Financial statements include generally Profit and Loss Account, Balance Sheet, Cash Flow Statement, and Statement of Changes in Equity.
Notes to financial statements aid the interested stakeholders in understanding the various items of financial statements.
Financial statements are normally prepared annually and at the end of the financial year, these are audited by a statutory auditor.
The preparation of these statements is based on company accounting police that are aligned with accounting standards like IFRS or US GAAP.
They are used by both external and internal stakeholders for many different purposes and objective because they contain much useful financial information that could help them in making decisions.
However, there are certain limitations attached to the financial statement:
limitation of Balance Sheet:
- Dependence on historical costs: Financial Statements i.e. Balance Sheet records all the transactions at cost. In case of assets, depreciation are provided and deducted from book value to arrive at a written down value. Financial statements can therefore be misleading if most assets are recorded at historical costs.
- Ignores effect of inflation: This again applies to long term assets and liabilities. If the rate of inflation is high, the amounts associated with assets and liabilities in balance sheet will appear very low as they are not adjusted for inflation.
- Issue of Comparison: It is not necessary that user would be able to compare financial statements of a business with competitors because of applicability of various accounting practices. This issue of comparison however can be resolved by making use of disclosures and notes to financial statements. For instance, Boeing used program accounting being the only on in aerospace industry to do so while other players use unit accounting to value the cost of aircraft. This makes comparison difficult and for comparison, financial statement needs to be restated.
- Prone to Fraud: There are various circumstances under which financial statements can be made subject to planned manipulation. Various agencies base their decisions on these financial statements. Financial statements are subject to window dressing by the management itself and this can blindfold all the related stakeholders.
- Ignores Non-financial Aspects: Financial Statements only record monetary transactions i.e. related to money. It completely ignores the qualitative aspects of business. For instance: resignation of 10-year veteran member of board is completely ignored by financial statements. The impact of such resignation cannot be shown directly in balance sheet.
- Errors and omissions: Financial statements are concise form of all the financial data accumulated during the year. The bookkeeping is done at the junior levels and may be subject to errors and omissions on their part unknowingly. Hence, whatever the financial information is processed, these will be reflected in financial statement on whole and further, auditors are not able to detect all the errors as the audit procedure is largely based on sampling.
- Valuation of Assets on closing date: The current assets like closing stock and cash can be tweaked by the management in order to make financial statement healthier. It is very easy to manipulate value of stock in manufacturing concern. For instance, in a complex manufacturing concern where stock is spread around various geographical areas, the auditor has very uphill task to value the closing stock while it becomes easier for the management to tweak the closing stock and inflate or deflate profits artificially.