Though financial statements provide various important information, they have got some limitations as well. The financial statements are based on some accounting conventions and concepts which are not easily understandable.
That is why despite being useful in particular aspects financial statements do not exhibit the final financial position of a business concern.
These statements depend on many elements. The financial statements are to be analyzed and evaluated with great care otherwise these may lead confusion in taking decisions.
For this reason, the analyst of financial statements should have clear idea regarding the limitations of financial statements.
The limitations of financial statements are stated below;
1. Ignoring information not measurable in times of money
The information measurable in terms of money only is mentioned in the financial statements.
There are some elements which are not measurable in terms of money but influence the economic activities and results of a business concern. The elements being immeasurable in terms of money are not mentioned in the financial statements.
For example, efficiency and reputation of management, source of sale and purchase, dissolution of contract, quality of produced goods, morale of employees, royalty and relationship of employees to and with the management etc. being immeasurable in terms of money are not disclosed in the financial statements.
That is why it can be said that financial statements index the accounting system but not the exact financial position of the business. For that reason financial statements can not reflect the entire financial picture of the business.
2. Interim report
Financial statements do not exhibit the true and final picture of the business. The data mentioned in such statements almost all are based on assumption. The real picture of a business is known when it is sold out or dissolved.
Financial statements are prepared for various accounting periods taking the life of a business into consideration on assumptions. Incomes and expenses are allocated for different accounting periods for determining profits.
Allocation of incomes and expenses depends on accountants’ best judgment. So, the financial statements do not exhibit the true and fair picture of a concern. Most of them are interim reports.
3. Influenced by personal views
Financial statements are mainly influenced by opinion, choice and judgment of account officers.
Determination of depreciation method, determination of method of issuing raw materials, determination of allowance for uncollectible debts, valuation of stock etc. depend on accountant’s individual choice and judgment and various information included in the financial statements based on methods and principles adopted by accountants if analyzed may not be accepted.
4. Unable to disclose exact position
Financial statements are expressed in terms of money. These financial statements usually cannot exhibit true and final financial position of a concern. The values of assets shown in the balance sheet do not mean probable market value of the assets.
Again, the values of assets do not represent the replacement cost. Periodic balance sheet is prepared on the basis of going concern assumption. That is why fixed assets are shown deducting depreciation expenses from their costs.
Fictitious assets shown in the balance sheet are not realised for cash at the time of dissolution.
5. Historical cost
Financial statements are prepared on the basis of historical costs of the assets. Here the changes in the value of assets that take place’ with the passage of time and current liabilities are not taken into consideration. The financial statements are not prepared keeping consistency with the present changed economic condition.
That is why the balance sheet loses its importance as an index of current economic reality. Profit earning’capacity as retained in the income statement does not index the real position of a business concern.
Increase of profit might be the result of price-hike or of any other abnormal situation and not the result of any increase in the efficiency.
The decision taken on the basis of financial statements might not exhibit the true and fair picture of a business concern.
6. Ignoring information relating to Human Resources
Financial statements do not contain any information of human resources. Human resources play an important role in earning profit for a concern but are not included in financial statement.
As a result the financial statements fail to exhibit the true picture of a concern. In the present day world it is a serious concern among the thinkers to include human resources in the financial statements and research is going on to innovate ways and means to make human resources accounted for.
At present human resource is emerging as Human Resources Accounting.
7. Limited Use
The uses of financial statements relating to a particular accounting period are very limited and these are also not very much helpful.
Therefore, dependence on such financial statements solely may bring harms. The final decision taken comparing financial statements of a few years might be of great use in lieu of considering only one year’s financial statements.
8. Loss of the quality of comparability
If accounting methods are changed, the financial statements become useless. Because, in such case the information shown in their periodical financial statements lose their comparability quality. As a result the main objective of financial statements is not achieved.
9. Objective comparison impossible
Comparative study of financial positions of two companies is not possible from their financial statements because there might be dissimilarities in different aspects between two companies.
For example, nature of business, nature of products, system of accounts, nature of fund collection, followed conventions & principles etc.
Therefore, the available information of one company is not comparable with that of the other. Under this situation if comparison is made on the basis of financial statements, it brings confusing results which are not expected.
10. Deduction in validity of analysis
In the present economy purchasing power of money changes fast and frequently. In such cases objectivity of analysis of financial statements remains always questionable.
Because due to change of purchasing power of money importance of analysis decreases to a great extent. Therefore^ no meaningful and workable decision can be taken from comparative analysis of a few years’ financial statements.
11. Possibility of window-dressing of the financial statements
Sometimes financial statements are prepared in such a way as to exaggerate the financial position. In this case the financial statements are prepared tactfully.
So taking decision on the basis of information available from such type of financial statements might bring negative results.
Therefore, the analyst of financial statements should be very much careful of such deceptive financial statements. No information should be taken blindly.
12. It is not a conclusion itself
Through the analysis of financial statements probable position or event can be guessed and it directs the way to taking logical decision. It is not a conclusion by itself.
13. Impossible for precision
Precision of financial statements is not possible because such statements contain matters which cannot be presented in a precise form.
The data of current year are recorded following the methods and conventions followed in the previous years. Various conventions, assumptions and individual judgments are taken into consideration for using data and information.
Therefore, before going for interpretation and analysis of the financial statements the above mentioned limitations should be brought under consideration.