Significance and

Limitations of Financial
Statements
Objective: explain the
significance and limitations
of statements

Indicator of
Performance
Accounting affect behaviour and
management and have effects
across departments, organisations
and even countries. Information
contained within a financial
statement has the power to
influence actions where profits and
the bottom line are daily concerns.

Financial Statements
Affect Decision Making
Financial statements affects
decision as it:
Provides managers with information
for decision making and planning
Assist managers in directing and
controlling operations
Motivate managers towards
organisations goals measure the
performance of managers and subunits within the organisation.

Financial Statements are

important to stakeholders

Organisations provide financial statements

for its stakeholders or users. The users of
the financial statements include:
managers, employees, members,
government, investors, and financial
advisors.
Financial statements are provided for
many reasons. They provided so users may
make informed decisions based on the
firms financial position as well as to
adhere to government regulations.
Stakeholders may use it to make
comparisons with other entities, determine
compliance to regulations, access
financial performance and estimate future
prospects of the firm.

Limitations of Financial Statements

Limitations of financial statements occurs
as a result of shortcomings in accounting,
these include:
Accounting information is historical
Accounting information is subject to
inflation Accounting information may be
misleading
It is subjective
It does not show social costs and
environmental costs
Costs are not tracked closely by
corporations.
Difficult to account for intangible costs
Accounting ignores the costs of not
producing
Accounting cannot measure predict or
justify change or innovation in product or
process

Limitation - Accounting
information is historical
The historical cost convention is
often applied when preparing
financial statements.
Although historical costs convention
offers objectivity as assets and
expenses are recorded at actual
costs as ascertained from source
documents, it fails to allow changing
value of money.
The application of the historic cost
convention also means that assets
and services having no cost cannot
be recorded in the ledger accounts.

Limitation - Accounting information is

subject to inflation
As mentioned before, in accounting to
record transaction at cost. The validity of
historic cost accounting rests on the
assumption that the currency in which the
transactions are recorded remains stable,
that is, purchasing power remains
unchanged, or very nearly so from year to
year.
This is not the case. For e.g., a new car
may cost $500 000 10 years ago and today
that same make car costs $5 000 000.
Goods and services have been devalued by
the process known as inflation which
increases the prices of goods and services.

Limitation - Accounting information

may be misleading
The users of financial statemenets
depend on the good faith of those
who prepare these statements. This
dependence places a duty on a
companys managemnet and its
accounts to act ethically in the
reporting process.
However, some corporations
intentially prepare misleading
financial statements called
fraudulent financial reporting. See
case - Enron

Limitation - It is subjective

Limitation - It does not show social

costs and environmental costs

Financial statements do not show social

and environmental costs.
Natural resources could be classified as
assets and environmental cost built into
product costs. Social costs to society are
not factored in, including externalties.
Externalties are costs not borne by the
firms responsible, for example, the
ecological impacts of climate change
resulting from automobile emissions are
not included into the price of petroleum.

Limitations - Costs are not

tracked closely by corporations.
Most corporations do not track costs closely in
their accounting and thereby the finanacial
statements.
Easily identifiable cost, such as labour or raw
materials are often finely tracked and allocated to
particular products or processes. However, many
costs, such as administration costs, environment,
health and safety costs are not considered to be
direct costs, hence are allocated broadly across
the firm.
Placing a cost in an overhead account allows it to
be shared across the firm, but generally removes
responsibility for the cost from one particular
manager. If no one is reponsible for a cost, it is
likely to be ignored.

Limitations - Difficult to
account for intangible costs
Intangible costs are difficult to
ascertain.
It is difficult to estimate the
costs associated with the firms
image, good relations with
investors, employees and
customers.

Limitations - Accounting ignores

the costs of not producing
Accounting and thereby
financial statements ignore the
costs of non-producing, whether
it is as a result of down time,
stock-outs, and defects.

Limitation - Accounting cannot measure

predict or justify change

Accounting and thereby

financial statements cannot
measure, predict or justify
change or innovation in product
or process. In other words,
accounting measure costs not
benefits.