Limitations of Financial Accounting

Introduction

Financial accounting is the branch of accounting that deals with the summary, analysis, and reporting of a company’s financial activities. This involves the preparation of financial statements. People who are interested in obtaining such information for decision-making purposes include stockholders, suppliers, banks, employees, regulatory agencies, business owners, and other stakeholders.

Components of Financial Accounting 

The following are the major information contents of different components of financial statements:

Balance Sheet- The value of economic resources held by a business is depicted on the balance sheet. It also gives data on a company’s liquidity and solvency, which may be used to forecast the company’s capacity to satisfy its financial obligations when they become due.

Statement of Profit and Loss- The profit and loss statement shows the results of an enterprise’s activities for a certain accounting period, i.e., it represents the company’s performance, particularly its profitability.

Cash Flow Statement- Cash Flow Statements reflect how a company generates cash and how it spends it throughout the course of a financial year and helps in analysing the company’s investing, financing, and operating operations.

Notes and other statements- Notes and other statements provide additional information to explain different items of a financial statement. They may, for example, include extra information about the items in the balance sheet and profit and loss statement that is relevant to the needs of users. Other disclosures include accounting policy disclosures, segment reporting, related party disclosures, earnings per share, and so on.

Limitations of Financial Accounting

1.  Historical in Nature -The nature of financial accounting is mostly historical. It keeps track of previously completed transactions and events. As a result, as part of the stewardship function of management, financial statements are created and presented at the closing of the accounting period. Although the data is historically significant, it does not offer management with current data for analysing operational efficiency.
2. Overall Performance: Financial accounting reveals and reflects the profit or loss of a company as a whole. It fails to offer information on expenses and profit of various sub-divisions of the organization since it does not classify accounts on the basis of departments or segments, products, processes, and sales territories.
3.  No Objective Classification: Personal and impersonal accounts are the two primary types of accounts in financial accounting. Such a subjective basic classification is of limited help to management in determining costs by products, jobs, and processes.
4.  Distinction between Direct and Indirect Expenses: Expenses are not divided into direct and indirect, fixed and variable, controllable and uncontrollable, and assigned to departments, jobs, or products in financial accounting. As a result, for the objectives of cost control and cost reduction, controllable and uncontrollable expenditures cannot be differentiated.
5.  Material Losses: There is no protection against material losses due to wastage, pilferage, depreciation, and obsolescence of materials since there is no material management system functioning under financial accounting.
6.  Labour Cost Control: Because workers are paid on the basis of hours worked, there is no way to compare the time taken with the time allowed in financial accounting. As a result, losses due to idle time, work evasion, and loitering are uncontrollable. Furthermore, no job-specific labour time is documented. As a result, there is no way to assess the effective use of labour time, and no incentive schemes based on results can be implemented.
7.  Idle Facilities: – Losses owing to idle plant and equipment are not recorded in financial accounting.
8. No Cost Comparison: – Financial accounting does not provide data that may be used to compare costs between periods, businesses, jobs, divisions, or procedures. As a result, conclusions about the profitability of various items, positions, departments, procedures, or sales areas are impossible to reach.
9.  Distortion of Trading Results: The value of closing inventory is calculated in financial accounting for the income statement and balance sheet. Costs and revenues cannot be effectively matched if the values are not expressed precisely. As a result, trading outcomes are skewed due to the wide range of values.
10.  Lack of Data for Decision-Making: -One of the most essential roles of management in every organization is decision-making. Financial accounting, on the other hand, fails to provide the necessary data for decisions such as the introduction of a product line, the discontinuation of production of a product or a department, whether to produce or purchase, equipment replacement, and appropriate product mix, and so on.

Conclusion

While there are numerous advantages to adopting financial accounting in a business, it does exclude some aspects. These are the financial accounting restrictions that may induce a change in the user’s perspective or choice. Taking into consideration this financial accounting and non-financial elements affects the user’s decision-making process at the same time. Significantly, the financial accounting system does not give data or support to guide decisions on some matters. Because of these flaws in the financial accounting system, cost accounting was developed.