Limitations
of accounting and financial reporting
1. 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.
2. Accounting estimates
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.
3. Professional judgment
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.
4. Verifiability
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.
5. 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.
6. Measurability
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.
7. 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.
8. 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.
9. 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
1. 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.
2. Accounting estimates
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.3. Professional judgment
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.4. Verifiability
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.5. 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.
6. Measurability
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.7. 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.8. 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.9. 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- See more at: http://accounting-simplified.com/financial/limitations-of-accounting-and-financial-reporting.html#sthash.6E55pBic.dpuf
1. 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.
2. Accounting estimates
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.3. Professional judgment
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.4. Verifiability
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.5. 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.
6. Measurability
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.7. 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.8. 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.9. 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- See more at: http://accounting-simplified.com/financial/limitations-of-accounting-and-financial-reporting.html#sthash.6E55pBic.dpuf
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