As previously mentioned, financial reporting records and communicates accounting and finance information of companies. To organize this information, the financial reporting process records each type of data into a specific financial statement. For instance, the balance sheet contains information related to the company's assets, liabilities, and shareholders' equity. The income statement conveys information related to the income and expenses of the company. Concerning the statement of cash flows, it indicates how cash was generated or spent in the various activities of a business organization within a period.
It is important to understand the limitations of financial statements before using them. For this, the following sections will identify and explain the main limitations of financial statements which are: the use of estimates and cost basis, accounting methods and unusual data, lacking data, and diversification.
Use of Estimates & Cost Basis
There are various scenarios where a value within financial statements cannot be measured with high accuracy. For this, accountants make use of estimates to have an approximation of the value that cannot be exactly measured. For instance, when equipment is purchased, the company should estimate how long it will be used. This process is necessary for financial reporting as accountants need to calculate the yearly depreciation cost of the equipment, which is the reduction of the value of the asset. If the company fails to make a proper estimate of the useful life of the equipment, the provided accounting information will be considered wrong.
Another limitation of financial statements is the use of the cost basis method. This method is commonly used. It records companies' purchases at their original costs. Therefore, the financial statements do not reflect the increase or decrease of the value of assets. For instance, the value of land might increase after a couple of years. However, the balance sheet will not reflect this change in the value. Also, some accounts in the balance sheet such as long-term assets might appear very low in periods of high inflations as they are not adjusted to it.
Accounting Methods & Unusual Data
Other limitations of accounting and financial reporting are the accounting methods as well as unusual data. Concerning accounting methods, they differ from one country to another. In addition, many regulatory bodies allow using multiple accounting methods. For instance, two companies that perform in the same industry might record their inventory using two different methods. Company A might use the FIFO method, which means the oldest unit of inventory is sold first, and company B might use the LIFO method, which means the newest unit of the inventory is sold first. In periods where the cost of the inventory is increasing, company B will incur a higher cost and will report a lower income compared to company A. Therefore, comparison between companies that use different accounting methods can be challenging and might provide wrong conclusions.
Concerning unusual data, this refers to having a sudden spike in sales due to unusual events or seasonality. When looking at the profitability of a company using a financial statement, it is impossible to identify if there are excessive gains due to unusual data or not. An example of seasonal data can be peak sales and low sales of snow blowers during periods of snow and summer, respectively.
Lacking Data
It is important to highlight that financial statements have lots of lacking data. One of the main limitations of financial reporting is the non-measurability issue, where accountants only record transactions capable of being measured. This means that financial statements do not include great deals of information such as the change in management and technological breakthroughs that will enhance the performance of the company in the future, government regulation changes that might impact the company's profitability, and the competence of the workforce amongst many others.
Diversification
Diversification is another limitation of financial reporting. In the case where a company performs in various industries such as consumer goods and the automotive industry, it is usually not qualified for comparison with other companies. It is challenging to compare this company to another one that performs in consumer goods only or that performs in consumer goods in addition to another industry different than the automotive.
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