Importance and Limitations of Financial Statements

Financial statements are prepared not for the accountant who draws them up but for the many users who rely on them, and a good student must be able to state both what makes them valuable and where they fall short.

Importance of financial statements

• To owners and shareholders — they show whether their investment has earned an adequate return and whether the business is being run efficiently, helping them decide whether to hold, increase or withdraw their stake.
• To management — they are the basis for planning, control and decision-making; comparing this year's statements with earlier years shows where performance improved and where it slipped.
• To lenders and creditors — banks and suppliers use them to judge the firm's ability to repay loans and settle bills on time before they extend credit.
• To prospective investors — they help an outsider assess the earning capacity and financial strength of the business before putting money into it.
• To employees and trade unions — a profitable, financially sound business gives employees confidence about job security and a basis for wage or bonus negotiations.
• To the government and tax authorities — they form the basis for assessing tax and for regulatory and statistical purposes.
• To researchers and the public — they are a source of information about the performance of an industry and of the economy.

Limitations of financial statements

• They are historical. They report what has already happened; they do not, by themselves, predict the future, and past performance is not a guarantee of future results.
• They ignore price-level (inflation) changes. Assets are usually recorded at their original cost, so in times of rising prices the figures can seriously understate the current value of the firm's resources.
• They omit non-monetary factors. Valuable factors such as the quality of management, the loyalty of customers, the skill and morale of employees and the firm's reputation cannot be measured in money and so find no place in the statements.
• They are affected by personal judgement. The choice of depreciation method, the valuation of closing stock and the size of provisions all involve estimates, so two equally honest accountants can arrive at somewhat different profit figures for the same business.
• They can be window-dressed. Figures can sometimes be presented so as to show a more favourable position than the reality — for example, by timing transactions near the year-end.
• They give aggregate, not detailed, information. A single 'other expenses' or 'sundry debtors' figure hides the detail a decision-maker may actually need. …