Significance and Limitations of Financial Statements

Objective: explain the significance and limitations of

statements

Indicator of Performance• Accounting affect behaviour and

management and have effects across departments, organisations and even countries. Information contained within a financial statement has the power to influence actions where profits and the bottom line are daily concerns.

Financial Statements Affect Decision Making• Financial statements affects decision as

it:Provides managers with information for

decision making and planningAssist managers in directing and

controlling operationsMotivate managers towards

organisation’s goals measure the performance of managers and sub-units within the organisation.

Financial Statements are important to stakeholders• Organisations provide financial statements for

its stakeholders or users. The users of the financial statements include: managers, employees, members, government, investors, and financial advisors.

• Financial statements are provided for many reasons. They provided so users may make informed decisions based on the firm’s financial position as well as to adhere to government regulations.

• Stakeholders may use it to make comparisons with other entities, determine compliance to regulations, access financial performance and estimate future prospects of the firm.

Limitations of Financial Statements Limitations of financial statements occurs as a result of shortcomings in accounting, these include:

Accounting information is historical Accounting information is subject to inflation

Accounting information may be misleading It is subjective It does not show social costs and

environmental costs Costs are not tracked closely by corporations. Difficult to account for intangible costs Accounting ignores the costs of not producing Accounting cannot measure predict or justify

change or innovation in product or process

Limitation - Accounting information is historical• The historical cost convention is often

applied when preparing financial statements.

• Although historical costs convention offers objectivity as assets and expenses are recorded at actual costs as ascertained from source documents, it fails to allow changing value of money.

• The application of the historic cost convention also means that assets and services having no cost cannot be recorded in the ledger accounts.

Limitation - Accounting information is subject to inflation• As mentioned before, in accounting to record

transaction at cost. The validity of historic cost accounting rests on the assumption that the currency in which the transactions are recorded remains stable, that is, purchasing power remains unchanged, or very nearly so from year to year.

• This is not the case. For e.g., a new car may cost $500 000 10 years ago and today that same make car costs $5 000 000.

• Goods and services have been devalued by the process known as inflation which increases the prices of goods and services.

Limitation - Accounting information may be misleading• The users of financial statemenets

depend on the good faith of those who prepare these statements. This dependence places a duty on a company’s managemnet and its accounts to act ethically in the reporting process.

• However, some corporations intentially prepare misleading financial statements called fraudulent financial reporting. See case - Enron

Limitation - It is subjective

Limitation - It does not show social costs and environmental costs

• Financial statements do not show social and environmental costs.

• Natural resources could be classified as assets and environmental cost built into product costs. Social costs to society are not factored in, including externalties. Externalties are costs not borne by the firms responsible, for example, the ecological impacts of climate change resulting from automobile emissions are not included into the price of petroleum.

Limitations - Costs are not tracked closely by corporations.

• Most corporations do not track costs closely in their accounting and thereby the finanacial statements.

• Easily identifiable cost, such as labour or raw materials are often finely tracked and allocated to particular products or processes. However, many costs, such as administration costs, environment, health and safety costs are not considered to be direct costs, hence are allocated broadly across the firm.

• Placing a cost in an overhead account allows it to be shared across the firm, but generally removes responsibility for the cost from one particular manager. If no one is reponsible for a cost, it is likely to be ignored.

Limitations - Difficult to account for intangible costs• Intangible costs are difficult to

ascertain. • It is difficult to estimate the costs

associated with the firm’s image, good relations with investors, employees and customers.

Limitations - Accounting ignores the costs of not producing

• Accounting and thereby financial statements ignore the costs of non-producing, whether it is as a result of down time, stock-outs, and defects.

Limitation - Accounting cannot measure predict or justify change

• Accounting and thereby financial statements cannot measure, predict or justify change or innovation in product or process. In other words, accounting measure costs not benefits.