What Is the Limitation (Disadvantages) of the Balance Sheet?

Overview:

A Balance Sheet is one of the financial statements that lists business assets, liabilities, and owner’s equity on a specified date. It is a synopsis of the business’s financial health as of the last date of the accounting period.

The Balance Sheet is also called the Statement of Financial Position, and it lists out three parts, what the business owns (assets), the business owes (liability), and the net worth of the business (Assets fewer Liabilities).

Or we can say that it lists three important elements of financial statements. The Asset’s side must equal the Liabilities and Owners’ equity. The common accounting standards for preparing balance sheets are IFRS and US GAAP.

Hence, this is called the Balance Sheet.

This also forms the most fundamental accounting concept, called the accounting equation. Balance Sheet has many advantages to users to help them assess the entity’s financial position, but it also has many other limitations that we should know:

Here are the lists of the Balance Sheet’s Limitations:

  1. Valuation of Internally Generated Assets: The major limitation of the balance sheet is that only acquired assets are accounted for. Hence, when the assets are developed internally through research and development works, these assets are not recognized at market value but rather at a cost that tends to generally be lower than the value or sometimes higher than the market value. Suppose the business builds the website and starts e-commerce. The balance sheet largely ignores the value capability of the cost of the website.
  2. Mis-stated Long-term assets: Long-term assets are expected to last more than one year and include plant and machinery, buildings, etc. The Balance Sheet records the value of the assets at historical or book value. The depreciation calculated is for tax purposes or is reliably estimated per accepted policies. However, this does not reflect the true wear and tear of assets. The Balance Sheet also ignores the monetary value the business would require to replace the assets in use. For instance: Machinery was purchased in 2015 with an estimated life of 5 years. In 2019, the machinery was recorded at historical cost, less accumulated depreciation. If the straight-line method is employed, machinery would be completely written off by the end of the 2020 financial year. This should not be the case. Machinery does have a market value that may be higher or lower than the recorded value. Salvage value can be estimated, but this is not a reality and is only based on certain accounting policies and assumptions.
  3. Snapshot at a particular date: As a balance sheet depicts the financial position on a particular date, the management or the owners want a balance sheet as healthy as possible. They would repay the bank debt on the last date to reduce the debt on that date. Businesses can manipulate the cash, debtors, and creditors’ data to manipulate the lenders. For instance, a high cash balance at the end date of the accounting period should confirm strong liquidity reserves. However, the company’s intention to apply cash can be different. Hence, at a given period, the figures for the balance sheet can be misleading.
  4. Needs Comparison: To use all the items in the balance sheet, one must compare the business balance sheet with that of competitors and their balance sheets over the various accounting periods. It is, therefore, an essential task to make the comparison to bear the fruits of the balance sheet.
  5. Ignore off-Balance Sheet Item: In certain situations, the balance sheets ignore several off-balance sheet financial information, which might be very important for users of financial liabilities. Those include an operating lease, contingent assets, and liabilities, tax contingency,
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