subject: Limitations of Financial Statements [print this page] Limitations of Financial Statements
Financial Statements are the key tools used to convey the economic state of an entity that help individuals make informed decisions. The important financial statements produced by an entity are the balance sheet, income statement, statement of changes in owner's equity and statement of cash flows. These statements are produced considering the concepts of consistency, full disclosure, materiality and conservatism. They provide a solid picture of an entity's performance and with comparative statements for consecutive years, the users of financial statements can easily spot changes in the entity's financial position and in the results of its operation.
However there are a lot of limitations with the current financial statements. They convey good details about the quantitative economic data but do not address any of the qualitative economic variables. Qualitative attributes such as the morale of the employee force or the quality of the management team are some of the critical factors that are relevant to the decisions and judgments that the financial statment user is making. The current accounting process has no way of measuring the value of these intangible assets. Hence, even though the entity's human resources and information resources are its most valuable assets, they are ignored in the financial statements. Similarly trademarks and brand value of a company are not recorded as assets. Brand value of a company is built over time and has a lot of economic value.
Assets are always valued at their original price. Even if the value of an asset has significantly increased over time, it is still reported at the original cost. The value of land has significantly risen over the past few decades, but entities still report it at the original cost for which they had bought it. Impact of inflation is also not considered when preparing financial statements. The impact to the usefulness of financial statements is negligible when inflation is low but it is significantly higher when inflation rate reaches 10% or more. A typical example is that the cost of goods sold reflects original cost even though the cost of replacement might be significantly higher.
Another limitation of financial statements is that it does not capture important changes in the market place and industry and hence sudden deviation in the financial performance of an entity is not addressed in the right context. This can mislead a lot of individuals from making the right decisions.
A key factor for understanding the financial standing of a company is by comparing it with competitors in the same industry. Comparability between firms using different accounting techniques is very difficult and with the current globalization this becomes even more complicated as accounting standards are different across the world.
Financial statements also do not reflect opportunity cost. This concept is related to income forgone because an opportunity to earn income was not pursued. The significance of this can be very high for companies with huge assets.
Another key limitation of financial statements is that it is based on estimates. The only known fact about estimates is that it is not the original value. Even though estimates are made with the best of the tools available, they are still estimates.
The most important limitation of financial statements is that it currently describes only one thing very well and that is how efficiently an entity is performing with the available assets. This is definetly required and important but the real strength of an entity is actually measured not just on its performance efficiency but on its Innovation Quotient. This key measurement is not available in the financial statements. In order for an entity to be more innovative, it needs to spend more time and money on research and try to do things that deviate from the standard path. It needs to take additional risks and invest for long term gains. All of these do not show up positively on the balance sheet or the income statement, in fact these show up as additional expenses. However, these expenses are mandatory for an entity to establish its leadership in the industry and expand its market share.
Hence though financial statements provide a good picture of the economic standing of an entity, it is important to understand its limitations and work around them to make sound decisions.
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