Financial Statement Limitations

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Top 10 Limitations of Financial Statement

The company releases financial statements, and hence the obvious limitation is that the information an analyst gets is limited to what the company wants to show and how it plans to manipulate the information.

Below is the list of top 10 limitations of a financial statement

Historical Costs
Inflation Adjustments
Personal Judgments
Specific Period Reporting
Intangible Assets
Comparability
Fraudulent Practices
No Discussion on Non-Financial Issues
It May Not be Verified
Future Prediction

#1 - Historical Costs

Financial reports depend on historical costs. All the transactions are recorded at historical costs; The value of the assets purchased by the company and the liabilities it owes change with time and depend on market factors; The financial statements do not provide the current value of such assets and liabilities. Thus, if any items are available in the financial statements based on historical costs and the company has not revalued them, the statements can be misleading.

#2 - Inflation Adjustments

The assets and liabilities of the company are not inflation-adjusted. Therefore, if the inflation is very high, the items in the reports will be recorded at lower costs and hence, not give much information to the readers.

#3 - Personal Judgments

The financial statements are based on personal judgments. The value of assets and liabilities depends on the accounting standard used by the person or group of persons preparing them. The depreciation methods, amortization of assets, etc., are prone to the personal judgment of the person using those assets. Therefore, all such methods cannot be stated in the financial reports and are limited.

#4 - Specific Time Period Reporting

The financial statements are based on a specific period; they can affect seasonality or sudden spike/dullness in the company's sales. One period cannot be compared to other periods very easily as many parameters affect the company's performance, and that is reported in the financial reports. Therefore, a reader of the reports can make mistakes while analyzing based on only one reporting period. Looking at reports from various periods and analyzing them prudently can give a better view of the company's performance.

#5 - Intangible Assets

The intangible assets of the company are not recorded on the balance sheet. For example, intangible assets, including brand value, and the company's reputation earned over a while, which helps it generate more sales, are not included in the balance sheet. However, if the company has incurred intangible assets, it is recorded on the financial statements. It is, in general, a problem for start-ups that, based on domain knowledge, create a huge intellectual property, but since they have not been in business for long cannot generate enough sales. Hence, their intangible assets are not recorded on the financial statements and are neither reflected in the sales.

#6 - Comparability

While it is common for analysts and investors to compare the company's performance with other companies in the same sector, they are not usually comparable. Due to various factors like the accounting practices used, valuation, and personal judgments made by the different people in different Companies, comparability can be a difficult task.

#7 - Fraudulent Practices

The financial statements are subject to fraud. There are many motives behind having fraudulent practices and thereby skewing the company's financial results. For example, if the management is to receive a bonus or the promoters would like to raise the share price, they tend to show good results of the company's performance by using fraudulent accounting practices, creating fraudulent sales, etc. Analysts can catch these if the company's performance exceeds the industry norms.

#8 - No Discussion on Non-Financial Issues

Financial statements do not discuss non-financial issues like the environment, social and governance concerns, and the steps taken by the company to improve the same. These issues are becoming more relevant in the current generation, and there is an increased awareness among the Companies and the government. However, the financial reports do not provide such information/discussion.

#9 - It May Not be Verified

An auditor should audit the financial statements; however, they are of minimal use to the readers if they are not. If no one has verified the company's accounting practices, operations, and general controls, there will be no audit opinion. An audit opinion that accompanies the financial statements highlights various financial issues (if any) in the reports.

#10 - Future Prediction

Although many financial statements comment that they contain a forward-looking statement, no prediction about the business could be made using these statements. The financial statements provide the company's historical performance; many analysts use this information and predict the sales and profit of the company in future quarters. However, it is prone to many assumptions. Thus, financial statements as a standalone cannot predict the future performance of the company.