Information contained in financial statements is organized and presented to enable users of financial statements draw conclusions about the financial well being and performance of the reporting business. Unfortunately, financial statements have limitations.
Financial statements are usually prepared on the historical cost basis. What this means is that transactions are recorded at their original cost at the date of transaction.
Historical costs will not give a true reflection of profits and values of assets in the balance sheet during period of inflation. Inflation causes changes in the purchasing power of money. This is just one of the limitations of financial statements.
The following are other limitations of financial statements;
- Fixed assets are shown at their original low cost, although some are revalued.
2.. The maintenance of fixed assets at their original low cost causes the overstatement of ratio of return on capital employed. This is misleading to those who may depend on the information for investment and management decisions.
3. The possibility of overstating profit as an ‘expense’ is understated. This is because depreciation, an expense in the profit and loss account will be low since it is based on low asset values.
4. The overstatement of profit may cause a company to pay out so much dividends.
5. The paying out of too much dividends on the basis of untrue profits may lead to liquidity problems.
6. Increase in profits sometimes gives employees the justification to ask for a pay raise. In a situation where the increase in profits is inaccurate, the business may find itself in an awkward position.
7. A business would pay out in taxes than it’s truly accurate when profits are overstated.
8. An increase in the value of reserves may not give a true picture of business growth. It may be necessary to use a portion of the reserves to provide coverage for inflation and maintain current level of efficiency.
9. One of the best ways of using ratios is to compare them with ratios for the same business in respect of previous years. Such comparisons may be invalid since increase in sales and profits may be due to inflation. And this is not considered in historic cost accounts.
10. Profit and loss is a financial statement that understates cost of goods sold and overstates gross profit. The reason is, sales are recorded at present day prices but cost of goods sold is calculated on the basis of original low cost of goods purchased.
The above limitations could be overcome by using the following methods;
- Adjusted historical cost.
With this method, the original historical cost of an asset is adjusted for the changes in the value of purchasing power of money over the period from acquisition to the present balance sheet date. The calculations use a price index.
The method revalues the money for which the asset was originally bought. The asset itself is not revalued.
This method forms the basis of current purchasing power (CPP).
2. Net realizable value;
Net realizable value is the estimated amount that would be received from the sale of an asset less the estimated cost on its disposal. The amount receivable when an asset leaves a business is known as exit value.
3. Replacement cost;
Replacement cost is the amount that would be paid to replace the asset at the date of valuation. It is often shown as entry value, since it is the cost of the asset entering the business.
4. Deprival value;
The amount of money an owner would to receive in order to compensate them exactly for being deprived of an asset. Note that the deprival value cannot exceed replacement cost but the replacement cost would be more than the deprival value if the owner feels the asset is not worth replacing.
If the deprival value of an asset equals its net realizable value, that value must be less than its replacement cost.
5. Present (economic) value;
This is the valuation of an asset as the sum of the future expected net cash flows associated with the asset, discounted to its present value.