I am asked a very common question: “What are some limitations of financial accounting?” The problem I often run into is that people tend to look at financial accounting as the end-all, be-all, of the accounting universe. As you can imagine, this is a huge mistake.
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 depicts an accurate picture of the enterprise’s financial position. The reality is that accounting as a language has its own limitations.
The accounting process’s figures of profit or loss are subject to many constraints within which the accounting work. 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 the accounting policies.
Limitations of Financial Accounting
- 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 measuring in terms of money. Accounting is based on the money measurement of concept. Qualitative factors are not recorded in books of account. For example, the loyalty and skill of the employees, which is the most important thing for a business concern but still it is not accounted for in financial accounts.
- The balance sheet shows the position of the business on the date of its preparation and not on the future date while the users of the accounts are interested in knowing the position of the business in the near future and long run instead of the past date. In fact, financial accounts deal with the previous data, events and transactions.
The time it takes for the annual reports to reach the users, business dynamics change. To resolve this, auditors use to 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.
- Due to conservatism concepts, fixed assets are recorded on the balance sheet at a historical cost. Hence, it is not possible to assess the value of the assets in the current market. Which does not show the true position
- Sometimes accounting concepts conflict with each other.
- 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 to say, and there is no uniform accounting policy in these areas. There will always be inconsistency in such cases.
- Different accounting policies for treating the same items add to the probability of manipulations 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.
- 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.
- 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.
In short, it can be said that accounting as a language has certain practical limitations and therefore, the financial statements should be interpreted carefully keeping in mind all various factors influencing the true picture.