Explain the limitations of financial statements.

Limitations of financial statements:

1)Historical Costs Financial reports depend on historical costs. All the transactions record at historical costs; The value of the assets purchased by the Company and the liabilities it owes changes with time and depends on market factors; The financial statements do not provide the current value of such assets and liabilities. Thus, if a large number of items available in the financial statements based on historical costs and the Company has not revalued them, the statements can be misleading.

2) Inflation Adjustments The assets and liabilities of the Company are not inflation-adjusted. If the inflation is very high, the items in the reports will be recorded at lower costs and hence, not giving much information to the readers.

3)Personal Judgments The financial statements are based on personal judgments. The value of assets\ and liabilities depends on the accounting standard used by the person or group of persons preparing them. The depreciation methods, amortization of assets, etc. are prone to the personal judgment of the person using those assets. All such methods cannot be stated in the financial reports and are, therefore, a limitation.

4) Specific Time Period Reporting The financial statements based on a specific time period; they can have an effect of seasonality or sudden spike/dull in the sales of the Company. One period cannot be compared to other periods very easily as many parameters affect the performance of the Company, and that reported in the financial reports. A reader of the reports can make mistakes while analyzing based on only one period of reporting. Looking at reports from various periods and analyzing them prudently can give a better view of the performance of the Company.

5) Intangible Assets The intangible assets of the Company are not recorded on the balance sheet. Intangible assets include brand value, the reputation of the Company earned over a while, which helps it generate more sales, is not included in the balance sheet. However, if the Company has done any expense  on intangible assets, it is recorded on the financial statements. It is, in general, a problem for start-ups which, based on the domain knowledge, creates a huge intellectual property, but since they have not been in business for long could not generate enough sales. Hence, their intangible assets are not recorded on the financial statements and neither reflected in the sales.

6) Comparability While it is a common practice for analysts and investors to compare the performance of the Company with other companies in the same sector, but they are not usually comparable. Due to various factors like the accounting practices used, valuation, personal judgments made by the different people in different Companies, comparability can be a difficult task.

7) Fraudulent Practices The financial statements are subject to fraud. There are many motives behind having fraudulent practices and thereby skewing the financial results of the Company. If the management is to receive a bonus or the promoters would like to raise the price of the share, they tend to show good results of the Company’s performance by using fraudulent accounting practices, creating fraud sales, etc. The analysts can catch these if the Company’s performance exceeds the industry norms.

8) No Discussion on Non-Financial Issues Financial statements do not discuss non-financial issues like the environment, social and governance concerns, and the steps taken by the Company to improve the same. These issues are becoming more relevant in the current generation, and there is an increased awareness amongst the Companies and the government. However, the financial reports do not provide such information/discussion.

9) It May Not be Verified An auditor should audit the financial statements; however, if they are not, they are of minimal use to the readers. If no one has verified the accounting practices of the Company, operations, and general controls of the Company, there will be no audit opinion. An audit opinion that accompanies the financial statements highlights various financial issues (if any)  in the reports.

10) Future Prediction Although many financial statements have a comment that these contain the forward-looking statement, however, no prediction about the business could be made using these statements. The financial statements provide the historical performance of the Company; many analysts use this information and predict the sales and profit of the Company in future quarters. However, it is prone to many assumptions. Thus, financial statements as a standalone cannot provide any prediction on the future performance of the Company.