The share market is a significant source of income for many investors. Most investors hold various assets and securities in the market. Usually, they invest in those securities for two reasons, including capital gains and dividend income. On top of that, when they buy a company’s shares, they become its part-owner. It allows them to participate in its decisions and contribute to them. However, they must hold a substantial portion of the overall shares to make an impact.
When investors choose security to invest in, they consider various factors. The most significant of these may include market factors that dictate the conditions. On top of that, they also evaluate the underlying company’s operations. Usually, they use financial statements to fulfil that objective. Most companies present their performance in their financial statements. They include four primary records.
However, the financial statements may have some flaws in the presented information. Furthermore, these statements may not satisfy the intended purpose of an investor. These flaws usually come in the form of the limitations of the financial statements. However, there are some ways investors can deal with those limitations. Before understanding those ways, it is crucial to study the primary financial statements.
What are the primary financial statements?
Companies prepare four financial statements with notes to the financial statements. The first is the balance sheet, which shows a company’s financial position. Usually, it includes a company’s assets, equity and liability balances. This statement presents a company’s financial picture at a specific date. It accumulates various balances throughout the years and classifies them under three categories.
The income statement shows a company’s profitability through three elements. These elements include revenues, expenses and profits. When the revenues forged by a company exceed its expenses, the company makes a profit. On the other hand, if the opposite applies, the company generates a loss. The income statement presents the financial performance for a specific period.
A cash flow statement is another primary financial statement prepared by companies. It shows movements in cash and cash equivalent balances for a specific period. Usually, companies use the indirect method of preparing the cash flow statement. In this method, they divide their cash flows into three categories. Those categories include cash flows from operating, investing and financing activities.
The last financial statement that companies prepare is the statement of changes in equity. This statement may come under different names. Nonetheless, it presents the movements in equity balance that companies maintain. The statement of changes in equity separates those movements into several periods. This statement uses the other financial statements to present the complete picture.
Lastly, companies also prepare notes to the financial statements. Although technically not a financial statement, it is crucial to enhance the information presented. These notes include a company’s policies and details of its operations. On top of that, it shows a breakdown of different balances and items in the financial statements. The notes to the financial statements enhance or expand the usability of the other financial statements.
What are the limitations of financial statements?
Financial statements are significantly crucial for various stakeholders. They present a view of a company’s operations, which users may find helpful. On top of that, they help companies summarize their financial position and performance. This way, they can attract new investors or creditors. However, financial statements also come with some limitations. Some of those limitations are as below.
Present historical view
Financial statements present a historical view of a company’s operations. Until companies report their finances, the transactions and balances may represent a historical position. On top of that, financial statements also include assets, liabilities and equity at an amount relating to the past. Therefore, it may distort the image presented to the stakeholders.
Cover a specific period
Accounting principles require companies to cover a specific period when reporting their operations. This principle falls under the periodicity assumption in accounting. For companies, it makes preparing and presenting information more comparable and straightforward. However, it may not show a proper picture of their operations. On top of that, seasonal fluctuations may also impact those statements, limiting the financial statements.
Can be manipulated
Financial statements use financial accounting as a base to present a company’s operations. The information presented in those statements is prone to manipulation. In the past, various high-profile corporate failures have occurred due to fraud and errors in the financial statements. The view reported in those statements can be shifted or distorted to present favourable financial health.
Use quantitative information
Quantitative information forms the essence of financial statements. These statements use figures and numbers to present a view of operations. However, they also ignore qualitative information by doing so. In some cases, investors may not receive a full picture of a company’s operations through quantitative information. Therefore, showing the quality of that information can also be highly crucial, which does not happen.
May not be verified
Financial statements require verification before presenting to the users. In some cases, companies may report their finances without performing such verifications. Usually, it occurs through an audit of the financial statements, which may be mandatory in some cases. However, companies can still report finances without going through the process. It also leads to higher chances of incorrect or fraudulent reporting.
How to overcome the limitations of financial statements?
There are many other limitations of financial statements apart from those listed above. These limitations can significantly impact the decisions made based on those statements. However, there is some good news for the users worried about them. There are various methods by which users can overcome the limitations of financial statements. These methods can apply to specific statements or all of them as a whole.
The first crucial way to overcome the limitations is to ensure users consider audited financial statements. As mentioned, in some cases, laws and regulations may mandate companies to perform an external audit. For those companies, users cover their risks by relying on the auditor’s report. If companies do not report their financial statements with an auditor’s report, users must be wary. The risks associated with those financial statements are significantly higher.
Users must also consider each financial statement individually. For example, the limitations of the balance sheet may not apply to the income statement. Therefore, they must understand each of these reports and what they present. Once users can separate them from each other, they can be more aware of their limitations. However, they must also consider them as a whole as some disadvantages may apply to all.
Another way to overcome the limitations of financial statements is to ensure companies follow accounting standards and regulations. When users ensure this, they can rely more on those financial statements. Accounting standards exist to help companies report their operations in an organized manner. For users, a company that follows those standards will provide better information. This way, they can overcome the limitations of financial statements.
However, the limitations of financial statements do not exist for external users only. They can also apply internally, for employees or the management. Nonetheless, they can also overcome those limitations. Internally, companies can use various analytical tools and techniques. On top of that, they can also use performance measures to restrict the limitations of financial statements.
Financial statements are records of a company’s operations. Usually, companies prepare these annually or quarterly. Companies report their finances through four primary financial statements. However, these financial statements can have several limitations. They may apply to a specific statement or all of them. Nonetheless, users can overcome the limitations of financial statements in various ways.