for the purpose of comparison.