Q.Explain the importance of financial statements and state their limitations.

Financial statements are read by many different users, each for a purpose of their own, but they are not a perfect mirror of the business.

Recognising these limitations is exactly why the raw statements must be analysed before they yield their full meaning.

Importance of financial statements — they serve many users:

• Owners/shareholders — to see whether their investment earns an adequate return and the business is run efficiently.
• Management — as the basis for planning, control and decision-making.
• Lenders and creditors — to judge the firm's ability to repay loans and settle bills on time.
• Prospective investors — to assess earning capacity and financial strength before investing.
• Employees and trade unions — to judge job security and support wage/bonus negotiations.
• Government and tax authorities — as the basis for tax assessment and regulation.
• Researchers and the public — as a source of information about an industry and the economy.

Limitations of financial statements:

• Historical — they report the past and do not, by themselves, predict the future.
• Ignore price-level (inflation) changes — assets at historical cost can understate current values when prices rise.
• Omit non-monetary factors — management quality, customer loyalty, employee skill and reputation cannot be measured in money and so do not appear.
• Affected by personal judgement — depreciation method, stock valuation and provisions all involve estimates, so honest accountants may reach somewhat different profits.
• Can be window-dressed — figures can be presented more favourably than the reality.
• Give aggregate information — a single 'other expenses' or 'debtors' figure hides needed detail.
• Interim in nature — true profit is known only when a business finally closes; annual statements are an approximate periodic measure.

Students frequently give only the limitations and skip the importance (or vice versa) when the question clearly asks for both. On limitations, the two most-forgotten points are the effect of price-level (inflation) changes and the influence of personal judgement/estimates — mentioning only 'they are historical' is an incomplete answer.