Limitations of Accounting Statements
Financial statements provide useful information about the financial performance and position of a business. However, they do not provide a complete picture. This chapter explains why users must understand the limitations before making decisions from accounting statements.
Topic 1: Why Financial Statements Have Limitations
Accounting statements are useful, but they cannot show every factor that affects business performance, value and future prospects.
1. Why Do Accounting Statements Have Limitations?
Financial statements provide useful information about the financial performance and position of a business. However, they do not provide a complete picture of the business.
The chapter concentrates on three main limitations:
1. Historic cost
Assets may be recorded using old purchase values rather than current values.
2. Difficulties of definition
Accounting rules and definitions may differ between countries and businesses.
3. Non-financial aspects
Important strengths such as customer loyalty and staff efficiency may not be shown.
Topic 2: Historic Cost
Historic cost can make asset values and comparisons misleading because original cost may not equal current economic value.
2. Limitation 1 – Historic Cost
In the statement of financial position, a non-current asset may be shown at:
Machine originally cost = $50,000
Accumulated depreciation = $20,000
Net book value = $50,000 − $20,000 = $30,000
However, the machine's current market value could be very different from $30,000.
3. Why is Historic Cost a Limitation?
The original cost may become outdated. For example, land purchased 20 years ago for $100,000 may now have a current market value of $500,000.
Historic cost does not take account of changes in the price level of an asset during its economic life.
4. Depreciation Makes Comparison More Difficult
Depreciation is based partly on estimates. Different businesses may use different depreciation methods.
Business A
Uses straight-line depreciation.
Business B
Uses reducing balance depreciation.
Even if they own similar assets, their depreciation expenses, net book values and profits may differ. This makes comparisons between businesses more difficult.
5. Textbook Historic Cost Example
| Company | Plant Cost / NBV Detail | Why comparison may mislead |
|---|---|---|
| Sondra Ltd | Plant originally cost $200,000; accumulated depreciation $100,000; NBV $100,000. | The difference partly reflects the different dates and prices at which the assets were purchased, not necessarily better or worse performance. |
| Toga Ltd | Similar plant purchased later for $400,000; NBV $400,000. |
6. Assets May Not Be Worth Their Book Value
The amount shown in the statement of financial position may not equal what the asset could actually be sold for. Some assets may even have very little or no value if the business is liquidated.
Topic 3: Difficulties of Definition and IAS
Different accounting definitions and rules can make comparisons difficult, especially between businesses in different countries.
7. Limitation 2 – Difficulties of Definition
Accounting principles and definitions may differ between countries. Without common accounting rules:
- The same transaction might be treated differently.
- Assets might be valued differently.
- Financial statements might be presented differently.
- Comparisons between international businesses could become difficult.
8. International Accounting Standards – IAS
IAS provides an accounting framework designed to reduce differences in the presentation and content of financial statements around the world.
Why are Common Standards Important?
They help businesses in different countries prepare financial statements using more consistent methods. This improves:
- Comparison.
- Understanding.
- Communication of accounting information.
Topic 4: Non-Financial Aspects
Many important business strengths and weaknesses cannot easily be measured in money and may be left out of financial statements.
9. Limitation 3 – Non-Financial Aspects
Financial statements mainly record items that can be measured in money terms. However, many important factors affecting the success of a business cannot easily be given a monetary value.
10. Examples of Non-Financial Factors
The textbook gives examples such as:
- Customer satisfaction.
- Customer loyalty.
- Efficiency of management.
- Efficiency of staff.
- Good relationships with suppliers.
These may be extremely valuable to a business even though they do not appear as ordinary monetary assets in its statement of financial position.
11. Example – Customer Loyalty
Business A
Assets shown in accounts = $500,000. However, it has poor customer service, dissatisfied customers and falling loyalty.
Business B
Assets shown in accounts = $450,000. However, it has highly loyal customers, excellent customer service and strong supplier relationships.
12. Well-Trained and Efficient Employees
Employees can be extremely valuable to a business. Experienced employees may:
- Produce better-quality work.
- Serve customers better.
- Reduce waste.
- Increase productivity.
However, the value of a skilled workforce cannot normally be measured reliably in money and included as an asset in the normal statement of financial position.
13. Financial Statements Do Not Show Everything
A business may have valuable machinery, strong cash balances and high profits but still suffer from:
- Poor management.
- Dissatisfied customers.
- Inefficient employees.
- Weak supplier relationships.
Topic 5: Summary Tables and Common Exam Distinctions
Exam answers often require clear comparisons such as historic cost vs market value and the role of IAS.
14. Three Main Limitations – Summary
| Limitation | Why It Is a Problem |
|---|---|
| Historic cost | Asset values may not reflect current market values. |
| Difficulties of definition | Different countries or businesses may use different accounting rules. |
| Non-financial aspects | Important factors such as customer loyalty and staff efficiency may not be shown. |
15. Historic Cost vs Market Value
Historic Cost
The original amount paid for an asset.
Net Book Value
Cost − accumulated depreciation.
Market Value
What the asset might currently be worth in the market.
16. Why Comparisons Can Become Misleading
Therefore, comparing their asset values directly may be misleading.
17. Why IAS Helps
Without common standards, businesses in different countries could:
- Define accounting items differently.
- Value assets differently.
- Present information differently.
Topic 6: Quick Exam Guide
Use precise limitation names, then explain why each one can mislead users.
Quick Exam Guide
| Question | Strong answer |
|---|---|
| State three limitations of accounting statements. | Historic cost, difficulties of definition and non-financial aspects. |
| Why is historic cost a limitation? | Historic cost is based on the original purchase price and may not represent the asset's current market value. Different depreciation methods may also make comparisons difficult. |
| Why are non-financial aspects a limitation? | Important factors such as customer satisfaction, customer loyalty, staff efficiency and supplier relationships cannot easily be measured in money and may therefore not appear in the financial statements. |
| Why are international accounting standards important? | They provide more standardised accounting methods, making financial statements prepared in different countries easier to understand and compare. |
Remember
Historic Cost
Original purchase price. Historic cost ≠ current market value.
Depreciation
Different methods can produce different profits and different asset values.
IAS
International Accounting Standards help make accounting information more comparable internationally.
Non-Financial Information
Customer satisfaction, customer loyalty, staff efficiency, management efficiency and supplier relationships may be important but missing.