The Quantitative Limitations of Financial Statements

Financial statements are reports used to show the financial performance and economic position of a business entity in a particular financial year. The organization's stakeholders -- such as its management, employees, creditors, investors and debtors -- use them to make informed decisions about investments and dividends. The most important financial statements are the statement of financial performance, statement of financial position and statement of cash flows. Those responsible for production of the financial statements -- namely, accountants -- must abide by the rules set in the International Financial Reporting Standards (IFRS).

  1. Qualitative Considerations

    • The quantitative information portrayed in financial statements does not consider the qualitative aspects of the entity, such as consumer satisfaction, management innovation, brand value, employee motivation and loyalty. These aspects are intangible, and the current accounting process has no defined procedure for measuring their value. This limits how much the end user can rely on the financial statements to make informed decisions about whether to invest in the firm or not.

    Use Estimates

    • Calculations done in the preparation of financial statements are mainly based on estimates. Human intuition and judgment are used to make estimates of certain financial statement items such as bad debt estimates. As such, the final statements produced don't present a totally accurate and precise picture of the real situation.

    Historical Cost

    • Computations of an asset's value are mainly based on historical or original cost, which ignores the fact that the asset's value could have appreciated over time. Some assets like land appreciate in value over time, so it is unreasonable to present them in the financial statements based on their historical costs. The inflationary effects on the asset values are also overlooked. This leads to undervaluation or overvaluation of the assets.

    Misconceptions

    • Relying on financial statements alone to evaluate the health of a business is misleading. A close scrutiny of financial statements may indicate a robust performance as indicated by a favorable sales turnover or profit margin, yet the company could be facing a host of internal problems. These problems may include a high employee turnover rate or legal suits.

    Opportunity Costs

    • During the preparation of financial statements, opportunity costs incurred by a business are overlooked. Such costs are important to the business, as they indicate the value the entity forgoes by carrying out or avoiding certain business transactions. Examples are opportunity costs of stock outs -- the costs of absence of stock to meet the customers' needs -- and the opportunity costs of overlooking certain investments, such as investing in bonds instead of shares of other companies.

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