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Limitations of Accounting & Financial Statements

August 25, 2015 by Ed Becker

The last several weeks we have discussed in detail the financial statements, what they do individually and how they are dependent on each other for a larger picture as well as who uses/views them and for what purposes. Today is the final segment in this series, we will discuss the limitations of the financial statements and accounting practices. This information is just as vitally important when making business decisions based on the financial statements and accountancy of a company.

The main limitations of accountancy and financial statements fall into the following categories:

  • Accounting policies
  • Estimates
  • Professional judgement
  • Verifiability
  • Using historical costing
  • Measurability
  • Predictive value
  • Fraud & Errors
  • Cost benefit compromises

Accounting policies- Different accounting policies with no global standard to follow creates some issues of comparability between entities. The use of accounting frameworks such as IFRS and GAPP help but not all companies chose to use one of these. Geographic locations are another reason there could be differences in accounting policies that are perfectly legal practices but make it harder to compare.

Estimates- Normal accounting requires estimating when preparing financial statements, when exact amounts cannot be established. Estimates are obviously subjective by nature, it is the person’s best guess in future prediction. These estimates reduce the reliability of the accounting information.

Professional judgement- Professional judgement by the accounting professionals preparing financial statements is typical to apply accounting policies consistent with the economic aspects of the company’s transactions. Because it again is subjective, the interpretation of the accounting standards and application will create differences in the judgement. The more judgement used the more subjective the financial statements will be.

Verifiability- An audit provides reasonable but not absolute guarantees of the accuracy of the financial statements. Even in audits there are limitations inherent in the process.

Using historical cost- Using historical cost to measure assets fails to account for changes in values over time. This causes the relevance of accounting information to be subjective, because the assets may be far less valuable today. It also does not account for the cost of using the assets.

Measurability- Financial statements cannot account for resources that do not have a monetary value. These may not be able to be assigned a reasonable value, such as goodwill.

Predictive value- As financial statements present the accounting snapshot of a company in a past time period there is limited insight for future prospects and lacks predictive value essential for investors.

Fraud & Errors- As always in statements prepared by humans, usually more than one, there is always room for errors and/or fraud. This would completely undermine the credibility and reliability of the statements and information within them. There could also be deliberate manipulation of the financial statements to create predetermined results.

Cost benefit compromises- Quality of accounting information could be compromised due to the cost of producing reliable information.

The financial statements are used to glean information about a company’s financial health for a specific period as well as for use of predictive for future economic decisions. These statements are used by many different persons for different reasons. The use of the financial statements has to be taken with the above subjective issues in mind.

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