A Key Note on Limitations of Financial Accounting

Learn about the meaning of financial accounting and the advantages and limitations of financial accounting

Financial accounting is one of the branches of accounting that deals with the recording, reporting, and analysis of monetary transactions of a company. It starts with the recognition of transactions through journal entries, then posting them into ledger accounts and balancing them through trial balance. After recording, the next step is to draft accounting reports, namely, profit and loss statements, balance sheets, and cash flow statements. Lastly, the analysis can be done through accounting ratios and trend percentages.

Advantages of Financial Accounting:
Preparation of accounting books

Financial accounting helps an entity to record business transactions on a day-to-day basis by preparing various books of accounts like journal books, sales books, purchase books, return outward books, etc. It ignores qualitative transactions as and when entered by an entity, like employee relations, the appointment of a manager or auditor, etc.

Drafting of accounting statements

Financial accounting enables the drafting of the accounting statements at the end of a financial year. It includes the profitability position, that is, the net gains or net losses, which can be determined from the profit or loss statement and the financial position, that is, the net worth from the balance sheet.  

Representing financial status

Accounting reports reflect the accurate financial status of an entity at the closing of an accounting year. These statements help investors understand the true picture of the company in which they want to invest. The internal management of an entity also gets ideas about its current financial status.

Analysis of financial reports

After finalising the accounting reports, the analysis can be done by applying various accounting ratios like solvency ratios, efficiency ratios, and profitability ratios. These ratios are applied in defined formulas where the figures are taken from the balance sheet or income statement. These ratios enable the entity to know its performance on various indicators like liquidity, profitability, and efficiency.

Used as evidence in litigation

The accounting books and reports can be served as proof in court proceedings for resolving disputes and conflicts relating to business transactions. This data can be submitted in the proceedings by the entity if it is questioned by any third party.

Comparative analysis:

Financial data can be prepared and documented for several accounting periods. It enables an entity to initiate a comparative analysis between past and present data, which results in figuring out the performance of the current year with respect to the past year.

Disadvantages/Limitations of Financial Accounting:
Recognition of quantitative transactions

Financial accounting recognises transactions of only monetary character. That means only money-related transactions should be considered. It ignores transactions of qualitative character, which can be market fluctuations, government principles, economic factors, political scenarios, etc.

Records data on historical cost

Financial accounting records the accounting information based on historical cost figures. This data is not appropriate for making future estimates relating to income, solvency, or for managerial decisions.

Classification of accounts and expenses

Financial accounting fails to bifurcate the expenses into direct or indirect nature or fixed or variable nature. As a result, it cannot be used for determining the cost of a product. It classifies the accounts in terms of personal, real, and nominal, which can’t be utilised by production companies.

Price fixation:

The accounting data doesn’t provide the data relating to material, labour, or overhead costs, and it also ignores the market changes. So, the manufacturer can’t be able to allocate a price to the product produced based on this data. 

No clear idea of operating efficiency

Financial data record the cost based on past information and disregard the variations due to inflation or trade depression. This leads to inaccurate amounts of profits, which don’t provide a true operating efficiency of an entity in the current accounting year.

Falsification of accounting reports

Accounting reports can be easily manipulated by accountants by increasing expenses, not recording all the charges or creating misstatements in assets or liabilities on the balance sheet. Manipulation can also be done by creating bogus or illegal invoices in the names of fictitious parties.

Conclusion

Financial accounting is the type of accounting that starts with the recording of the financial transactions in the book and ends with the finalisation of the income statement, balance sheet, and cash flow statement. It enables the drafting of books of accounts, preparation and analysis of accounting reports, making comparative analyses, etc. However, it has a few limitations: it can be easily manipulated, it is hard to fix the price of a product, it gives unclear operating efficiency, etc