written by khatabook | November 23, 2022

Limitations and Drawbacks of Financial Accounting Explained

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Table of Content


Financial accounting is the systematic process of documenting, categorising, summarising, analysing, and reporting a company's business transactions. The main goal of financial accounting is to disclose a company's profits and losses. It allows for an accurate and fair evaluation, and thus, it protects the interests of all its stakeholders.

The creation of financial statements, such as a company's balance sheet, income statement, and cash flow statement, is known as financial accounting. Financial accounting entails recording a company's financial transactions, including sales, purchases, receivables and payables. Accountants produce income statements, cash flow statements, balance sheets, and shareholder's equity statements in accordance with accepted practices and operating efficiency over a predetermined time.

The term "limitation of financial accounting" refers to conditions that could make it difficult for any user of the financial statements—including shareholders, executives, directors, and other interested parties in the company—to make a choice based solely on those figures.

Did you know? To become a financial accountant in India, you must hold a bachelor's degree in accounting or finance. You can also be required to complete all three levels of the Cost Management Accountant (CMA) course offered by the Institute of Cost and Management Accountants of India (ICMAI).

What is Financial Accounting?

The information generated from financial accounting is primarily intended for use by people outside of the company, such as creditors, investors, owners, governmental organisations, and the general public.

Most businesses provide their financial accounting information in a collection of all-purpose documents called annual reports. Most of the information required by outside users is contained in these statements. The primary focus of financial accounting is the yearly creation of a summarised Profit and Loss Account and Balance Sheet that is valuable to the company's owners, investors, creditors, and government. 

Financial accounting is a well-adopted system, but it has many flaws. It is essential to understand the drawbacks of this system of accounting:

Also read: What is an Accounting Transaction? Example & Types of Accounting Transaction

Limitations of Financial Accounting

Before placing an undue amount of reliance on financial statements, a user should be aware of their limits. If one were aware of these characteristics, one might decide to spend less money in a company or take additional steps to look into them. Following are some of the limitations of financial accounting-

  1. Supplies Limited Information: 

Financial accounting only records information about financial activities, not specific individuals, departments, products, etc. 

  1. Controlling Cost Is Not Possible: 

Controlling costs is not feasible because it is known only at the end of the fiscal year or after a certain amount of time whether an expense will be spent or not; therefore, neither the expense account nor the cost can be controlled. In other words, it is impossible to control a particular cost even if it is discovered to be higher.

  1. Difficulty in Price Setting: 

Only when all costs associated with a product have been incurred can the overall cost of a product be determined. To estimate the selling price, with financial accounting, it is only possible to know the product's price in advance. Financial accounting cannot account for all of these issues since total cost, which includes fixed cost, variable cost, direct cost, and indirect cost of a product, varies on numerous variables and this emerges as a significant limitation of financial accounting.

  1. Recording Actual Cost: 

Only the Real Cost, or Historical Cost, of the Assets, is recorded in Financial Accounting. Asset values are subject to vary, but only their purchase costs are recorded. In other words, price changes or changes in the price level are not captured by financial accounting, thereby presenting inaccurate information.

  1. The incomplete revelation of the facts: 

In financial accounting, only activities and transactions that can be demonstrated or described in monetary terms are recorded.  Financial accounting cannot reveal many other aspects of a corporation that are non-financial and non-monetary, such as effective management, product demand, positive industry relationships, and favourable working conditions. 

  1. Personal judgement impacts financial figures: 

The accountant's subjective judgement impacts numerous financial statement events. The accountant determines the depreciation calculation method, the provision rate for questionable debts, and the stock valuation methodology. Financial statements, therefore, need to present a true and accurate picture of the business. There is also a possibility of manipulation of accounts, and financial reports can also be obliged to be audited.

  1. No proper division of costs: 

In financial accounting, costs are not segregated into direct and indirect costs, constant and variable costs, and controllable and uncontrollable costs. These divisions serve a purpose all on their own. Also, it needs to provide more information for the comparison of prices.

  1. It does not offer a proper system for performance evaluation: 

In financial accounting, there is no system for creating norms and standards to evaluate how effectively a company uses its resources, including labour, materials, and other costs, by contrasting its actual performance with what it ought to have achieved in a given amount of time.

Also read: Accounting Period - Definition, Types & How Does an Accounting Period Work?

  1. Technical Subject: 

Because financial accounting is a technical subject, the average person cannot possibly understand it. A thorough understanding of accounting principles and practices makes it possible to analyse financial data and make financial decisions. Naturally, it is of little use to someone unfamiliar with the subject.

  1. Accounting Principles Cannot Be Evaluated: 

Accounting principles cannot be evaluated or assessed, which means that the actual performance cannot be compared to the planned amount. In other words, the budget and the result cannot be compared.   

  1. Historic in nature: 

Financial accounting is mainly historic because it keeps track of every transaction that occurs during a specific period.  In other words, even though all financial decisions are made based on preliminary financial data, the present financial knowledge only pertains to the past and not the future. 

  1. Material Losses: 

Because there is no material management system under financial accounting, there is no protection against material losses brought on by material waste, theft, degradation, and obsolescence.

  1. Controlling labour costs: 

Since employees are paid according to the number of hours they put in, there is no way to compare the time clock with the time booked in financial accounting. As a result, costs brought on by idleness, task avoidance, and loitering are uncontrollable. Additionally, job-specific labour time needs to be documented. As a result, there is no way to assess the effective use of labour time, and no incentive programs based on performance can be implemented.  

  1. No data for wastages: 

The financial accounting data does not consider any waste, whether material, personal or machine; hence nothing can be done to eliminate this waste. 

  1. Business Reports Are Financial Reports: 

A period's P/L is displayed in a profit and loss statement. The balance sheet's depiction of the financial condition is appropriate when it was made, but it does not anticipate any future changes. Asset and liabilities values must be adjusted in accordance with market inflation. Because accounting does not account for inflation, the results must accurately represent the firm's actual status.

  1. Financial Accounts Only Address the Business Concern's Overall Profitability: 

A business concern's financial statements are set up to show the overall profit or loss of that business concern over a given period. Financial records do not cover the firm's profitability from a product, job, process, or departmental standpoint. As a result, the business's unprofitable activities need to be disclosed, making it impossible to take the required actions to turn them profitable or stop them altogether. 

Even though financial accounting is very popular, the information that can be supplied to the management by financial accounting needs to be more constrained and insufficient. Despite new accounting devices, improved techniques, and detailed subsidiary records over the past 30 years, businesspeople have been eager to adopt additional accounting practices known as cost accounting.

Also read: Perpetual Inventory System - Methods, Advantages and Disadvantages

Conclusion:

According to established principles, accounting standards, and legal requirements, financial accounting offers an accurate and fair assessment of the overall results of transactions and events recorded in the books of accounts in terms of money. The income, position, and funds flow statements that make up the financial statements show how the corporate entity has performed and where it stands.

Such reporting is based on an analysis of historical occurrences after the fact. The information in these assertions may be of some interest to management, but it acts as a  limitation of financial accounting, as it has a practical value from the perspective of planning, control, and decision-making. Financial accounting is not a flawless science, and it has evolved and will continue to grow in the future, but its limitations are considerable for now.

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FAQs

Q: What is a Balance Sheet?

Ans:

A balance sheet is a type of financial statement that depicts the connection between a company's assets, liabilities, and shareholder's equity at a certain period. It shows the financial position of a company at the specified time.

Q: What Is the main goal of financial accounting?

Ans:

The main goal of financial accounting is to inform creditors and investors about the company's economic activity so that they can make informed investment decisions.

Q: What Is financial accounting?

Ans:

To provide financial reports for the management of the company, investors, lenders, suppliers, tax authorities, and other stakeholders, such as the balance sheet and income statement, financial accounting collects and summarises financial data.

Q: What is the price fixation of products?

Ans:

Price fixing is an agreement between participants in a market who are on the same side to buy or sell a good, service, or commodity only at a specific price or to keep the market's conditions so that the price is supported at a particular level by managing supply and demand.

Q: What is the proper division of expenses?

Ans:

Proper division of expenses is when expenses are classified into direct and indirect, fixed and variable, controllable and uncontrollable. These classifications have utilities of their own.

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.