Long Answer Question
Explain the limitations of financial statements.
The following are the limitations of financial statements.
1. Historical Data- The items recorded in the financial statements reflect their original cost i.e. the cost at which they were acquired. Consequently, financial statements do not reveal the current market price of the items. Further, financial statements fail to capture the inflation effects.
2. Ignorance of Qualitative Aspect- Financial statements does not reveal the qualitative aspects of a transaction. The qualitative aspects like colour, size and brand position in the market, employee’s qualities and capabilities are not disclosed by the financial statements.
3. Biased- Financial statements are based on the personal judgments regarding the use of methods of recording. For example, the choice of practice in the valuation of inventory, method of depreciation, amount of provisions, etc. are based on the personal value judgments and may differ from person to person. Thus, the financial statements reflect the personal value judgments of the concerned accountants and clerks.
4. Inter- firm Comparisons- Usually, it is difficult to compare the financial statements of two companies because of the difference in the methods and practices followed by their respective accountants.
5. Window dressing- The possibility of window dressing is probable. This might be because of the motive of the company to overstate or understate the assets and liabilities to attract more investors or to reduce taxable profit. For example, Satyam showed high fixed deposits in the Assets side of its Balance Sheet for better liquidity that gave false and misleading signals to the investors.
6. Difficulty in Forecasting- Since the financial statements is based on historical data, so they fail to reflect the effect of inflation. This drawback makes forecasting difficult.