Comprehensive Analysis: Uses and Limitations of Financial Statements

This report provides a comprehensive analysis of financial statements, including income statements, balance sheets, and cash flow statements. It details the purposes of each statement, such as assessing profitability, liquidity, and financial position. The report explores the uses of financial statements for various stakeholders, including investors, lenders, and tax authorities. It also critically evaluates the limitations of these statements, such as reliance on accrual accounting, historical costs, and the inability to fully capture future growth prospects. The report emphasizes the importance of understanding both the strengths and weaknesses of financial statements to make informed economic decisions. The report also highlights the importance of financial reporting in the corporate governance and provides valuable insights for students seeking to understand financial analysis.

Running Head: Uses and Limitations of financial statements
Financial Statements of an Entity

Uses and Limitations of financial statements 1
Introduction:
Every entity has to prepare the financial statements, on a regular basis, to communicate the
financial results of the business operated by it. These financial statements contain the
summarised information expressed in financial terms about all the transactions and events
that are entered into during the course of business. All the financial information that helps the
readers to assess the financial health of business of an entity is compiled in the financial
statements and shared with the intended users by the way of annual report. There are
primarily three types of financial statements that are prepared by almost every business
entity. They are: Income Statement, Balance Sheet and Cash Flow Statement. All these
financial statements convey different but related information about the business. Therefore, it
is important for the users of financial reports of the company to study all the three financial
statements to evaluate the performance of the business. Preparation and presentation of
financial statements is called the financial reporting function which is performed by the
entities to comply with the corporate governance requirements as applicable to the entities.
The basic objective behind the following the practices of financial reporting is to disseminate
the relevant and necessary financial information about the business to allow the key
stakeholders to make sound economic decisions relating to the reporting entity.
Critical evaluation of financial statements:
The first and foremost financial statement that is required to be prepared by the entities is the
income statement which is traditionally termed as profit and loss account. This statement
mainly reflects the profitability position of the reporting entity. It is mainly composed of two
important elements of the business i.e. income and expense. Income is something that the
business earns over a period of time. There are various types of income that forms part of
income statement of the entity such as sales revenue, interest and dividend income etc. On the

Uses and Limitations of financial statements 2
other side expenses of the business are the costs that are incurred in the course of business
over a period of time. The examples of expenses of the business are: depreciation, rent,
salaries and wages, interest and tax payments. The income statement enables the users to
determine whether the company has made profits or losses during the reported period in the
course of business. The expenses that are reported in the income statement are charged
against the revenues generated in the concerned period by following the matching principle
of accounting. Income statement represents the financial performance of the business during
a period of time and not at a particular moment of time (Van Auken & Carraher, 2013). The
income statements render the important portion of financial reports of the entity as they form
an important basis in the preparation of statement of financial position since net profit is
earned during the year by the entity is transferred to the general reserves of the company that
becomes the key component of its statement of financial position. Not only operating
incomes and expenses are reported in the income statement of an entity but also the non-
operating incomes and expenses (De Franco, Kothari & Verdi, 2011).
Income statement of an entity possesses various features that make it an important document
to assess the financial position of the business. They provide detailed information about the
ways in which net profits of the business are ultimately derived as it not only covers the
information of revenues earned by the business but also the information regarding the cost of
goods sold and other expenses that are incurred while operating the business. Moreover, the
income statements help the owners to determine their tax obligation on the profits earned as a
part of business. There are various parties for whom income statement act as an ideal source
of information to make various economic decisions such as the potential investors, lenders of
finance, governmental agencies etc. (Boundless Finance, n.d.)
The Earning per share as depicted by the income statements of the entity enables the potential
investors to evaluate the return potential of the reporting entity. It shows them the current

Uses and Limitations of financial statements 3
return that the company is paying to its existing investors and the potential of the company to
pay them the desired returns in the subsequent periods (Penman & Penman, 2007). Further,
the net income shown in the income statement helps the lenders of finance such as bank and
financial institutions to assess the profitability position of the business that will in turn allow
them to decide as to whether they should provide the company the required financial
assistance or not. Furthermore, the net income reflected in the income statement allows the
tax regulatory bodies to calculate the tax obligations of the reporting entity on the basis of
such book profits (Hanlon, 2003). In spite of these many uses of income statement, such
statements suffer from certain limitations that affect their usefulness for the intended users.
Such limitations are discussed in the further section.
There are multiple types of profits reported in the income statement such as gross profit and
net profit and these profits have different interpretations. Since each profit reflected in the
income statement carries different meaning it becomes tough for the readers to understand
and interpret each profit separately and to identify the reasons for the differences in the
values of different sort of profits. In order to evaluate the overall profitability of the business,
the readers are therefore required to possess requisite knowledge of all the concepts of
business profits (Accounting Coach, 2018). Further, the income statements of any entity are
usually prepared on the accrual basis and hence it reports all the transactions that are entered
into, by the business managers in the normal course of business, irrespective of the
involvement of cash in such transactions. The preparation of income statement on accrual
basis does not allow the closing cash balance of business to match with the net profits earned
over the period of time. The amount of revenue from sales shown in the income statement
includes those amounts also that are not even collected till the end of reporting year and also
the amounts that are actually not paid during the reporting period. Even the non-cash
expenses such as goodwill amortisation expenses, depreciation expenses and so on are

Uses and Limitations of financial statements 4
reported in the income statements to determine the true picture of profitability of the
business. The free cash flow of the business cannot be ascertained through the income
statements. The reporting of all such items in the income statement sometimes leads to
misrepresentation of true profitability of the reporting entity (Spathis, 2002). Moreover,
though the income statement contains the information regarding the earning per share but at
the same time it does not contain information that helps the readers to gauge the future
growth prospects of the business. Therefore, it is necessary for the readers to make use of
other financial statements before reaching the ultimate decision making (Maine & McDaniel,
2000).
Once the income statements of the business of the entity are prepared, the accountants have to
take next step of preparing statement of financial position which is conventionally known as
the balance sheet. Balance sheet of an entity contains the summaries of the current financial
position of all the assets and liabilities carried by the business along with the information
regarding the equity of the owners. Assets, liabilities and the owner’s equity are the integral
components of any business (Edupristine, 2015). Assets are those properties of the business
that are owned and controlled by the business entity such as inventory, trade receivables,
plant and machineries, goodwill etc. Liabilities are those items that the business entity owes
to any other party. The trade payables, bank loan, debentures, share capital and so on. The
balance sheet typically contains the information about the total assets financed through the
use of internal and external sources of finance such as retained earnings, borrowings from
banks and financial institutions, issue of debentures or shares. Unlike, the income statement,
the data and information that constitutes the balance sheet of an entity provides the clear
insights about the financial position of the company at a particular point of time (Myers,
n.d.). It basically reflects the valuable resources that are controlled and possessed by the
entity as well as the information about how such resources are financed in the business. The

Uses and Limitations of financial statements 5
statement of financial position helps the intended users to assess the liquidity position of the
business as well the degree of efficiency used by entity to manage its debts and total assets.
The analysts use the balance sheet to identify the ability of the company to pay off its short
term and long term financial obligations and to distribute its profits among the shareholders.
Banks and other financial institutions assess the balance sheet of the company to determine
the credit worthiness and the current financial exposure of the business (Young, 2006).
The income statement and the statement of financial position are connected in the sense that
the net profit earned in the current financial year becomes the part of the owner’s capital of
the firm. If the owner does not invest or withdraw the profits of the business then it is quite
likely that owner’s capital and net income will remain same. The double entry system of
accounting establishes the relationship between the income statement and balance sheet of the
firm. Though the balance sheet serves as the fundamental financial statement of an entity that
facilitates evaluation of overall financial position of the business at a particular point of time,
it suffers from certain pitfalls that impact its relevance for the users of financial reports
(Barth, 2006). Such pitfalls will be discussed further.
The figures on which the some of the assets and liabilities of the business of the entity are
carried at the historical costs and not at their respective fair market values while some other
items are measured on the basis of fair values of such items prevailing in the market.
Therefore, it becomes difficult to instil uniformity in the financial statements (Chea, 2011).
The measurement method that is used to measure the key items of assets and liabilities affects
the amount with which they are reflected in the statement of financial position. The balance
sheet does not contain the information that helps the readers to analyse the growth prospects
of the business (Analyst Prep, 2016). The balance sheet does not reflect the strategies and
policies of the company. Further, it is also not possible to carry out the comparative study of

Uses and Limitations of financial statements 6
the financial performance of the business using income statements and statement of financial
position (Analyst Prep, 2016).
The third most fundamental financial statement that is prepared by almost all the entities is
the statement of cash flows of the business. This statement covers all the information relating
to the inflow and outflows of cash to and from the business of the reporting entity. The major
advantage of this statement is that it bifurcate the cash flows in three main categories i.e.
operating activities, investing activities and the financing activities. The cash flows from the
operating activities cover all such transactions that are undertaken as a part of main
operations of the business. These activities are the core business activities. Whereas investing
activities and financing activities are those activities that are generally non-core in nature but
involves significant amount of cash inflows and outflows during the course of the business.
The cash flow statement helps the readers to understand the actual movement of cash in the
business (Georgiou, 2010). However, there are various limitations that influence its overall
value for the users. Such limitations are discussed below:
Cash flow statements fail to represent the overall profitability of the business during a
particular period and also the liquidity and solvency position of business is not reflected
through the cash flow statements of the entity. Further, this statement does not contain the
information that helps the analysts to identify the future growth scope of business. The cash
flow statement is neither the substitute of the entity’s profit and loss account nor the fund
flow statement.
Conclusion:
It can now be concluded that though the financial statements plays great role in allowing
various parties from within and outside the business to critically evaluate the financial
performance of the business of the reporting entity. The income statement, balance sheet and

Uses and Limitations of financial statements 7
the statement of cash flows reflects the information that serves different purposes but all the
three statements depicts the information that is related to each other in some context. These
statements provide necessary information to the stakeholders of the business so that they can
take informed economic decision in the matters in which they are directly or indirectly related
to the entity. Thus, these statements are commonly known as the fundamental financial
statements of the company. However, there are certain features of the financial statements
that makes causes them to lose their relevance for the intended users (Barth, Beaver &
Landsman, 2001). The financial statements of the entity are prepared on the basis of various
accounting assumptions and conventions which are not uniformly followed by all the entities
of same industry. Hence it gets difficult to carry out the comparative study of the financials
results of different entities of the same industry. Also, the preparation of financial statements
sometimes requires application of personal judgements of the accountants of the firm which
is quite objective is nature. Further, since few items are carried at their historic cost and not at
their existing value in the market, therefore the results are often misleading and not accurate
in nature. One of the major drawbacks of financial statements is that these statements does
not recognise necessary non-financial information about the business which is material to be
taken into account by the intended users to undertake decision making.

Uses and Limitations of financial statements 8
References:
Barth, M.E., 2006. Including estimates of the future in today's financial
statements. Accounting Horizons, 20(3), pp.271-285.
Barth, M.E., Beaver, W.H. and Landsman, W.R., 2001. The relevance of the value relevance
literature for financial accounting standard setting: another view. Journal of accounting and
economics, 31(1-3), pp.77-104.
Chea, A.C., 2011. Fair value accounting: its impacts on financial reporting and how it can be
enhanced to provide more clarity and reliability of information for users of financial
statements. International journal of business and social science, 2(20).
De Franco, G., Kothari, S.P. and Verdi, R.S., 2011. The benefits of financial statement
comparability. Journal of Accounting Research, 49(4), pp.895-931.
Foster, G., 2004. Financial Statement Analysis, 2/e. Pearson Education India.
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financial statement users. The British Accounting Review, 42(2), pp.103-118.
Hanlon, M., 2003. What can we infer about a firm's taxable income from its financial
statements?. National Tax Journal, pp.831-863.
Maines, L.A. and McDaniel, L.S., 2000. Effects of comprehensive-income characteristics on
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Spathis, C.T., 2002. Detecting false financial statements using published data: some evidence
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