Accounting Study Notes: Limitations of Accounting Statements
Hello IGCSE Accountants! You’ve done a fantastic job learning how to prepare financial statements (Income Statements and Statements of Financial Position). These documents provide powerful insights into a business’s health.
However, it is crucial to understand that these statements are not perfect. They have limitations. Think of it like a photograph: it captures a moment in time and looks precise, but it doesn’t tell the whole story or show what’s happening *outside* the frame.
In this chapter, we explore why financial statements, despite being accurate based on accounting rules, might sometimes give a misleading or incomplete picture of a business's true value and future prospects. This ability to spot flaws is essential for strong evaluation (AO3)!
1. Limitation Due to Historic Cost
One of the fundamental rules we follow is the Historic Cost principle (sometimes called the cost principle). This means that assets are recorded in the accounts at the price they were originally bought for, minus any depreciation.
What is Historic Cost (HC)?
- The original purchase price of an asset (e.g., $10,000 paid for machinery in 2010).
- This value remains in the accounts for the entire life of the asset (adjusted only for depreciation).
Why is HC a Limitation?
The biggest problem with Historic Cost is that it ignores changes in market value and inflation.
Analogy: Imagine a shop bought its piece of land 40 years ago for $50,000. Today, that land might be worth $2,000,000. The Statement of Financial Position will show the land at $50,000 (or less, if accounting standards allow revaluation only in very specific cases, which is usually beyond IGCSE scope).
- Distorted Asset Value: The figures shown on the Statement of Financial Position for non-current assets (especially land and buildings) may be drastically understated or overstated compared to what they are actually worth today.
- Misleading Comparisons: If you compare your business (using old historic costs) to a new competitor (using current purchase costs), the comparison can be unfair.
- Inflation: During periods of high inflation (when money loses its buying power), the Historic Cost figures quickly become irrelevant. A dollar spent 20 years ago is not the same as a dollar spent today.
Quick Takeaway: Historic Cost is great for reliability (it’s a verifiable number), but it is often terrible for relevance (it doesn't reflect the current economic reality).
2. Limitation Due to Difficulties of Definition (Subjectivity)
Financial statements look like pure facts, but often they rely on judgement and estimation. Accountants must make choices about how to record certain items, and these choices are known as accounting policies.
Where Does Subjectivity Creep In?
Accounting statements rely on several estimates that are not precise facts. This is known as the "Difficulties of Definition" limitation.
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Depreciation Methods:
The calculation of depreciation requires guessing two things:
(a) The useful life of the asset.
(b) The residual value (scrap value).
If Company A thinks a machine will last 10 years, and Company B thinks an identical machine will last 5 years, their reported annual profits will be different, even if their sales are exactly the same! This choice is subjective and affects the Profit Margin and ROCE.
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Provision for Doubtful Debts:
This is an estimate of how much of the money owed by debtors (Trade Receivables) will never be collected.
An accountant might decide to provide 2% of debtors as doubtful debts, while another might decide 5%. This is a subjective assessment of risk, not a certainty. -
Inventory Valuation:
Inventory is valued at the lower of cost and net realisable value. While the cost is usually known, the net realisable value (the estimated selling price minus selling expenses) requires significant management estimation, especially if the goods are old or obsolete.
Why is this a limitation?
Because management has flexibility in choosing these definitions and estimates, they could potentially use these choices to make the company look more profitable than it truly is (known as "creative accounting"). It also makes inter-firm comparison problematic, as we might be comparing two businesses that use different policies.
Memory Tip: S.E.E. for Difficulties of Definition: Subjectivity, Estimates, Effect on profit.
3. Limitation Due to Non-Financial Aspects
Accounting statements are constrained by the Money Measurement principle: they can only record things that can be measured accurately in monetary terms ($). This means that crucial factors about the business's success are completely ignored.
What Key Factors Are Ignored?
These factors, which cannot be measured in cash, are often the most important determinants of future success:
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Quality of Management and Staff:
A company with a highly skilled, motivated, and stable management team is much stronger than a company with high staff turnover and poor leadership. However, the skill of the CEO or the motivation of the workforce does not appear anywhere on the Statement of Financial Position.
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Customer Loyalty and Reputation:
A business with a fantastic brand name and loyal customer base (like Apple or Coca-Cola) has enormous hidden value. This reputation (often called Goodwill) is only recorded in the accounts if the business is bought by another company. If it was built internally, it is ignored.
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Technological Changes and Competition:
Financial statements look at the past (the year that just ended). They do not warn users about future threats. For example, the Income Statement doesn't show that a major new competitor is opening next door, or that the company’s main product is about to be replaced by new technology (like selling VCRs when DVDs are launched).
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Ethical and Environmental Standing:
How a company treats the environment, its suppliers, and its employees is increasingly important. A company might have high short-term profits but be facing huge fines or boycotts due to unethical practices. The financial statements often do not fully capture this future liability or risk.
Did you know? This limitation is why banks, when considering giving a loan, will always ask to meet the managers and look at the company’s business plan—they know that financial statements alone are insufficient.
Quick Review: Summary of Limitations (0452)
| Limitation Factor | Explanation and Impact |
| Historic Cost | Assets are recorded at their original purchase price. This ignores inflation and current market values, leading to an unreliable Statement of Financial Position value. |
| Difficulties of Definition | The statements rely on subjective estimates and judgments (e.g., depreciation rate, doubtful debts provision). Different choices affect reported profit and make comparison difficult. |
| Non-Financial Aspects | Statements only record what can be measured in money. Key factors like staff skill, customer loyalty, market changes, and quality of management are entirely omitted. |
Understanding these limitations is vital. When you calculate ratios like ROCE or Profit Margin, you must remember that the underlying figures might be based on old costs or subjective estimates. Good luck!