IGNOU : M.COM : MCO 5 : UNIT 4 : Q - 2. Write a note on nature and limitations of financial statements.

Ans. LIMITATION OF FINANCIAL STATEMENTS

Despite the fact that financial statements are the back-bones of the decision-making process for different levels of executives in an organisation, financial analysts and advisors and other interested persons, these suffer from certain limitations because the facts and figures which are reported may not be precise, exact and final. Again some aspects which may be crucial for decision-making purposes may go unreported.

1) Periodic nature of statements : The profit or loss arrived at in the Profit and Loss Account is for a specified period. It does not give any idea about the earning capacity over time. Similarly, the financial position as at the date of Balance Seet is true of that point of time. The likely change in position on a future date is not depicted. Liabilities which were dependent on future events (contingent liabilities) are estimated and shown in the Balance Sheet. They are not accurate figures. Similarly, revenue expenditure is sometimes partly charged to Profit and Loss Account and partly deferred or carried forward. The proportion which is deferred and shown on the asset side of Balance Sheet is based on convenience and depends on the level of earnings relatively to the expenditure. In all these respects the annual statements do not reveal the exact earning capacity or financial state of affairs.

2) The statements are not realistic : Financial statements are prepared on the basis of certain accounting concepts and conventions. As a result, the financial position depicted in the statements cannot be considered realistic. For example, fixed assets are required to be shown on the basis of their value to the business as represented by their acquisition price less depreciation, not as per the estimated resale price. Also, the Profit and Loss Account invariably includes probable losses but does not include probable income. This is according to the accounting convention of conservation.

3) Lack of objectivity due to personal judgement : Values assigned to many items are determined on the basis of the personal judgement of accountants. Hence, relevant amounts shown in the financial statements have no objectivity and they are not varifiable. For instance, estimates of the life of fixed assets and the method of depreciation to be used are based on the personal judgement of accountants. So is the case with valuation of inventories (stock) of materials, work in progress, stores and spare parts, etc. The method of valuation to be adopted depends on the poilicy at the discretion of management based on their judgement.

4) Only financial matters are reported: The financial statements present information in terms of monetary units. There is no information relating to the nonmonetary aspects of business operations. Facts which cannot be depicted in money terms are excluded from the statements. Thus, information relating to the development of skill and efficiency of employees, the reputation of management, public image of the firm, and such matters do not find a place in the financial statements. Yet these are very relevant for investors to consider while forming any opinion about the future prospects of the firm.

5) No Suggestive Approach : Financial Statements disclose information about the past (historical) i.e. what has happened? But it does not disclose why and how it happened. If a company makes profits or incurs losses, the financial statements will show only the amount of profits or losses made but fails to divulge any details as to why there is an increase or decrease in profits or losses.

6) Subjective Approach of the Management : Financial performance (profitability) cannot be taken as the only indicator of managerial performance. The profit figures, to a greater extent, are affected by managerial policy of charging depreciation, writing off fictitious assets, amortisation of intangible assets, allocation of advertisement cost, valuation of stock etc. Likewise, objectivity factor is lost while preparing financial statements to depict the financial position of the concern. Further application of certain concepts and conventions does not allow to show the assets at the true current values (cost concept). The assets shown in the Balance Sheet reflect unexpired cost (W.D.V.) However, liabilities are shown at the same figures thereby distrorting the solvency position of the enterprise. Likewise, the accounting year may be chosen after due thought so that financial statements can send the desired signals to outside interested parties.

7) Conflicting Principles : According to Principle of conservatism stock may be valued at cost or market price whichever is less. This implies that current assets are shown at cost in one year and at marker price the other year. It shows clear violation of principle of consistency. Similarly the change of method of charging depreciation from straight line method to written down value method and vice versa highlights contradiction in application of accounting principles. Again, because of flexibility of accounting principles, certain liabilities are not provided for, such as no provision for gratuity payment is made. This is bound to give distorted picture of the financial statements.

8) Figures are not-self explanatory : How far the financial statements are useful depends upon the ability of the users to analyse and interpret accounting data for their decision making purposes. Truly accounting is the language of the business but financial statements do not speak themselves, you need certain expertise and tools to make them speak. Every user is not competent to draw conclusions from these statements. Even audited financial statements do not provide a complete and total guarantee of accuracy.