0452 · 6.5Limitations of accounting statements

How financial statements are limited

0:00A repair shop can present carefully prepared figures and still face serious problems next year. Its best technician might leave, or nearby roadworks might prevent customers from reaching it. This video covers limitations of accounting statements due to historic cost, application of accounting policies and non-financial aspects. Each limitation changes how far the figures can be relied on when judging a business. Financial statements are summaries that show a business's profit or loss for a period and what it owns and owes at a date.

0:27They provide useful evidence about financial performance and position. However, their figures depend on recorded amounts and decisions about measurement. They also leave out important information that cannot be reliably expressed in money. Revenue is the income a business earns from its main activity, such as selling goods or providing services. At Nadia's Repairs, customers pay for repair services. Expenses are the costs used up in running the business and earning revenue during a period.

0:51The wages she pays her technicians and the electricity bills are expenses. Profit for the year is the amount by which revenue exceeds expenses over one financial year. A lower recorded expense therefore produces a higher reported result, if everything else stays unchanged. This relationship matters when an expense includes an estimate. Financial statements can be correctly prepared even though some amounts involve judgement.

Historic cost and inflation

1:14Assets are resources owned or controlled by a business that bring future benefit. Nadia's Repairs owns land and repair equipment. Historic cost means assets are recorded at the price paid when they were acquired. The original purchase amount provides evidence that can usually be checked against a document. However, a past purchase price does not necessarily represent a resource's value today. Suppose Nadia's Repairs bought land for forty thousand dollars and continues to report it at historic cost.

1:40Its estimated current value is now sixty-five thousand dollars. To measure the difference, subtract forty thousand dollars from sixty-five thousand dollars. The difference is twenty-five thousand dollars, so the land is recorded at that amount below its estimated current value. Inflation is a general rise in prices over time. During inflation, buying an equivalent resource may require much more money than the original purchase required. Historic cost can therefore leave recorded amounts out of date.

2:07Comparing figures across different years becomes harder because the same amount of money buys less in the later year. The effect can also reach expenses through depreciation. Non-current assets are assets held for continuing use in the business rather than for resale. Nadia's land and repair equipment are non-current assets. Depreciation is the loss in value of a non-current asset over its useful life. It is an estimate that is charged as an expense in each year of use.

2:32A depreciation charge based on an old purchase price may be lower than a charge based on today's replacement price. A figure recorded too high is overstated, and one recorded too low is understated. The reported profit for the year can therefore be overstated relative to current prices. The calculation is still correct under the historic cost basis. However, the reported result may give an overly favourable impression of the business's ability to replace equipment.

Accounting policies and estimates

2:57Accounting policies are the principles, bases and methods used to prepare and present financial statements. Their application includes choices such as the depreciation method and estimates such as equipment's useful life. Useful life is the estimated period for which an asset will be used by the business. Different reasonable decisions can produce different figures from the same underlying situation. Consider equipment at Nadia's Repairs that cost twelve thousand dollars. Straight-line depreciation allocates an equal charge to each full year of use.

3:25Residual value is the estimated amount recoverable when the useful life ends. Under the straight-line method, Nadia estimates a useful life of five years and a residual value of zero dollars. Twelve thousand dollars minus zero dollars leaves twelve thousand dollars to allocate. Dividing twelve thousand dollars by five years gives an annual charge of two thousand four hundred dollars. Accumulated depreciation is the running total of depreciation charged on an asset since it was acquired.

3:49After the first year, it equals that single charge. Carrying amount is the asset's cost less its accumulated depreciation. Under the straight-line method, twelve thousand dollars minus two thousand four hundred dollars gives nine thousand six hundred dollars at the year end. Reducing balance depreciation applies a fixed percentage to the opening carrying amount. Nothing has been charged before the first year, so that opening figure is the full cost of twelve thousand dollars.

4:13Nadia could instead choose a reducing balance rate of twenty-five per cent. Twenty-five per cent of twelve thousand dollars gives a first-year charge of three thousand dollars. Deducting that charge from twelve thousand dollars leaves a carrying amount of nine thousand dollars. So the same equipment shows a different asset figure under each policy. Suppose Nadia's profit before depreciation is eighteen thousand five hundred dollars under either policy. Under straight-line depreciation, eighteen thousand five hundred dollars minus two thousand four hundred dollars gives sixteen thousand one hundred dollars.

4:43The reducing balance policy gives eighteen thousand five hundred dollars minus three thousand dollars, which is fifteen thousand five hundred dollars. Sixteen thousand one hundred dollars minus fifteen thousand five hundred dollars leaves a difference of six hundred dollars. Both calculations concern the same equipment, the same year and the same repair work. The six hundred dollar gap in profit comes only from the method and estimates chosen. The carrying amount at the year end also differs by that amount, so both profit and assets change.

5:13Before comparing two businesses or two years, check whether their methods and estimates provide a comparable basis. Trade receivables are amounts owed by credit customers who have not yet paid for goods or services. Some of Nadia's business customers pay a month after their repairs. An allowance for irrecoverable debts is an estimate of trade receivables that may not be paid. A higher allowance means a larger charge against profit.

5:35Both the profit for the year and the trade receivables reported after the allowance are then lower. Inventory means goods held for resale, such as the spare parts Nadia sells to customers. Cost of sales is the cost of inventory sold during a period. Valuing the inventory left at the year end involves judgement about its cost and condition. A lower year-end valuation raises cost of sales, so the profit for the year and the inventory figure are both lower.

5:59Depreciation, the allowance and inventory valuation all show why some figures are subjective. They depend partly on informed judgement, so two careful accountants can report different amounts. Accounting policies must be appropriate and applied consistently from year to year. Even so, two businesses using different policies may report figures that are not directly comparable.

Non-financial aspects

6:19Money measurement means only items that can be expressed in monetary terms are recorded. Non-financial aspects are features of a business that cannot be reliably measured in money, so money measurement leaves them out of the statements. In a later year, Nadia's Repairs and another repair shop each report a profit for the year of thirty thousand dollars. Nadia has experienced technicians and premises that customers can reach easily. The other repair shop has staff shortages and restricted customer access, so its future prospects may be weaker.

6:46The skill of the workforce affects how accurately and quickly repairs are completed. High morale can help a business retain employees and maintain service quality. Wage payments appear in the financial statements, but those payments do not measure employees' skill or enthusiasm. Similar wage costs can therefore support very different standards of service. The location of the business can influence customer numbers, convenience and access to suppliers. Rent records a monetary cost, but it does not fully describe those advantages.

7:13Customer loyalty and reputation can also affect whether people return for further repairs. Their effects may influence future revenue without appearing as separate recorded amounts today. The economic climate means general conditions such as employment, prices and whether customers' incomes are rising or falling. Customers may reduce spending during difficult economic conditions, even after a successful year. Environmental and social impact can also influence customers' decisions and the business's reputation.

7:41Recorded spending captures some financial effects, but it does not fully measure these wider consequences. Because of money measurement, financial statements give only a partial picture of workforce quality, location and economic conditions. These features still affect future profit, even without a reliable monetary amount. Statements also report past activity and the position at one date. A good past result therefore gives no guarantee of future results.

Exam answers and recap

8:05A strong examination answer names each limitation and then explains its effect. For historic cost, connect the original amount to prices that may have changed. With accounting policies, identify how a method or estimate changes reported expenses or asset amounts. For non-financial aspects, name a specific feature and explain its effect on the business's prospects. Paper One contains forty multiple-choice questions, while Paper Two contains five compulsory structured questions. A multiple-choice question may ask you to identify a limitation from a situation.

8:36Identify means name or select, while explain means give reasons, why and how, supported by evidence. In a structured answer, connect each reason to the business described. A model answer for Nadia's Repairs uses all three limitations. Historic cost records original amounts, so recorded values may be out of date after price changes. Depreciation methods and estimates affect reported figures, so comparisons may reflect different measurement decisions. Workforce skill and customer access influence future activity, but the statements do not fully measure these features.

9:08Financial statements remain useful, but each limitation has a particular cause. Historic cost can report past prices when current prices have changed. Application of accounting policies introduces choices and estimates that affect reported figures and comparability. Non-financial aspects influence future prospects without being fully recorded in money. Because the statements describe the past, decisions also require information beyond them.