Limitations of financial reports

There are 6 major limitations of financial reports.

1. Normalised earnings - Are earnings that have been adjusted to take into account changes in the economic cycle or to remove one off or unusual items that will affect profitability.

Why?

This is done to give a more accurate depiction of the true earnings of a company. This makes it easier to compare profitability figures for a business from one year to the next, and against other businesses.

Example

The removal of a selling land, which would achieve a large capital gain increasing profits.

2. Capitalising expenses - This refers to an accounting method where a business records an expense as an asset on the balance sheet rather than as an expense on the income statement.

Why?

This does not accurately represent the true financial condition of the business as it understates the expenses and overstates the profits as well as the assets of the business.

Example

Research and development, and development expenditure.

3. Valuing assets - This is the process of estimating the value of assets when recording them on a balance sheet. This can be difficult for financial managers or accountants to estimate, especially for non-current assets. Sometimes when an asset is recorded on a balance sheet, its value is written as its historical cost.

a) Historical cost is an accounting method where assets are listed on a balance sheet with the value at which they were purchased.

Positive - Historical cost is that the cost can be verified.

Negative - Is that this value may distort the business’s balance sheet, meaning that it will not accurately represent the true worth of the business’s assets. This is because the original cost of an asset may be different from its current market value.

Examples

A company constructed a building at a cost of $45,000 in 2005. On December 31, 2017, the fair market value of the building is $65,000 but still stands on the balance sheet at its original cost of $45,000.

b) Depreciation non-current assets, such as vehicles or machinery, may actually lose value over time.Some non-current assets, such as land, typically increase in value over time. With assets that typically lose value over time, businesses have to estimate how much value they lose every year.

Why?

Financial managers are allowed to depreciate assets using accounting standards so that the value of the assets on the balance sheet presents a more accurate picture of the business. While there are rules governing how depreciation is calculated, financial managers are free to choose from several methods, which may mislead some investors. This is therefore a limitation when interpreting financial reports because the depreciation rate is an estimate and this may give a false impression about how much the business is actually worth.

Examples

Fixed assets are buildings, furniture, office equipment, machinery etc.. Land is the only exception which cannot be depreciated as the value of land appreciates with time.

c) Intangible assets - items of value to a business, but they do not physically exist.

Why?

While these assets are of value to the business, sometimes they are not included on a balance sheet because their value is too difficult to work out since there is no set formula for their calculation. If financial managers decide to include these assets on the balance sheet, there may be a temptation to overvalue them to make the business appear more financially stable than it really is.

Examples

Goodwill, trademarks, patents and brand names.

4. Timing issues - When an accountant records revenue, they should also record at the same time any expenses that were directly related to that revenue.

Why?

One of the basic accounting concepts is the matching principle. Under the matching principle, expenses incurred by a business must be recorded on the income statement for the accounting period in which the revenue, to which those expenses relate, is earned. When this principle is followed, the revenue earned will match the costs that were incurred to earn that revenue. The matching principle results in the presentation of a more accurate representation of the financial position of a business.

Example

A real estate agent may have sold a property in June. They receive a 2% commission for sales, but their employer did not pay them until July. This expense should be recorded in June.

5. Debt repayments - The recording of debt repayments on financial reports can be used to distort the ‘reality’ of the business’s status and this may be undertaken to provide a more favourable overview of the business at that point in time. When analysing a financial report, the gearing ratio is often used to determine whether businesses are at risk of meeting their long-term financial commitments. A business that is highly geared may be alarming for some stakeholders. However, there is an increased potential for profit is greater.

Why?

Financial reports can be limited because they do not have the capacity to disclose specific information about debt repayments such as:

Examples

• How long the business has had or has been recovering the debt?

• The capacity of the business or its debtor to repay the amount/s owed

• The adequacy of provisions and methods the business has for the recovery of debt (Larger businesses have the ability to outsource debt recovery by hiring an agent to undertake this process, but smaller business may not have the resources to do the same as it is costly and time consuming.)

• What provision the business has in place for doubtful debts and how this is evident in the financial reports?

• Whether debt repayments have been held over until another accounting period, therefore giving a false impression of the situation

• When are the debts are due?

6. Notes to the financial statement - Notes to the financial statements report the details and additional information that are left out of the main reporting documents, such as the balance sheet, income statement and cash flow statement. They contain information that may be useful to stakeholders to help them make sense of these financial statements and to explain them.

Examples

• The accounting methodologies used for recording and reporting transactions that can affect the bottom-line return expected from an investment in a company. E.g. Activity based costing vs traditional costing.
• How the figures in the financial statements were calculated and the procedures that were used to develop them.

2013

16 Auditors have discovered that the value of legal fees paid has been included in the asset value of a new warehouse purchased by a business.

What limitation of financial reports does this show?

(A) Capitalised expenses

(B) Debt repayments

(C) Normalised earnings

(D) Timing issues

2015

A potential new partner is concerned about the accuracy of the financial reports and the effectiveness of current management.

The potential new partner has asked you to write a business report in which you:

• explain possible limitations of the financial reports