Limitations of Financial Accounting

Publication Date :

31 Mar, 2020

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Table Of Contents

What is the Limitation of Financial Accounting?

Limitation of financial accounting refers to those factors which may averse the user of the financial statements, be it investors, management, directors, and all other stakeholders of the business, in arriving at any decision by simply relying on financial accounts only.

It shall be correct to say that limitations of financial accounting are those aspects that are not covered or taken into consideration while drawing up the financial statements and thus affect the core decision-making by the user of the financial statements for any given essential purpose.

What is the Limitation of Financial Accounting?

Top 12 Limitations of Financial Accounting

#1 - Historical in Nature:

Financial accounting is based upon the historical cost method, which means that financial accounting requires recording the financial transactions at the cost of purchase or acquisition of the product or asset.
It fails to recognize that the product or asset may have a completely different market value. The products or assets may fetch a little value if disposed of at the current date or vice versa.
This limitation provides an inaccurate picture to the user of the financial statement.

Financial Accounting Video Explanation

#2 - Overall Profitability

Moving on to the profitability aspect: it is crucial to understand that financial accounting gives financial information on an overall entity basis.
In other words, it provides information concerning the entity's business as a whole; it does not give financial information per product, department, or job.

#3 - Segmental Reporting

An entity could also be doing business under several different segments. Consequently, the entity earns revenue from these segments and incurs costs to run these businesses.
Financial Accounting does not provide any information or inputs, i.e., the profit margin per segment and the costs specific to those segments.
Financial accounting fails to consider that all types of businesses have differentiable profit margins and that each business has a unique requirement of costs under various heads.
Additionally, it becomes a cumbersome process to trace which segment is the most profitable unit and which is the least profit earning or a sick unit.

#4 - Inflation Impact

Financial accounting requires recording assets on a historical cost basis. The same applies to long-term wealth-generating assets as well.
In an economy with relatively high inflation, financial accounting entails risk by not adjusting such assets towards inflation changes, thus exhibiting a not so strong balance sheet of the entity to the extent of these long-term assets.

# 5 - Fixed Period Financial Statements Information

Financial accounting requires the preparation of financial statements for a specific period.
The user may not get a correct view of the financial information by merely referring to the specific period financial statement.
Also, the business cash flows vary because of any sudden changes or the business being seasonal.
Thus, the user will be required to refer to financial reports about different periods to get the correct picture of the business.

#6 - Fraud and Window Dressing

To showcase a powerful financial net worth, the accountant or the management may resort to window dress the financial statements.
In such a scenario, it will be difficult for the user to know this fact, and the user may make the decision based on financial statements that do not give an accurate and fair view of the state of a business carried on.

# 7 - Non-Financial Aspects

The first and foremost important aspect of financial accounting is that it records only those transactions which can be measured in monetary terms.
It has no scope for recording transactions, which, although non-monetary, have an important effect on running the business.
Factors such as employee efficiency, market competition, laws, and statute governing the business, economic and political scenarios, affect the business operations. However, they find no place in the financial accounts of the entity.

# 8 - Intangible Assets

Financial accounting does not recognize many intangible assets. Intangible assets such as brand value, goodwill, and the development of new assets find no place in financial statements.
On the contrary, it requires creating a charge towards the expenditure incurred on generating these intangible assets.
It gives a very weak picture of the balance sheet and impacts the net worth of those organizations which are highly invested in assets but low on sales.
It is a major problem for many start-ups and IT-based companies that invest heavily in intellectual property.

# 9 - Audit Concerns

Various business entities are working on a small and medium level, considering the level of operations of such businesses. The audit is not mandatory to avoid unnecessary hardships, provided they fall under the specified category.
However, this small and medium business does have to prepare financial statements but is not required to be audited.
In the absence of an audit, it is not just that they have followed the policies and principles appropriately. This leads to the question of whether the financial statements are reliable?

# 10 - Future Prediction

The complete financial statements theory is formulated on the historical cost basis and specific to the period as required by statute.
In simple words, all the financial data is based on past transactions and provides no scope for analyzing what shall be the expected or future viability of the business.
It does not provide any information on the stability or growth aspects of the business in the years to come.

# 11 - Comparability

To compare the financial statements of different companies, the accounting policies followed by the companies must be the same.
However, that’s not the case practically, as accounting policies involve the use of judgments and experience. The same can vary from entity to entity based on different business models and accountants having unique expertise and competence.

# 12 - Personal Bias

Although the books of accounts are prepared to keep in mind the accounting principles, many of these principles require the accountant to use his judgment and experience in practical cases.
Thus, the basis on which the principles have been applied may differ based on the varied experience and competence of the accountant involved in preparing the financial statements.

Conclusion

Although there are various advantages associated with applying financial accountancy in business, it does leave out certain factors from its purview. These factors are nothing but the limitations of financial accounting and could result in a change or difference of opinion or decision of the user of the financial statements. Simultaneously, consideration of these factors, which are left out of the scope of financial accounting, affects the user's way forward or action.