Accountancy assists users of financial statements to make better financial decisions. It is important however to realize the limitations of accounting and financial reporting when forming those decisions.
Different accounting policies and frameworks
Accounting frameworks such as IFRS allow the preparers of financial statements to use accounting policies that most appropriately reflect the circumstances of their entities.
Whereas a degree of flexibility is important in order to present reliable information of a particular entity, the use of diverse set of accounting policies amongst different entities impairs the level of comparability between financial statements.
The use of different accounting frameworks (e.g. IFRS, US GAAP) by entities operating in different geographic areas also presents similar problems when comparing their financial statements. The problem is being overcome by the growing use of IFRS and the convergence process between leading accounting bodies to arrive at a single set of global standards.
Accounting requires the use of estimates in the preparation of financial statements where precise amounts cannot be established. Estimates are inherently subjective and therefore lack precision as they involve the use of management’s foresight in determining values included in the financial statements. Where estimates are not based on objective and verifiable information, they can reduce the reliability of accounting information.
The use of professional judgment by the preparers of financial statements is important in applying accounting policies in a manner that is consistent with the economic reality of an entity’s transactions. However, differences in the interpretation of the requirements of accounting standards and their application to practical scenarios will always be inevitable. The greater the use of judgment involved, the more subjective financial statements would tend to be.
Audit is the main mechanism that enables users to place trust on financial statements. However, audit only provides ‘reasonable’ and not absolute assurance on the truth and fairness of the financial statements which means that despite carrying audit according to acceptable standards, certain material misstatements in financial statements may yet remain undetected due to the inherent limitations of the audit.
Use of historical cost
Historical cost is the most widely used basis of measurement of assets. Use of historical cost presents various problems for the users of financial statements as it fails to account for the change in price levels of assets over a period of time. This not only reduces the relevance of accounting information by presenting assets at amounts that may be far less than their realizable value but also fails to account for the opportunity cost of utilizing those assets.
The effect of the use of historical cost basis is best explained by the use of an example.
Company A purchased a plant for $100,000 on 1st January 2006 which had a useful life of 10 years.
Company B purchased a similar plant for $200,000 on 31st December 2010.
Depreciation is charged on straight line basis.
At the end of the reporting period at 31st December 2010, the balance sheet of Company B would show a fixed asset of $200,000 while A’s financial statement would show an asset of $50,000 (net of depreciation).
The scenario above presents an accounting anomaly. Even though the plant presented in A’s financial statements is capable of producing economic benefits worth 50% of Company B’s asset, it is carried at a historical cost equivalent of just 25% of its value.
Moreover, the depreciation charged in A’s financial statements (i.e. $10,000 p.a.) does not reflect the opportunity cost of the plant’s use (i.e. $20,000 p.a.). As a result, over the course of the asset’s life, an amount of $100,000 would be charged as depreciation in A’s financial statements even though the cost of maintaining the productive capacity of its asset would have notably increased. If Company A were to distribute all profits as dividends, it will not have the resources sufficient to replace its existing plant at the end of its useful life. Therefore, the use of historical cost may result in reporting profits that are not sustainable in the long term.
Due to the disadvantages associated with the use of historical cost, some preparers of financial statements use the revaluation model to account for long-term assets. However, due to the limited market of various assets and the cost of regular valuations required under revaluation model, it is not widely used in practice.
An interesting development in accounting is the use of ‘capital maintenance’ in the determination of profit that is sustainable after taking into account the resources that would be required to ‘maintain’ the productivity of operations. However, this accounting basis is still in its early stages of development.
Accounting only takes into account transactions that are capable of being measured in monetary terms. Therefore, financial statements do not account for those resources and transactions whose value cannot be reasonably assigned such as the competence of workforce or goodwill.
Limited predictive value
Financial statements present an account of the past performance of an entity. They offer limited insight into the future prospects of an enterprise and therefore lack predictive value which is essential from the point of view of investors.
Fraud and error
Financial statements are susceptible to fraud and errors which can undermine the overall credibility and reliability of information contained in them. Deliberate manipulation of financial statements that is geared towards achieving predetermined results (also known as ‘window dressing’) has been a unfortunate reality in the recent past as has been popularized by major accounting disasters such as the Enron Scandal.
Cost benefit compromise
Reliability of accounting information is relative to the cost of its production. At times, the cost of producing reliable information outweighs the benefit expected to be gained which explains why, in some instances, quality of accounting information might be compromised.