What are the limitations of accounting ratios?

Answer 1

Limitations of Conventional financial statements are as follows;

1. Companies may use different methods of valuation, cost calculation and recognising profit.

2. The balance sheet does not reflect the true worth of the company.

3. Financial statements can only show partial information about the financial position of an enterprise, instead of the whole picture.

Answer 2

Inncome statements should help investors and creditors determine the past performance of the enterprise, predict future performance, and assess the capability of generating future cash flows. However, information of an income statement has several limitations: * The items that might be relevant but cannot be reliably measured are not reported (e.g. brand recognition and loyalty) * some numbers depend on accounting methods used (e.g. measuring inventory level) * some numbers depend on judgments and estimates (e.g. depreciaion expense depends on estimated useful life and salvage value).

Answer 3

Following are the limitations:

Financial accounting permits alternative treatmentsAccounting is based on concepts and it follows " generally accepted principles" but there exist more than one principle for the treatment of any one item. This permits alternative treatments with in the framework of generally accepted principles. For example, the closing stock of a business may be valued by anyone of the following methods: FIFO (First-in- First-out), LIFO (Last-in-First-out), Average Price, Standard Price etc., but the results are not comparable.

Financial accounting does not provide timely information

It is not a limitation when high powered software application like HiTech Financial Accenting are used to keep online and concurrent accounts where the balance sheet is made available almost instantaneously. However, manual accounting does have this shortcoming.

Financial accounting is designed to supply information in the form of statements (Balance Sheet and Profit and Loss Account) for a period normally one year. So the information is, at best, of historical interest and only 'post-mortem' analysis of the past can be conducted. The business requires timely information at frequent intervals to enable the management to plan and take corrective action. For example, if a business has budgeted that during the current year sales should be $ 12,00,000 then it requires information whether the sales in the first month of the year amounted to $ 10,00,000 or less or more?

Traditionally, financial accounting is not supposed to supply information at shorter interval less than one year. With the advent of computerized accounting now a software like HiTech Financial Accounting displays monthly profit and loss account and balance sheet to overcome this limitation. Financial accounting is influenced by personal judgments'Convention of objectivity' is respected in accounting but to record certain events estimates have to be made which requires personal judgment. It is very difficult to expect accuracy in future estimates and objectivity suffers. For example, in order to determine the amount of depreciation to be charged every year for the use of fixed asset it is required estimation and the income disclosed by accounting is not authoritative but 'approximation'.

Financial accounting ignores important non-monetary information.

Financial accounting does not consider those transactions of non- monetary in nature. For example, extent of competition faced by the business, technical innovations possessed by the business, loyalty and efficiency of the employees; changes in the value of money etc. are the important matters in which management of the business is highly interested but accounting is not tailored to take note of such matters. Thus any user of financial information is, naturally, deprived of vital information which is of non-monetary character. In modern times a good accounting software with MIS and CRM can be most useful to overcome this limitation partially.

Financial Accounting does not provide detailed analysis

The information supplied by the financial accounting is in reality aggregates of the financial transactions during the course of the year. Of course, it enables to study the overall results of the business the information is required regarding the cost, revenue and profit of each product but financial accounting does not provide such detailed information product- wise. For example, if business has earned a total profit of say, $ 5,00,000 during the accounting year and it sells three products namely petrol. diesel and mobile oil and wants to know profit earned by each product Financial accounting is not likely to help him unless he uses a computerized accounting system capable of handling such complex queries. Many reports in a computer accounting software like HiTech Financial Accounting which are explained with graphs and customized reports as per need of the business overcome this limitation.

Financial Accounting does not disclose the present value of the business

In financial accounting the position of the business as on a particular date is shown by a statement known as 'Balance Sheet'. In Balance Sheet the assets are shown on the basis of "Continuing Entity Concept. Thus it is presumed that business has relatively longer life and will continue to exist indefinitely, hence the asset values are 'going concern values.' The 'realized value' of each asset if sold to-day can't be known by studying the balance sheet.

Answer 4

Ratios place significant emphasis on short-term results. Ratios such as EPS and the ROCE are subject to accounting conventions that might deter businesses pursuing policies that are in their long term interest.

Answer 5

Financial statements are based on historical costs and as such the impact of price level changes is completely ignored. They are interim reports. The basic nature of financial statements is historic. These statements are neither complete nor exact. They reflect only monetary transactions of a business. The following limitations may be noted:
1. The financial position of a business concern is affected by several factors-economic, social and financial, but financial factors are being recorded in these financial statements. Economic and social factors are left out. Thus the financial position disclosed by these statements is not correct and accurate.
2. The profit revealed by the Profit and Loss Account and the financial position disclosed by the Balance Sheet cannot be exact. They are essentially interim reports.
3. Facts which have not been recorded in the financial books are not depicted in the financial statement. Only quantitative factors are taken into account. But qualitative factors such as reputation and prestige of the business with the public, the efficiency and loyalty of its employees, integrity of management etc. do not appear in the financial statement.
4. The rupee of 1995, as for example, does not mean the same as the rupee of 2010. The existing historical accounting is based on the assumption that the value of monetary unit, say rupee, remains constant and accordingly assets are recorded by the business at the price at which they are required and the liabilities are recorded at the amounts at which they are contracted for. But monetary unit is never stable under inflationary condition. This instability has resulted in a number of distortions in the financial statements and is the most serious limitation of historical accounting.
5. Many items are left to the personal judgment of the accountant. For example; provision of depreciation, stock valuation, bad debts provision etc. depend on the personal judgment of accountant.
6. On account of convention of conservation the income statement may not disclose true income of the business since probable losses are considered while probable incomes are ignored.
7. The fixed assets are shown at cost less depreciation on the basis of "going concern concept" (one of the accounting concept). But the value placed on the fixed assets may not be the same which may be realized on their sale.
8. The data contained in the financial statements are dumb; they do not speak themselves.
The human judgment is always involved in the interpretation of statement. It is the analyst or user who provides tongue to those data and make them to speak.

Answer 6

One disadvantage of financial accounting is the fact that it can be hard to understand. Most people need to take courses in accounting to understand the language.

Answer 7

they all are static.