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Limitations of published financial statements - Coggle Diagram
Limitations of published financial statements
Historical cost basis
Historical cost is the most widely used basis
Fails to account for the change in price levels of assets over a period of time
Reduces the relevance of accounting information by presenting assets at amounts that may be less than their realisable value
Fails to account for the oppotunity cost of using those assets
The published financial statements neither represent the value for which non-current assets can be sold nor the amount which will be required to replace those assets
Creative accounting or earnings management
Creative accounting is the presentation of an entity's financial statements in the best possible or most flattering way
It is a deliberate manipulation of financial statements which is gearing towards achieving predetermined results
Occurs due to inherent weaknesses in the accounting system, accounting choices, accounting judgement and accounting transactions
Largely outlawed by
IAS 37: aims to ensure proper accounting and disclosure of provisions, contingent liabilities and contingent assets
IAS 27: entrees consolidation of financial statements of subsidiaries with that of parent entity
IFRS 16: aims to ensure proper reporting of leased assets
A rigorous audit process will almost invariably identify areas where management may improve their controls or processes, further adding value to the company by enhancing the quality of its business processes
An audit underpins the trust and obligation of stewardship between those who manage a company and those who own it or otherwise have a need for a clear and objective view
Intra-group transactions
Occurs when one unit of an entity is involved in a transaction with another unit of the same entity
Common for entities to carry on activities with or through subsidiaries and associates or occasionally to engage in transactions with directors or their families
There is a high possibility that such transactions have not been agreed at arms length prices or in the best interests of the entity itself
Such transactions might have been entered into in order to evade taxes
IAS 24 (related party disclosures) has been introduced to ensure adequate disclosure of all such transactions
Ignoring non-financial matters
There are certain factors which have a bearing on the financial position and operating results of the business but they do not become part of the financial statements because they cannot be measured in monetary terms
Such factors may include the reputation of the management, creditworthiness of the entity, co-operation and skills of the employees, environmental attentiveness or how well the business works with the local community
A business reporting excellent financial results might be weak in these areas
Not forward looking
A prospective investor will be interested in knowing those developments that will affect the future prospects on an entity
It becomes very difficult for an investor to arrive at any decision by looking at the financial statements prepared on the basis of histocial information
The strategic report can provide some insights into the future prospects of the business
Seasonality of trading
Many entities whose trade is seasonal in nature tend to report their results when the company is at its most solvent
This may distort results and particularly SOFP items
Not always comparable
Different entities use different accounting practices and accounting policies depending on their size, nature of business and conventions
Can be difficult to compare two different entities on the basis of their published financial statements
Only covers a specific time period
The position may be different he day before to the day after
The timing of various transactions can be manipulated to influence the appearance of the financial statements