Financial statement limitations comprise concerns related to fraudulent practice while recording information, dependency on historical costs, lack of comparability, and non-adjustability to inflation that the analysts cannot overlook.
Top 10 Limitations of Financial Statement
The company releases financial statements, and hence the obvious limitation is that the information an analyst gets is limited to what the company wants to show and how it plans to manipulate the information.
Below is the list of top 10 limitations of a financial statement
- Historical CostsHistorical CostsThe historical cost of an asset refers to the price at which it was first purchased or acquired.
- Inflation Adjustments
- Personal Judgments
- Specific Period Reporting
- Intangible Assets
- Fraudulent Practices
- No Discussion on Non-Financial Issues
- It May Not be Verified
- Future Prediction
#1 – Historical Costs
Financial reports depend on historical costs. All the transactions are recorded at historical costs; The value of the assets purchased by the company and the liabilities it owes change with time and depend on market factors; The financial statements do not provide the current value of such assets and liabilities. Thus, if any items are available in the financial statements based on historical costs and the company has not revalued them, the statements can be misleading.
#2 – Inflation Adjustments
The assets and liabilities of the company are not inflation-adjusted. Therefore, if the inflation is very high, the items in the reports will be recorded at lower costs and hence, not give much information to the readers.
#3 – Personal Judgments
The financial statements are based on personal judgments. The value of assets and liabilities depends on the accounting standard used by the person or group of persons preparing them. The depreciation methods, amortization of assets, etc., are prone to the personal judgment of the person using those assets. Therefore, all such methods cannot be stated in the financial reportsFinancial ReportsFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making. and are limited.
#4 – Specific Time Period Reporting
The financial statements are based on a specific period; they can affect seasonality or sudden spike/dullness in the company’s sales. One period cannot be compared to other periods very easily as many parameters affect the company’s performance, and that is reported in the financial reports. Therefore, a reader of the reports can make mistakes while analyzing based on only one reporting period. Looking at reports from various periods and analyzing them prudently can give a better view of the company’s performance.
#5 – Intangible Assets
The intangible assets of the companyIntangible Assets Of The CompanyIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. are not recorded on the balance sheet. For example, intangible assets, including brand value, and the company’s reputation earned over a while, which helps it generate more sales, are not included in the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.. However, if the company has incurred intangible assets, it is recorded on the financial statements. 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.
#6 – Comparability
While it is common for analysts and investors to compare the company’s performance with other companies in the same sector, they are not usually comparable. Due to various factors like the accounting practices used, valuation, and personal judgments made by the different people in different Companies, comparability can be a difficult task.
#7 – Fraudulent Practices
The financial statements are subject to fraud. There are many motives behind having fraudulent practices and thereby skewing the company’s financial results. For example, if the management is to receive a bonus or the promoters would like to raise the share price, they tend to show good results of the company’s performance by using fraudulent accounting practices, creating fraudulent sales, etc. Analysts can catch these if the company’s performance exceeds the industry norms.
#8 – No Discussion on Non-Financial Issues
Financial statements do not discuss non-financial issues like the environment, social and governance concerns, and the steps taken by the company to improve the same. These issues are becoming more relevant in the current generation, and there is an increased awareness among the Companies and the government. However, the financial reports do not provide such information/discussion.
#9 – It May Not be Verified
An auditorAuditorAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws. should audit the financial statements; however, they are of minimal use to the readers if they are not. If no one has verified the company’s accounting practicesAccounting Practices Of The CompanyAccounting practice is a set of procedures and controls used by an entity's accounting department to keep track of accounting records and entries. Other reports are generated based on accounting records, such as financial statements, cash flow statements, fund flow statements, payroll, tax workings, payment and receipts statements, and so on, and they form the basis of the auditor's reliance while auditing the financial statements., operations, and general controls, there will be no audit opinion. An audit opinion that accompanies the financial statements highlights various financial issues (if any) in the reports.
#10 – Future Prediction
Although many financial statements comment that they contain a forward-looking statement, no prediction about the business could be made using these statements. The financial statements provide the company’s historical performance; many analysts use this information and predict the sales and profit of the company in future quarters. However, it is prone to many assumptions. Thus, financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. as a standalone cannot predict the future performance of the company.
This has been a guide to Financial Statement Limitations. Here we provide the top 10 financial statement limitations, including Historical costs, Inflation adjustments, etc. You can learn more about financing from the following articles –