Characteristics and limitations of financial information.
Financial statement or report is a formal or written document that contains information about a business's financial activities, status, condition, and position, as well as a variety of other business entities. Financial Statements or Information consist of the following:
a) balance sheet,
b) profit and loss statement, and
c) cash flow statement.
These accounting information have a number of benefits and drawbacks. Consider the financial statement's limitations.
Financial Statements or Information’ Limitations:
Financial Statements or Information have limitations that should be considered before relying on them excessively. Knowing about these factors may result in a reduction in the amount of money invested in a business or in actions taken to evaluate further. Let us examine them in greater detail.
1. Using historical costs as a guide: Financial results do not specify the company's current value. We begin by recording transactions at their expense. Assets and liabilities have a changing value over time. We occasionally adjust the amount of certain items, such as marketable securities, to reflect changes in their market values, but we do not adjust the amount of other items, such as fixed assets. Thus, the balance sheet may be deceptive if a significant portion of the amount is based on historical costs.
2. On the basis of one's own judgement: The value of assets that appear in financial Statements or Information is determined by the standards used by the individual who deals with them. For instance, the method of depreciation and the manner in which assets are amortised are subjective to the accountant's judgement.
3. Inflationary implications: If the rate of inflation is relatively high, the balance sheet's assets and liabilities will appear abnormally low, as we cannot adjust for inflation. This is especially true for long-term assets.
4. Accounting policy determinations: As we prepare a balance sheet on a going concern basis, where asset valuation does not reflect the asset's realisable or replacement value. Additionally, we are aware that the amount expressed in financial Statements or Information is not accurate. Additionally, it is contingent upon management's judgement regarding the accounting policies used.
5. Non-recorded intangible assets: We do not account for a large number of intangible assets as assets. Rather than that, we expense any spend created to create an intangible asset. This policy grossly underestimates the value of a business, particularly one that invests heavily in brand development or product development. It is a particular issue for startup companies that generate intellectual property but have so far generated only a small amount of revenue.
6. Interim reports are generated: Financial Statements or Information, as we all know, are interim reports; thus, these are not final reports. As a result, a user can obtain an erroneous view of financial results by examining only one reporting period. We can only calculate the business's final gain or loss at the time of termination.
7. Not all companies are comparable: If a business wishes to compare its results to those of other businesses, its financial Statements or Information are not always comparable, as different businesses employ different accounting practises.
8. Fabricated figures: A company's management team may skew the results. This situation occurs when an organisation is under undue pressure to report excellent results, for example, when a bonus plan provides for payouts only if sales increase. When the results exceed the industry standard, one may suspect the presence of this issue.
9. Inadequate consideration of non-financial factors: Financial Statements or Information consider only financial factors and do not address non-financial issues such as a company's environmental stewardship or its relationship with the local community. A business that reports excellent financial results may be a failure in other areas, such as its image, employee loyalty, and so on.
10. Inaccuracies in figures: Financial Statements or Information contain information about a business's historical results or financial condition as of a specified date. The Statements or Information add no value to forecasting what will occur in the future.
Financial Statements or Information' Importance:
The significance of financial Statements or Information stems from their ability to satisfy the diverse interests of various categories of parties, including management, creditors, and the general public.
1. Management's Importance: The increasing size and complexity of the factors affecting business operations necessitate a scientific and analytical approach to business enterprise management in the modern era. The management team requires current, accurate, and systematic financial data to accomplish its objectives. Financial Statements or Information assist management in determining the business's position, progress, and prospects in relation to the industry. They enable management to formulate appropriate policies and courses of action for the future by providing them with the causes of business results. The management communicates their performance to various parties solely through these financial Statements or Information and thus justifies their activities and thus their existence. A comparative analysis of the financial Statements or Information reveals the trend in the enterprise's progress and position and enables management to make appropriate policy adjustments to avoid unfavourable situations.
2. Shareholders' Importance: In the case of businesses, management is distinct from ownership. Shareholders are unable to participate directly in the day-to-day operations of the business. However, the results of these activities should be presented to shareholders in the form of financial Statements or Information at the annual general meeting. These Statements or Information inform shareholders about the management's efficiency and effectiveness, as well as the company's earning capacity and financial strength. By analysing the financial Statements or Information, prospective shareholders can ascertain the company's profit earning capacity, current position, and future prospects and make an informed investment decision. Financial Statements or Information published in the public domain are the primary source of information for prospective investors.
3. Lenders/Creditors' Importance: Financial Statements or Information serve as a useful guide for a company's current and prospective suppliers and potential lenders. These groups can learn about a company's liquidity, profitability, and long-term solvency position by conducting a critical examination of its financial Statements or Information. This would assist them in determining their next course of action.
4. Labor's Importance: Employees are entitled to bonuses based on the profit margin as disclosed in the audited profit and loss account. Thus, P&L a/c becomes critical to workers. Profitability and profitability achieved are also critical factors in wage negotiations.
5. Public Importance: A business is a social organisation. While not directly involved in business, various segments of society are interested in the state, progress, and prospects of a business enterprise. They include financial analysts, lawyers, trade associations, labour unions, financial press, academics, and educators, among others. These individuals can only analyse, judge, and comment on business enterprises based on their published financial Statements or Information.
6. Economic Importance: The rise and expansion of the corporate sector have a significant impact on a country's economic progress. Unscrupulous and fraudulent corporate management undermines the public's confidence in joint stock companies, which is critical for economic progress, and slows the country's economic growth.
All of the following quality attributes of financial Statements or Information are present;
The information should be easily comprehensible to financial statement users. This requires information to be presented plainly, with supporting footnotes providing additional information as needed for clarification.
The information must be pertinent to the users' needs, which occurs when the information has an effect on their economic decisions. This may entail disclosing particularly pertinent information or information whose misstatement could have an effect on users' economic decisions.
The info must be free from random inaccuracies and bias, as well as being truthful. Thus, the information should accurately represent transactions and other events, accurately reflect the true substance of events, and appropriately disclose estimates and uncertainties.
The info must be similar to the finance information presented for prior accounting periods in order for users to identify trends in the reporting entity's performance and financial position.