The limitations of financial statements refer to factors whose awareness a user should have before relying on them excessively. Perhaps the biggest drawback of financial statements is that they do not reflect the current situation to the fullest extent as they are based on past data of the previous period. This is why Knowledge of financial statement limitations could help you to reduce invested funds in a business. This knowledge also opens the door to take action for further investigation. Financial statement limitations involve concerns that assets may not realise and fraudulent financial practices. Bias may also be a reason for untrue reporting. Let us look at the various financial statement limitations to understand how they do not reflect the current situation.
Historical Costs
Financial reports are dependent on historical costs. The recording of all the transactions occurs at historical costs as per the GAAP requirement. As such, a change occurs in the value of the assets and the liabilities concerning time. This change is dependent on certain market factors. So, you will not get the current value of such assets and liabilities from financial statements.
Inflation Adjustments
Inflation Adjustments of the assets and liabilities of an organisation do not take place. Suppose the inflation is extremely high, the financial report items will be recorded at lower costs during such a time. Therefore, the readers will not receive such information. Due to a lack of inflation adjustments, financial statements do not reflect the current situation during such time.
No Discussion on Non-Financial Issues
There is no discussion of non-financial issues during the preparation of financial statements. Such non-financial issues can be as follows:
- The environment
- Social and governance concerns,
- Steps were taken by the Company to improve the same
These issues are highly relevant, but the financial statements do not cover them.
Bias
The financial statements are made based on personal judgments. As such, they can be easily subject to the maker’s bias. So, the value of assets and liabilities in a financial statement is mainly dependent on the accounting standard chosen.
The person or team responsible for preparing them can manipulate figures by choosing an accounting standard according to their desires. Methods like depreciation methods, amortisation of assets, and more are prone to bias. This is another reason why financial statements do not reflect the exact situation in all the cases.
Fraudulent Practices
The financial statements have a possibility of being inflicted with fraudulent practices. People can skew the result of financial statements for their benefit. Therefore, financial statements are not 100% trustworthy. It is also why they do not reflect on the current situation all the time.
Specific Time Period Reports
The financial statements are prepared based on a specific period. Therefore, there may impact reporting results due to a sudden spike or dullness in the market or stock. This makes one period to be incomparable to other periods. As such, the assets may not realise their true value at the time of reporting.
Intangible Assets
The recording of the company’s intangible assets does not take place on the balance sheet. Intangible assets, in particular, include the following two important parts:
- Brand value
- Company’s reputation earned over a while
This lack of intangible assets is one of the biggest limitations of financial statements. It is another strong reason why financial statements do not reflect the current situation.
Comparability
Comparing the organisation’s performance is an important practice for investors. However, the results of financial statements are, but they are not usually comparable. This is because of various factors such as:
- Different accounting practices used
- Different Valuation methods
- personal judgments of different individuals in the organization
All of this makes comparability a difficult task.
Conclusion
The limitations of financial statements are certain factors that reduce their effectiveness of financial statements. A user must have an awareness of them before trusting financial statements excessively. Perhaps the biggest problem with financial statements is that they do not reflect the current situation to the utmost extent as they are based on past data of the previous period. Knowing these limitations can help reduce invested funds in a business and allow an action for further investigating the matter. There are 8 limitations: Historical Costs, Inflation Adjustments, No Discussion on Non-Financial Issues, Bias, Fraudulent Practices, Specific Time Period Reports, Intangible Assets, and Comparability.
