Limitations of Financial Statement
Financial statements provide information or record of finances of the Company their business activities, projects available, etc. Although these reports provide a lot of information to various stakeholders however, they have some limitations of financial statements which the reader must keep in mind before analyzing the financial reports.
Below is the list of top 10 limitations of financial statement
- Historical Costs
- Inflation Adjustments
- Personal Judgments
- Specific Time Period Reporting
- Intangible Assets
- Comparability
- Fraudulent Practices
- No Discussion on Non-Financial Issues
- It May Not be Verified
- Future Prediction
Let us discuss the above mentioned financial statement limitations in detail.
Top 10 Limitations of Financial Statements
#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 changes with time and depends on market factors. The financial statements do not provide the current value of such assets and liabilities. Thus, if a large number of items available in the financial statements are 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. If the inflation is very high the items in the reports will be recorded at lower costs and hence, not giving much information to the readers.
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#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 asset, etc. are prone to personal judgment of the person using those assets. All such methods cannot be stated in the financial reports and is a limitation of financial statements.
#4 – Specific Time Period Reporting
The financial statements are based on a specific time period they can have an effect of seasonality or sudden spike/dull in the sales of the Company. One period cannot be compared to other periods very easily as there are many parameters which affect the performance of the Company and that reported in the financial reports. A reader of the reports can make mistakes while analyzing based on only one period of reporting. Looking at reports from various periods and analyzing them prudently can give a better view of the performance of the Company.
#5 – Intangible Assets
Intangible assets of the Company are not recorded on the balance sheet. Intangible assets include brand value, the reputation of the Company earned over a period of time which helps it generate more sales, is not included in the balance sheet. However, if the Company has done any expense on intangible assets they are recorded on the financial statements. This is, in general, a problem for start-ups which based on the domain knowledge create a huge intellectual property but since they have not been in business for long could not generate enough sales. Hence, their intangible assets are not recorded on the financial statements and neither reflected in the sales.
#6 – Comparability
While it is a common practice for analysts and investors to compare the performance of the Company with other company in the same sector but they are not usually comparable. Due to various factors like the accounting practices used, valuation, 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 financial results of the Company. If the management is to receive a bonus or the promoters would like to raise the price of the share they tend to show good results of the Company’s performance by using fraudulent accounting practices, creating fraud sales, etc. These can be caught by the analysts if the Company’s performance exceeds the industry norms.
#8 – No Discussion on Non-Financial Issues
Financial statements 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 amongst the Companies and the government. However, the financial reports do not provide such information/discussion.
#9 – It May Not be Verified
The financial statements should be audited by an auditor, however, if they are not, they are of minimal use to the readers. If no one has verified the accounting practices of the Company, operations and general controls of the Company there will be no audit opinion. An audit opinion which accompanies the financial statements highlights various financial issues (if any) in the reports.
#10 – Future Prediction
Although, many financial statements have a comment that these contain the forward-looking statement, however, no prediction about the business could be made using these statements. The financial statements provide the historical performance of the Company, 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 statements as a standalone cannot provide any prediction on the future performance of the Company.
Conclusion
Financial statements are the first documents which users go through before making the informed decision about the Company. However, these statements are prone to many limitations and hence, should be read or used in conjunction with these limitations.
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