Limitations of Financial Accounting

What is the Limitation of Financial Accounting?

Limitation of financial accounting refers to those factors which may averse the user of the financial statements, be it investors, management, directors and all other stakeholders of the business, in arriving at any decision by simply relying on financial accounts only.

It shall be correct to say that limitations of financial accountingFinancial AccountingFinancial accounting refers to bookkeeping, i.e., identifying, classifying, summarizing and recording all the financial transactions in the Income Statement, Balance Sheet and Cash Flow Statement. It even includes the analysis of these financial statements.read more are those aspects that are not covered or taken into consideration while drawing up the financial statements and thus affect the core decision making by the user of the financial statementsUser Of The Financial StatementsFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers.read more for any given required purpose.

Top 12 Limitations of Financial Accounting

Financial Accounting Limitations

#1 – Historical in Nature:

  • Financial accounting is based upon historical cost method, which means that financial accounting requires recording of the financial transactions at the cost of purchase or acquisition of the product or asset.
  • It fails to recognize the fact that the product or asset may have a completely different market value as on date. The products or assets may fetch a little value if disposed of at the current date or vice versa.
  • This limitation ends up providing an inaccurate picture to the user of the financial statement.

#2 – Overall Profitability

#3 – Segmental Reporting

#4 – Inflation Impact

  • Financial accounting requires recording assets on a historical cost basis. The same applies to long term wealth-generating assets as well.
  • In an economy with relatively high inflation, financial accounting entails risk by not adjusting such assets towards inflation changes, thus exhibiting a not so strong balance sheet of the entity to the extent of these long-term assets.

# 5 – Fixed Period Financial Statements Information

#6 – Fraud and Window Dressing

  • To showcase a powerful financial net worth, the accountant or the management may resort to window dress the financial statements.
  • In such a scenario, it will difficult for the user to know this fact, and the user may make the decision based on such financial statements that do not give an accurate and fair view of the state of a business carried on.

# 7 – Non-Financial Aspects

  • The first and foremost important aspect of financial accounting is that it records only those transactions which can be measured in monetary terms.
  • It has no scope for the recording transactions, which are, although non-monetary, but have an important effect on running the business.
  • Factors such as employee efficiency, market competition, laws, and statute governing the business, economic and political scenarios, affect the business operations. However, they find no place in financial accounts of the entity.

# 8 – Intangible Assets

# 9 – Audit Concerns

  • Various business entities are working on a small and medium level considering the level of operations of such businesses, and avoiding unnecessary hardships, the audit is not mandatory, provided they fall under the specified category.
  • This small and medium business, however, does have to prepare financial statements but are simply not required to be audited.
  • In the absence of an audit, it is not just that they have followed the policies and principles appropriately. Thus, leading to the question of whether the financial statements are reliable?

# 10 – Future Prediction

# 11 – Comparability

# 12 – Personal Bias

  • Although the books of accounts are prepared to keep in mind the accounting principles, a lot of these principles require the accountant to use his judgment and experience in practical cases.
  • Thus, the basis on which the principles have been applied may differ based on the varied experience and competence of the accountant involved in the preparation of the financial statements.

Conclusion

Although there are various advantages associated with applying the financial accountancy in business, it does leave out certain factors from its purview. These factors are nothing but the limitations of financial accounting and could result in a change or difference of opinion or decision of the user of the financial statements. Simultaneously, consideration of these factors, which are left out of the scope of financial accounting, affects the way forward or action to be taken by the user.

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This article has been the guide to Limitations of Financial Accounting. Here we discuss the list of top 12 limitations includes Historical in Nature, Comparability, Future Prediction, etc. You can learn more about financing from the following articles –

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