Financial statements are the end-products of the accounting process which serve the financial information needs of various interested parties. The financial statement should be a faithful representation of the economic activities of the business. While a full description of the actual economic activity of the organisation is not possible, the financial statement should contain as full and as faithful a representation as feasible. The report should be accurate and timely, consistent with preceding statements and containing the adequate amount of disclosure.
The degree to which the financial statements accurately present the economic status of the company depends to a large extent upon the assumptions and procedures inherent in the accounting process (Kimwell, 2005, p. 50). The balance sheet gives one input that is helpful information in determining the degree of financial risk. The most important thing to remember in preparing financial reports for management use is that a report prepared in accordance with generally accepted accounting principles may not be useful for decision-making.
This means that the conventional balance sheet may have to be adjusted before it can be helpful to management. The balance sheet is important to the extent that it provides a comprehensive overview of the financial position of the business. This attempt at comprehensiveness also accounts for the principal limitations. Despite the usefulness of the information furnished by the balance sheet, there are limitations and criticisms leveled against the statement. The balance sheet reflects only those activities that can be reduced to monetary terms.
Many items which are of financial value to the company are not shown in the balance sheet. For instance, such items as market position, superior products, capable personnel, favorable location, high credit standing, are not quantified in the balance sheet. Estimates enter into the preparation of the balance sheet. The estimates are significantly pronounced in the matter of reporting receivables, plant and equipment, inventories and intangibles and certain liabilities.
The balance sheet does not show the current value of the company assets and of the company itself. The assets are generally shown at cost, and very often, there is a significant difference or variation between historical cost and current market values. Thus, the net worth of the company is not also measured accurately. It may be overstated or understated because assets are not in conformity with current values. In view of these limitations, proponents of fair value accounting consider that the most relevant appraisal for financial reporting is fair value.
However, others argue that since fair value is based on estimates, it may not be reliable and confirmable, thus historical cost is more valuable in measuring the economic status of the business. Further, it is contended that a dynamic and sheer market is not available for numerous assets and liabilities. Thus, gauging fair value will be subjective thus; appraisal will also be less dependable. When market prices are not available, reliability of financial reports will remain to be an issue whenever management will use fraught judgment in choosing market data (“Fair”n. d. ). The major concern now is management bias that it possibly exists.
Management preconception has the effect of unreliable financial information and measurement of fair value estimates. Earnings management happens even under the historical cost accounting measurement. Thus, without a reliable basis for fair value estimates, the possibility of misstatements of accounting data will even be more expectant. In recent years, there were cases of over valuation of some assets when there were no active market prices and substantial reduction in the book values of these over valued assets resulted in failure of some financial institutions and businesses (Bies, 2004, p. 27)