4.19: Limitations of Financial Statements
Learning Outcome
- Discuss the limitations of financial statements
One of the drawbacks of financial accounting from a manager’s perspective is that the information represents past performance. This is useful in giving out bonuses, and of course in reporting to the public, but proactive internal decisions have to come from the most current data available, and have to be tailored to the decision being considered. That is the purview of the managerial accountant. For instance, if management is considering replacing a machine to improve production, a managerial accountant could produce an ad hoc report comparing the cost of the new machine with lower maintenance costs and higher production yields against keeping the old machine and putting more dollars into maintaining and improving it, and maybe even options to lease a machine or outsource that particular process. There are other limitations as well.
Historical Cost versus FMV
Following the general concept of verifiability and conservatism, GAAP requires most assets to be recorded at cost. However, there are some provisions within GAAP to revalue assets such as marketable securities, and even inventory, if the market value is less than the original cost. Even so, items like land, that may appreciated in value over time, are stated at the original cost, which may result in understating the actual value of the asset. Inflation can also affect the value of assets and is not taken into account under GAAP. Historical cost is objective and therefore reduces the chance that management is subjectively valuing assets for more than they are worth, as Enron did when it fraudulently led investors to believe the company was worth far more than it actually was.
Using historical cost can also overstate the value of an asset. For instance, in our cab company example from earlier, the cost of the cab may be $60,000 but its actual value may be much less. Under the historical cost principle of GAAP, however, it will still be listed as a $60,000 asset.
Undervalued Assets
Some intangible assets, such as customer lists, are not recorded as assets. Instead, any expenditures made to create an intangible asset are immediately charged to expense. This policy can drastically underestimate the value of a business, especially one that has spent a large amount to build up a brand image or to develop new products. It is a particular problem for startup companies that have created intellectual property, but which have so far generated minimal sales.
Predictive Value
The information in a set of financial statements provides information about either historical results or the financial status of a business as of a specific date. The statements do not necessarily provide any value in predicting what is happening in the present or what will happen in the future. For example, a company may show solid financial results for the fiscal year ended December 31, but be struggling in March when the statements are issued to the general public, as was the case with Harley Davidson, Inc., which issued its financial statements and SEC form 10-K on February 21, 2018 for the fiscal year ended December 31, 2017. Looking at past financials for the venerable motorcycle company doesn’t make it obvious that sales were quickly sliding downward as the core demographic for big bikes aged and demand shifted toward smaller, cheaper bikes. By the first quarter of 2018, when the financials were being issued, Harley was already shutting down a plant and cutting jobs, but none of that was apparent from the published income statement or balance sheet, partly due to the historical nature of the statements, and partly due to the fact that the financials are just numbers reflecting past performance.
Comparability
Many investors use financial statements as a way to compare one company against another; however, even companies that are similar, such as Home Depot and Lowe’s, may not use the same accounting methods. Depreciation and inventory costing are examples of accounting issues that offer choices and rely upon estimates. Although these issues are detailed in the footnotes and disclosures, it may be difficult, if not impossible, to reconcile the differences between two companies that choose different accounting methodologies.
Fraud
Management may deliberately skew financial information, as did the Enron team when they reported income that had not yet been earned in order to bolster the stock price. Relying on audited financial statements can give you some assurance that the information is correct, but recall that Enron’s financial statements had been audited. Fraud like that can arise when there is undue pressure, such as shareholders are demanding and expecting excellent results that will push the stock price higher.
practice questions