Qualitative Limitations of Financial Statements

Financial statements provide a consistent framework for analysis of a company's financial position, but this framework is not without its downfalls. While a balance sheet or income statement is frequently used to make judgements on creditworthiness, investment potential or even viability, users of financial statements need to consider the reliability of the documents they are using to come to financial decisions. Even the most fairly presented financial statements have limitations inherent in their design.

  1. Historical Cost

    • Under generally accepted accounting principles, most financial transactions are recorded at historical basis, as cost is easily observable and reliable. However, for long-term or highly volatile assets and liabilities, historical cost may not be representative of the actual value of the transaction. For example, a company purchases the land for its corporate offices in 1970 for $10,000 in the middle of a major metropolitan city. If the company is still in operation in 100 years, the land will still be carried on the books at $10,000. As real estate generally appreciates in value over time, financial statements that hold land at historical cost have an inherent qualitative limitation in reliability.

    Backwards Looking

    • Although financial statements are frequently used to make decisions about a company's future, there is little information on the future of a company to be found in the financial statements. In general, most statements are prepared on prior-period activity. While past performance can shed light on future performance, we still are unable to reliably predict future earnings or solvency from historical financial statements.

    Prepared by Management

    • While many sets of financial statements are audited by external accountants, the financial statements are the product and responsibility of management. This needs to be kept in mind when analyzing a company. While there are substantial penalties for fraudulent financial reporting, there is also a good amount of leeway in the interpretation of complex financial transactions, and the preparer has a vested interest in making the company's financial position look as good as possible. This limitation is compounded by the varying amounts of transparency that companies use in financial reporting. As some companies are more aggressive than others, comparability becomes more and more difficult.

    Use of Estimates

    • Some of the most material figures on a set of financial statements are simply estimates. Warranty liabilities, contingent liabilities, deferred revenue amounts and even salary expense can be significantly influenced by estimates that are made because of the absence of information as of the balance sheet or filing date. Due to the materiality of these figures, it is important to get a feel for how good the company is at estimating these figures. However, this can be difficult, as information related to past accrual accuracy has to be unwoven from current-period transactions with limited visibility into internal accounting practices.

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References

  • "Intermediate Accounting: 12th Edition"; Kieso, Weygandt and Warfield; 2007
  • Photo Credit Jupiterimages/Photos.com/Getty Images

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