Limitations of Financial Reports

Accounting procedures and statements are limited in conveying the financial performance and position of a firm. There are ways to make the numbers appear better than they actually are; impacting the value of the business.

• Capitalising Expenses: The process of listing an expense as an asset (moved from the Income Statement to the Balance Sheet). This process removes expenses from the income statement making firm appear more profitable. It also add to the asset value of the firm. Example is ‘Research and Development’.

• Valuing Assets: The monetary value attached to business assets is subject to dispute. Of particular challenge is how to value intangible assets like 'goodwill' or the value of a company's brand.

  • Discounted Cash Flow method (projected revenues from an asset); 

  • Guideline Company method (how similar companies value their assets); and 

  • Historical Cost Accounting (listing asset value at purchase price, ignoring market value for assets).

• Timing Issues: Firms can represent performance inaccurately by intentionally playing with the time periods of firm activity; poor recent performance can be masked by an annual report, revenue / costs can be moved into different accounting periods to reflect better results.

• Debt Repayments: The nature of debt agreements are not included on the Balance Sheet; interest rate, date due for repayment of debentures, security attached to loan, length of time firm has held debt.  Information specific to debt is not reflected in financial statements.

Due to these limitations and potential for misrepresentation, extra notations are required to fill these gaps.

• Notes to the Financial Statement: Financial reports are acknowledged to be so limited that extra ‘notes’ are common; these notes provided clarity on issues such as accounting methodology used, asset valuation methods, and description of firm’s debt. These notes flesh out the report (they ar enot a limitation in themselves)