Limitations of financial statements
/The limitations of financial statements are those factors that a user should be aware of before relying on them to an excessive extent. Knowledge of these factors could result in a reduction of invested funds in a business, or actions taken to investigate further. The following are all limitations of financial statements.
Financial Statements Are Derived from Historical Costs
Transactions are initially recorded at their cost. This is a concern when reviewing the balance sheet, where the values of assets and liabilities may change over time. Some items, such as marketable securities, are altered to match changes in their market values, but other items, such as fixed assets, do not change. Thus, the balance sheet could be misleading if a large part of the amount presented is based on historical costs.
Financial Statements Are Not Adjusted for Inflation
If the inflation rate is relatively high, the amounts associated with assets and liabilities in the balance sheet will appear inordinately low, since they are not being adjusted for inflation. This mostly applies to long-term assets, such as fixed assets.
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Financial Statements Do Not Contain Some Intangible Assets
Many intangible assets are not recorded as assets. Instead, any expenditures made to create an intangible asset are immediately charged to expense. This policy can drastically underestimate the value of a business, especially one that has spent a large amount to build up a brand image or to develop new products. It is a particular problem for startup companies that have created intellectual property, but which have so far generated minimal sales.
Financial Statements Only Cover a Specific Period of Time
A user of financial statements can gain an incorrect view of the financial results or cash flows of a business by only looking at one reporting period. Any one period may vary from the normal operating results of a business, perhaps due to a sudden spike in sales or seasonality effects. It is better to view a large number of consecutive financial statements to gain a better view of ongoing results.
Financial Statements May Not Be Comparable
If a user wants to compare the results of different companies, their financial statements are not always comparable, because the entities use different accounting practices. These issues can be located by examining the disclosures that accompany the financial statements.
Financial Statements Could be Wrong Due to Fraud
The management team of a company may deliberately skew the results presented. This situation can arise when there is undue pressure to report excellent results, such as when a bonus plan calls for payouts only if the reported sales level increases. One might suspect the presence of this issue when the reported results spike to a level exceeding the industry norm, or well above a company’s historical trend line of reported results.
Financial Statements Do Not Cover Non-Financial Issues
The financial statements do not address non-financial issues, such as the environmental attentiveness of a company's operations, or how well it works with the local community. A business reporting excellent financial results might be a failure in these other areas.
Financial Statements May Not Have Been Verified
If the financial statements have not been audited, this means that no one has examined the accounting policies, practices, and controls of the issuer to ensure that it has created accurate financial statements. An auditor’s opinion that accompanies the financial statements is evidence of such an examination. A lesser level of review is the financial statement review, which does not provide as complete a level of assurance as an audit regarding the fairness of presentation of the financial statements.
Financial Statements Have No Predictive Value
The information in a set of financial statements provides information about either historical results or the financial status of a business as of a specific date. The statements do not necessarily provide any value in predicting what will happen in the future. For example, a business could report excellent results in one month, and no sales at all in the next month, because a contract on which it was relying has ended.
Financial statements are normally quite useful documents, but it can pay to be aware of the preceding issues before relying on them too much.