Limitations of Accounting Statements (Copy)

1. Historic Cost Principle

• Assets are recorded at original purchase price, not current market value.
• Does not reflect inflation or real-time worth.
• Affects the relevance of:
  • Non-current assets (e.g. property, equipment)
  • Long-held investments

Example:

• A building bought for 5,000,000 may now be worth 12,000,000, but it’s still shown as 5,000,000 (minus depreciation) in the accounts.

Limitation:

• Users may be misled about the true financial position of the business.

2. Difficulties of Definition and Estimation

• Some items require subjective judgment, not precise measurement.
• Examples:
  • Provision for doubtful debts
  • Useful life of assets for depreciation
  • Inventory valuation method (FIFO, LIFO, AVCO)

Resulting Issues:

• Different methods = different profit figures.
• Makes inter-firm or year-on-year comparisons less reliable.

Example:

• One firm may depreciate machinery over 5 years, another over 10 years → impacts profit.

3. Non-Financial Aspects Are Ignored

• Accounting statements only show quantifiable financial data.
• They do not account for qualitative factors, such as:
  • Employee morale
  • Customer satisfaction
  • Brand reputation
  • Environmental impact
  • Innovation potential

Example:

• A company may be making profit but have poor employee relations or product quality — this risk isn’t shown in the accounts.

Limitation:

• Can give a false sense of security to stakeholders who only see the profit figure.

4. Time Lag and Relevance

• Financial statements are prepared periodically, often annually.
• By the time users review them, the data may already be outdated.
• Not ideal for real-time decision-making.

Example:

• A report showing profit for last year doesn’t reveal that the current year’s sales are falling rapidly.

5. Creative Accounting and Window Dressing

• Businesses may use legal loopholes to present a better picture than reality.
• Example techniques:
  • Delaying expenses until the next period
  • Overstating closing inventory
  • Early recognition of revenue

Impact:

• Reduces reliability and comparability of financial statements.