Importance And Limitations - Analysis and interpretation of Financial statements, Cost Accounting | Cost Accounting - B Com PDF Download

Importance of Financial Statements

The most important objective of financial statements is to present information for the use of different categories of persons as mentioned below:

1. The Management: The scope of modern business and the multiplicity of factors affecting the business operations call for an increasingly scientific and analytical approach in the management of such businesses. This is possible only when up-to-date, accurate and systematic financial records are available to the management team. Financial accounts and statements are of a very great help in understanding the progress, position and prospects of the business vis-a-vis the industry. Financial statements, by helping the management to be acquainted with the causes of the business results, enable them to formulate appropriate policies and courses of action for the future.

Not only such financial statements - which are generally made public, but unpublished subsidiary accounts and statements also play an important role in policy-making and planning. Such subsidiary records provide more detailed, frank and revealing information than the financial statements. A comparative analysis of financial statements should enable management to see the trends in the progress and position of the enterprise and make suitable modifications in policies to avert unfavourable situations. It is through the release of such financial statements that the managements communicate their performance to various parties and justify their existence, and activities.

2. The Public: Business is a social entity. Various groups of the society, though not directly connected with business, are interested in the progress, position and prospects of a business enterprise. These groups are financial analysts, lawyers, trade associations, labour unions, financial press, students and teachers, etc. It is only through the published financial statements that these people can analyse, judge and comment upon the business enterprise. It should be noted that these financial statements are available to the public in case of joint stock companies. In case of proprietorships or partnerships, and other form of ownership no such statements are published or made available to the public.

3. The Shareholders and the Lenders: The financial statements serve as a useful guide for the shareholders and probable shareholders, the suppliers, and the lenders and probable lenders of a company. It is through a critical examination of the financial statements that these groups can come to know about the efficiency and effectiveness of the management and position, progress and prospects of the company. For this purpose, it is necessary that the financial statements should contain accurate, complete and systematic facts and figures so that these people can get a full and accurate idea regarding the present position and future of the company.

Since published financial statements are the main bases available to such group of people to judge the affairs of the company, it has been found that some managements have been resorting to ‘window dressing’ in the presentation of these statements, to project a “better” than “what is” the position of the company.

4. The Labour and Trade Unions: In India, workers are entitled to bonus under the Payment of Bonus Act, depending upon the size of the profit as disclosed by audited Statement of Profit & Loss. Thus, Statement of Profit & Loss becomes greatly important to the workers. In wage negotiations also, the size of profits and the profitability achieved are greatly relevant.

5. The Country and Economy: Economic progress of country is to a great extent, associated with the rise and growth of joint stock companies. But unscrupulous acts affect the industry and people in the region in which the company operates, to a significant extent. Such fraudulent activities impair the confidence of the general public in joint stock companies as forerunner of economic progress, and thus retard economic growth of the country. The solution lies in raising the level of business andfinancial morality of the promoters and managements and in imparting knowledge about financial statements to the public so that they can examine and assess the real worth of the company and avoid being cheated by unscrupulous persons.

The law endeavours to raise the level of business morality by compelling the companies to draw up financial statements in a clear systematic form and disclose certain minimum information. Such provisions increase the confidence of the public in joint stock companies, thus enabling faster economic progress of the country. This has all the more greater significance in under developed and developing countries. In such countries, capital is not only scarce but also shy. Malpractices on the part of promoters and managements, only help to increase the scarcity and shyness of capital, thus blocking economic progress. Published financial statements provide an opportunity for the critical assessment of the worth of company and thus protect innocent public, increase their confidence, and help faster economic progress.

Financial statements are also valuable for the various regulatory authorities. They can judge whether the regulations are being followed in word and spirit, and also whether the regulations are producing the desired effect or not, by evaluating the financial statements submitted by the companies.

Limitations of Financial Statements

Financial statements are the result of the accounting process which begins with recording of transactions. Accounting process involves recording, classifying and summarising business transactions. Financial statements are the result of the third process viz. summarising. The financial statements are based on certain accounting concepts and conventions which can not be said to be foolproof.

The following are the limitations of the financial statements:

1. Financial statements are essentially interim reports and therefore, cannot be final because the final gain or loss can be computed only at the termination of the business. Financial statements only reflect the progress and position of the business at frequent intervals during its life. The decision regarding the period of these statements is a matter of personal judgement and it gives rise to the problem of allocating expenditures over various periods. Again the existence of contingent liabilities, deferred revenue expenditure make them more imprecise.
2. Financial statements though expressed in exact monetary terms, are not absolutely final and accurate. As the balance sheet is prepared on the basis of a going concern asset valuation represents neither the realisable value nor replacement costs. Further, they depend on the judgement of the management in respect of various accounting policies.
3. The values ascribed to the assets presented in the statements depend upon the standards of the persons dealing with them. For instance, the method of depreciation, mode of amortisation of fixed assets, treatment of deferred revenue expenditure, all depend on the personal judgement of the accountant. The soundness of such judgement will necessarily depend upon his competence and integrity.
4. Financial statements take into consideration only the financial factors. They fail to bring out the significance of non-financial factors which may have considerable bearing on the operating results and financial conditions of an enterprise. For example, public image of the enterprise, the calibre of its management, efficiency and loyalty of its workers etc.
5. It is not always possible to discover false figures in financial statements. Unscrupulous managements generally resort to ‘window dressing’ in the preparation of such statements.
6. Financial statements are prepared primarily for shareholders. Other interested parties have to generally make many adjustments before they use them profitably.
7. Quite often, financial statements do not disclose current worth of the business. Only historical facts are presented and the true current worth is not reflected.
8. Owing to the fact that financial statements are compiled, on the basis of historical costs, while there is a marked decline in the value of the monetary unit and resultant rise in prices, the balance sheet losses its function as an index on current economic realities. Again the financial statements contain both historical and current costs items, hence figures are distorted. It is seen that holding gains and operating gains are added together, no differentiation is made between these two.