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. 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. for any given required purpose.
Top 12 Limitations of Financial Accounting
#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
- Moving on to the profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. aspect: it is crucial to understand that financial accounting gives financial information on an overall entity basis.
- In other words, it provides information concerning the business of the entity as a whole; it does not give financial information per product or department or job.
#3 – Segmental Reporting
- An entity could also be doing business under several different segments. Consequently, the entity earns revenue from these segments and incurs costs to run these businesses.
- Financial Accounting does not provide any information or inputs, i.e., the profit margin per segment and the costs specific to those segments, respectively.
- Financial accounting fails to consider the fact that all types of businesses have differentiable profit marginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. and also that each business has a unique requirement of costs under various heads.
- Additionally, it becomes a cumbersome process to trace which segment is the most profitable unit and which is the least profit earning or a sick unit.
#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 entityBalance Sheet Of The EntityA 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. to the extent of these long-term assets.
# 5 – Fixed Period Financial Statements Information
- Financial accounting requires the preparation of 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. for a specific period.
- The user may not get a correct view of the finaFinaFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.ncial informationNcial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc. by merely referring to the specific period financial statement.
- Also, the business cash flowsBusiness Cash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. vary on account of any sudden changes or the business being seasonal.
- Thus, the user will be required to refer to financial reportsFinancial ReportsFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. about different periods along with to get the correct picture of the business.
#6 – Fraud and Window Dressing
- To showcase a powerful financial net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus., 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
- Financial accounting does not recognize many intangible assets. Intangible assets such as brand value, goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price., and development of new assets find no place in financial statements.
- On the contrary, it requires creating a charge towards the expenditure incurred on generating these intangible assetsIntangible AssetsIntangible 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. .
- This gives a very weak picture of the balance sheet and impacts the net worth of those organizations which are highly invested in assets but low on sales.
- It is a major problem for many start-ups being IT-based companies invested heavily in intellectual property.
# 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
- The whole financial statements theory is formulated on the historical cost basisCost BasisCost basis is the valuation of assets at their original or at-cost price inclusive of incidental expenses determined after making relevant adjustments for dividends, stock splits and distribution of return on capital. It facilitates the taxation of assets. and specific to the period as required by statute.
- In simple words, all the financial data is based on past transactions and provides no scope for analyzing on what shall be the expected or future viability of the business.
- It does not provide any information on the stability or growth aspects of the business in the years to come.
# 11 – Comparability
- To compare the financial statements of different companies, the accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level. followed by the companies must be the same.
- However, that’s not the case practically, as accounting policies involve the use of judgments and experience, and the same can vary from entity to entity based on different business models and different accountants having unique expertise and competence.
# 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.
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.
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 –