7 Major Limitations of Financial Reporting

The following points highlight the seven major limitations of financial reporting.

1. The objectives of financial reporting are affected not only by the environment in which financial reporting takes place but also by the characteristics and limitations of the kind of information that financial reporting, and particularly financial statements, can provide.

The information is to a significant extent financial information based on approximate measures of the financial effects on individual business enterprise of transactions and events that have already happened; it cannot be provided or used without incurring a cost.

2. The information provided by financial reporting is primarily financial in nature—it is generally quantified and expressed in units of money. Information that is to be formally incorporated in financial statements must be quantifiable in units of money.

Other information can be disclosed in financial statements (including notes) or by other means, but financial statements involve adding, subtracting, multiplying, dividing numbers depicting economic things and events and require a common denominator.

The numbers are usually exchange prices or amounts derived from exchange prices. Quantified nonfinancial information (such as number of employees or units of product produced or sold) and non-quantified information (such as descriptions of operations or explanations of policies) that are reported normally relate to or underlie the financial information. Financial information is often limited by the need to measure in units of money or by constraints inherent in procedures, such as verification, that are commonly used to enhance the reliability or objectivity of the information.

3. The information provided by financial reporting pertains to individual business enterprises, which may comprise two or more affiliated entities, rather than to industries or an economy as a whole or to members of society as consumers.

Financial reporting may provide information about industries and economies in which an enterprise operates but usually only to the extent the information is relevant to understanding the enterprise. It does not attempt to measure the degree to which the consumption of wealth satisfies consumer wants.

Since business enterprises are producers and distributors of scarce resources, financial reporting bears on the allocation of economic resources to producing and distributing activities and focuses on the creation of, use of, and rights to wealth and the sharing of risks associated with wealth.

4. The information provided by financial reporting often results from approximate, rather than exact, measures. The measures commonly involve numerous estimates, classifications, summarizations, judgements, and allocations. The outcome of economic activity in a dynamic economy is uncertain and results from combinations of many factors.

Thus, despite the aura of precision that may seem to surround financial reporting in general and financial statements in particular, with few exceptions, the measures are approximations, which may be based on rules and conventions rather than exact amounts.

5. The information provided by financial reporting largely reflects the financial effects of transactions and events that have already happened. Management may communicate information about its plans or projections, but financial statements and most other financial reporting are historical.

For example, the acquisition price of land, the current market price of a marketable equity security, and the current replacement price of an inventory are all historical data—no future prices are involved.

Estimates resting on expectations of the future are often needed in financial reporting, but their major use, especially of those formally incorporated in financial statements is to measure financial effects of past transactions or events or the present status of an asset or liability.

For example, if depreciable assets are accounted for at cost, estimates of useful lives are needed to determine current depreciation and the current un-depreciated cost of the asset.

Even the discounted amount of future cash payments required by a long-term debt contract is, as the name implies, a “present value” of the liability. The information is largely historical, but those who, use it may try to predict the future or may use the information to confirm or reject their previous predictions.

To provide information about the past as an aid in assessing the future is not to imply that the future can be predicted merely by extrapolating past trends or relationships. Users of the information need to assess the possible or probable impact of factors that may cause change and form their own expectations about the future and its relation to the past.

6. Financial reporting is but one source of information needed by those who make economic decisions about business enterprises. Business enterprises and those who have economic interests in them are affected by numerous factors that interact with each other in complex ways.

Those who use financial information for business and economic decisions need to combine information provided by financial reporting with pertinent information from other sources, for example, information about general economic conditions or expectations, political events and political climate or industry outlook.

7. The information provided by financial reporting involves a cost to provide and use, and generally the benefits of information provided should be expected to at least equal the cost involved. The cost includes not only the resources directly expended to provide the information but may also include adverse effects on an enterprise or its shareholders from disclosing it.

For example, comments about a pending lawsuit may jeopardize a successful defence, or comment about future plans may jeopardize a competitive advantage.

The collective time needed to understand and use information is also a cost. Sometimes, a disparity between costs and benefits is obvious. However, the benefits from financial information are usually difficult or impossible to measure objectively, and the costs often are; different persons will honestly disagree about whether the benefits of the information justify its costs.