subject: Financial Statements and their Limitations [print this page] Financial Statements and their Limitations
Financial statements are a main source of financial information for an organization. Users analyze these statements to evaluate the ability of an organization to use its resources efficiently and effectively and form expectations about risks and returns by studying the changes in assets, liabilities, earnings and cash flows over time.
A balance sheet shows the assets, liabilities and owners' equity at a point in time, for example a balance sheet prepared on March 31st, 2011 provides a snapshot of the assets, liabilities and owners' equity for that entity at that point in time. The income statement and statement of cash flows help explain the changes in balance sheet accounts during a period of time. Balance sheets for the beginning and ending of a fiscal period reveal changes in an entity's resources and finances. Examining an entity's income statement and statement of cash flows will reveal major events that caused these changes. The relationship between financial statements can be attributed to the manner in which the numbers on one statement explain numbers on other statements.
Even though financial statements provide a wealth of information, their usefulness is limited because of certain constraints in the reporting process. These constraints exist mainly due to costs associated with reporting financial information. Information is a resource, and it is costly to provide. For information to be valuable, its cost must be less than the benefits it provides to its users. Therefore, the amount and type of reported information are constrained by costs and benefits. Users should keep these limitations in mind when interpreting financial statement information. Some of these limitations are briefly explained below.
Financial statements are many times based on numbers derived from estimates and allocations. For example, when calculating depreciation, one has to estimate the cost of an asset that was used up during a fiscal period and allocate that amount to the depreciation expense for that period. These are estimates and not exact numbers since it is difficult to exactly determine how much of an asset is consumed during a particular fiscal period. Also frequently management has to use their judgment when determining how certain expenses and revenues are recorded. These decisions and estimates mean that accounting numbers are not as precise as they might appear.
Financial statements primarily report the purchase or exchange price of an asset or liability at the time it is acquired or incurred. The recorded values are not adjusted for inflation or for changes in the appreciation or depreciation of the assets or liabilities. Therefore the true value of an asset is ambiguous.
Even though the financial statements include the primary transactions that occur as part of an entity's business activities, there are no guarantees that all important transactions are fully recorded in the financial statements. Accountants and managers sometimes disagree about when certain activities should be recognized. Also, they may disagree about the amount that should be reported in the financial statements for these activities.
Certain types of resources and costs are not reported in financial statements. The value of employees is not an asset listed on most balance sheets even though an organizations human capital may be its most important asset. Without their skilled human capital, the physical resources of an organization often would have little value. Financial statements do not report this human capital as their value is difficult and costly to determine. In the scientific and technological industry, research and development activities are responsible for majority of the revenues but the costs of these efforts are expensed when they are incurred each fiscal period even though they may have a major effect on the future earnings of a company. Such costs are expensed because of difficulty in identifying the timing and amount of future benefits a company will receive from these efforts. The economic value of a company differs from the amount reported on its financial statements because of these measurement limitations.
Information provided by the statements is not always timely. Annual financial statements may sometimes report information that is pertinent a year ago and monthly statements may have data that is from a few weeks ago. Such delays may be critical for certain types of decisions. Some users, particularly managers, may need information on an ongoing basis to make effective decisions. Traditional financial statements are only one type of accounting information. Some ways of providing more timely information is to provide quarterly reports to stockholders and to use information technology to help reduce reporting costs.
Though a variety of problems impair their usefulness, financial statements continue to be a primary source of information for managers and external users about a company's activities. But these problems mean that considerable care is needed to understand accounting information and to use it correctly in making decisions.
