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 accounting 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 statements 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. It is possible that the products or assets may fetch a very low 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 profitability aspect, it is important to understand that financial accounting gives financial information on an overall entity basis.
- In other words, it provides information with respect to the business of the entity as a whole, it does not provide financial information per product or per department or per 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 in order 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 margins 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 entity to the extent of these long-term assets.
# 5 – Fixed Period Financial Statements Information
- Financial accounting requires the preparation of financial statements for a specific period.
- The user may not get a correct view of the financial information by simply referring to the specific period financial statement.
- Also, the business cash flows vary on account of any sudden changes or the business being seasonal in nature.
- Thus, the user will be required to refer to financial reports pertaining to different time periods along with in order to get the correct picture of the business.
#6 – Fraud and Window Dressing
- In order to showcase an extremely strong 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 a true 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 in nature but have an important effect in 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 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, goodwill, 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 assets.
- 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
- There are various business entities working on a small and medium level. Considering the level of operations of such businesses and in order to avoid unnecessary hardships to them, 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 basis 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
- In order to compare the financial statements of different companies, the accounting policies 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 personal 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 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 –