Question

1.4 Explain Three limitations of financial statements, and Explain four characteristics of good financial statements?

Answer 1

Limitation of Financial Statements

1. Inflation: .

Assets and liabilities are not being adjusted with inflation. Eg If the inflation rate is quite high, the amounts associated with assets and liabilities in the balance sheet will appear very low, because they are not being adjusted for inflation.

2. Depend on historical costs. Transactions are initially recorded at their cost. The value of assets and liabilities may change over time. Eg: marketable securities, are altered to match changes in their market values, but other items, such as fixed assets, do not change.

So the balance sheet could be misleading if a large part of the amount presented is based on historical costs

3. Subject to fraud. The management team of a company may deliberately change the results presented. This situation may arise when there is undue pressure to report excellent results.Eg: There is a a bonus plan if the reported sales level increases. So management team may change the results

Good Characteristics of Financial Statements

a. Rules of Accounting

Companies follow Generally Accepted Accounting Principles (GAAP). It is intended to provide a set of common concepts . Other financial industry professionals can evaluate company's business practices. If companies follow GAAP.

b. Understandable and Reliable

People with different backgrounds or levels of understanding read financial statements. It is advised to make the language of these statements as simple as possible. Reliability is one of good characteristics of good financial statements. That means the statements should be free from error.

c. Relevant and Material

If there is no material and relevant facts it is difficult to evaluate a company's strength from a financial statement. Relevancy is controlled by information about prior expectations and the ability to predict future trends

Materiality refers to information that will directly affect a decision.

d. Comparable and Consistent

It should be similar and comparable . it is to ensure a consistent evaluation method of companies working in a particular industry.

All reporting periods reflect consistent data.