What Are the Limitations of Financial Accounting?

Many of us still belief that the financial accounting system is perfect, and it would be a miracle to find something wrong with the financial accounting system.

This belief is simply a delusion, and it has been said that people who don’t know the history of accounting should not talk about accounting. However, in today’s modern world of high-tech industries and the internet, there are many people who don’t even know the history of accounting and therefore do not know that what they believe is a belief and not a reality.

The fact is that we have a whole lot more to learn about accounting than we even think about. As an example, I thought it was obvious that a business’s “book value” is a pretty poor indicator of its value. But when I taught accounting and found that virtually every accounting textbook did not discuss book value at all, I began to rethink my assumptions.

Financial accounting is helpful for management as it provides them with valuable information. But, there are limitations of financial accounting too.

A common man presumes that an income statement presents the correct income or loss of the business enterprise and that a balance sheet accurately depicts the enterprise’s financial position. The reality is that accounting as a language has its limitations.

The accounting process’s profit or loss figures are subject to many constraints within which the accounting works. The assumptions and principles on which the accounting is based become the limitation of accounting. The financial statements are not always free from errors and biases, as accounting is mostly the outcome of the personal judgement of the accountant concerning the adoption of accounting policies.

Limitations of Financial Accounting

1. The factors which may be relevant to assessing the worth of the enterprise don’t find a place in the accounts as they are not capable of being measured in terms of money. Financial accounting is based on the concept of money measurement. Hence, financial accounts deal with only things that can be quantified in terms of money. Qualitative factors are not recorded in books of account. For example, the loyalty and skill of the employees, which are the most important things for a business concern, are not accounted for in financial accounts.
2. The balance sheet shows the position of the business on the date of its preparation and not on the future date, while the account users are interested in knowing the company’s position shortly and long run instead of the past date. Financial reports deal with the previously mentioned data, events, and transactions.
   Business dynamics change when it takes time for the annual reports to reach the users. To resolve this, auditors usually disclose the events occurring after the balance sheet date, but that too is limited till the approval of accounts by the board of directors or owners of the business, as the case may be.
3. Due to conservatism concepts, fixed assets are recorded on the balance sheet at a historical cost. In real life, the value may fluctuate on day to day basis. Hence, assessing the assets’ value in the current market is impossible, which does not show the true position.
4. Specific accounting estimates are based on the sole judgement of the accountant, for example, provision for doubtful debt, method of depreciation adopted, treatment of the expense in capital or revenue nature, valuation of goodwill and so on. This means that there is no uniform accounting policy in these areas. There will always be inconsistency in such cases.
5. Different accounting policies for treating the same items increase the probability of manipulation and window dressing. Though various laws and accounting standards (ASs) are made to reduce these options and bring uniformity, there cannot be one uniform policy regarding each area.
6. Financial accounting does not provide detailed cost information, which is one of the critical deciding factors at what price goods or services have to be offered to customers.
7. Financial accounting does not distinguish the nature of expenses, whether fixed or variable, relevant or not. Management needs to resort to management accounting for these areas.
8. Finally, financial accounting is subject to certain rules and regulations. This means that companies must follow certain guidelines when preparing their financial statements. This can be a problem because it can be costly and time-consuming to comply with all the rules and regulations.

In short, it can be said that accounting as a language has certain practical limitations. Therefore, the financial statements should be interpreted carefully, keeping in mind all factors influencing the true picture.