Question 7Q What is the likely limitation of... [FREE SOLUTION] (2024)

Chapter 1: Question 7Q (page 22)

What is the likely limitation of “general-purpose financial statements”?

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Meanings of Financial Statements

Financial statementsare the statements prepared to provide information regarding the financial position, its operating results and keep track of the cash flows of the business.

Limitations of Financial Statements

Financial analysts, advisors, and other interested persons suffer from certain limitations even though financial statements are the back-bones of the decision-making process for different levels of executives of the organization. The reported facts and figures may not be precise, exact, and final. Also, some aspects which may be crucial for decision-making purposes may go unreported.

The following are some of the limitations of financial statements:

Periodic nature of statement: The profit or loss arrived at in the profit and loss account is for a certain period. It does not give any idea about the earning capacity over time. Similarly, the financial position as of the balance sheet date is true of that point in time. The likely change in position on a future date is not depicted. The balance sheet estimates and shows the liabilities dependent on future events that are contingent liabilities. They are not accurate figures. Likewise, revenue expenditure is sometimes partly charged to profit and loss accounts and partly deferred or carried forward. The annual statements do not reveal the exact earning capacity in all these respects.

The statements are not realistic: Financial statements are prepared based on certain accounting concepts and conventions. As a result, the financial position depicted in the statements cannot be considered realistic. Also, the profit and loss account invariably includes probable losses but does not include probable income. This is according to the accounting convention of conservation.

Lack of objectivity due to personal judgment: Values assigned to many items are determined based on the personal judgment of accountants. Hence, relevant amounts shown in the financial statements have no objectivity and are not verifiable. For instance, estimates of the life of fixed assets and the depreciation method are based on the personal judgments of the accountants. The method of valuation to be adopted depends on the policy at the discretion of the management based on their judgment.

Only financial matters are reported: The financial statements present information in terms of monetary units. Facts that cannot be depicted in money terms are excluded from the statements. Thus, information relating to the development of skill and efficiency of employees the firm’s public image is not found in the financial statements. Yet these are quite relevant for investors to consider while forming opinions about the firm’s future prospects.