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Limitations of Management Accounting

 Data based on Financial accounting – Decisions taken by the management team are based on the data
provided by Financial Accounting

 Less knowledge – Management has insufficient knowledge of economics, finance, statistics, etc.

 Outdated data – Management team receives historical data, which may change eventually when
management is taking the decisions.

 Expensive – Setting up a management accounting system requires a lot of investment.

Objectives of Management Accounting:

Objective # 1. Assistance in Planning and Formulation of Future Policies:

Management accounting assists management in planning the activities of the business. Planning is
deciding in advance what is to be done, when it is to be done, how it is to be done and by whom it is
to be done. It involves forecasting on the basis of available information, setting goals, framing
policies, determining the alternative courses of actions and deciding on the programme of activities
to be undertaken.

Objective # 2. Helps in the Interpretation of Financial Information:

Accounting is a technical subject and may not be easily understandable by everyone till the user has
a good knowledge of the subject. Management may not be able to use the accounting information
in its raw form due to lack of knowledge of accounting techniques.

Objective # 3. Helps in Controlling Performance:

Management accounting is a useful device of managerial control. The whole organisation is divided
into responsibility centres and each centre is put under the charge of one responsible person. He
will be associated with the planning and framing of the budgets and be required to execute the
plans and standards and deviations are analysed in order to pinpoint the responsibility.
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Objective # 4. Helps in Organizing:

Thus management accountant recommends the use of budgeting, responsibility accounting, cost
control techniques and internal financial control. This all needs the intensive study of the
organisation structure. In turn, it helps to rationalise the organisation structure.

Objective # 5. Helps in the Solution of Strategic Business Problems:

Whenever there is a question of starting a new business, expanding or diversifying the existing
business, strategic business problem has to be faced and solved.

Similarly when in a particular situation, there are different alternatives as whether labour should
be replaced by machinery or not, whether selling price should be reduced or not, whether to export
the item or not etc., a management accountant helps in solving such problems and decision-
making.

Objective # 6. Helps in Coordinating Operations:

Management accounting helps the management in co-coordinating the activities of the concern by
getting prepared functional budgets in the first instance and then co-coordinating the whole
activities of the concern by integrating all functional budgets into one known as master budget.
Thus, management accounting is a useful tool in coordinating the various operations of the
business.

Objective # 7. Helps in Motivating Employees:

The management accountant by setting goals, planning the best and economical course of action
and then measuring the performance tries his best to increase the effectiveness of the organisation
and thereby motivate the members of the organisation.
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Objective # 8. Communicating Up-to-date Information:

Management accounting assists management in communicating the financial facts about the
enterprise to the persons who are interested in these facts so that they may be guided to a line of
action to be pursued. Management needs information for taking decisions and for evaluating
performance of the business.

Objective # 9. Helps in Evaluating the Efficiency and Effectiveness of Policies:

Management accounting also lays emphasis on management audit which means evaluating the
efficiency and effectiveness o£ management policies. Management policies are reviewed from time
to time to make an improvement in them so that maximum efficiency may be achieved.

Relationship between financial and management accounting

Basis Financial Accounting Management Accounting

1. External and Financial accounting information is Management accounting information

mainly intended for external users is mainly meant for internal user, i.e.,
Internal users
like investors, shareholder, management

creditors, Govt. authorities etc.

2. Statutory Under company law and tax law, Management accounting is optional

financial accounting is obligatory to though its utility makes it highly

requirements
satisfy various statutory provisions. desirable to adopt it.

3. Analysis of Financial accounting shows the Management accounting provides

profit / loss of the business as a detailed information about individual

cost and profit
whole. It does not show the cost and products, plants, departments or any

profit for individual products, other responsibility centre.

processes or departments, etc.

4.Past and It is concerned with recording It is future oriented and concentrates

transactions, which have already on what is likely to happen in future

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taken place, i.e., it represents past though it may use past data for future
future data
or historical records. projections.

5. Periodic and Financial reports, i.e., Profit and Management accounting reports are

Loss account and Balance Sheet are prepared frequently, i.e, these may be
continuous
prepared usually on a year to year monthly, weekly or even daily
reporting
basis. depending on managerial

requirements

6. Accounting Companies are required to prepare Management accounting is not bound

financial accounts according to by accountings standards. It may use

standards
accounting standards issued by the any practice which generates useful

Institute of chartered accountants of information to management.

India.

7.Types of Financial accounting prepares In Management accounting special

general purpose statements Profit & purpose reports are prepared, eg,,
statements
Loss account and Balance sheet performance report of sales manager
prepared
which are used by external users. or any other department manager

which are used by top level

Management.

8.Pubilcation Financial statements, i.e., P&L A/c Management accounting statements

and and Balance sheet are published for are for internal use and thus neither

general public use and also sent to published for general public use nor
audit
share holders. These are required to these are required to be audited by

be audited by the chartered chartered accountants.

Accountants.

Meaning of Financial Statements

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Financial statements are basically reports that depict financial and accounting information relating to
businesses. A company’s management uses it to communicate with external stakeholders. These
include shareholders, tax authorities, regulatory bodies, investors, creditors, etc.

Financial statements basically include the following reports:

Balance sheet

Profit and Loss statement

Cash flow statement

Importance of Financial Statements:

The importance of financial statements lies in their utility to satisfy the varied interest of different
categories of parties such as management, creditors, public, etc.

1. Importance to Management:

Increase in size and complexities of factors affecting the business operations necessitate a
scientific and analytical approach in the management of modern business enterprises.

The management team requires up to date, accurate and systematic financial information for the
purposes. Financial statements help the management to understand the position, progress and
prospects of business vis-a-vis the industry.

2. Importance to the Shareholders:

Management is separated from ownership in the case of companies. Shareholders cannot, directly,
take part in the day-to-day activities of business. However, the results of these activities should be
reported to shareholders at the annual general body meeting in the form of financial statements.
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These statements enable the shareholders to know about the efficiency and effectiveness of the
management and also the earning capacity and financial strength of the company.

3. Importance to Lenders/Creditors:

The financial statements serve as a useful guide for the present and future suppliers and probable
lenders of a company.

It is through a critical examination of the financial statements that these groups can come to know
about the liquidity, profitability and long-term solvency position of a company. This would help them
to decide about their future course of action.

4. Importance to Labour:

Workers are entitled to bonus depending upon the size of profit as disclosed by audited profit and
loss account. Thus, P & L a/c becomes greatly important to the workers. In wages negotiations also,
the size of profits and profitability achieved are greatly relevant.

5. Importance to the Public:

Business is a social entity. Various groups of society, though directly not connected with business,
are interested in knowing the position, progress and prospects of a business enterprise.

They are financial analysts, lawyers, trade associations, trade unions, financial press, research
scholars and teachers, etc. It is only through these published financial statements these people can
analyze, judge and comment upon business enterprise.

6. Importance to National Economy:

The rise and growth of corporate sector, to a great extent, influence the economic progress of a
country. Unscrupulous and fraudulent corporate managements shatter the confidence of the
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general public in joint stock companies, which is essential for economic progress and retard the
economic growth of the country.

Financial Statements come to the rescue of general public by providing information by which they
can examine and assess the real worth of the company and avoid being cheated by unscrupulous
persons.

Limitations of Financial Statements:

Most of the limitations are mainly due to the cumulative effect of recorded facts, accounting
conventions and personal judgment on financial statements. Unless they are prepared specially
they fail to reflect the current economic picture of business. As such, financial statements have a
number of limitations.

The important limitations are as follows:

1. Information is Incomplete and Inexact:

The financial statements are interim reports usually prepared for an accounting period. Hence, the
financial information as revealed by them is neither complete nor exact.

The true financial position or ultimate gain or loss, can be known only when the business is closed
down.

2. Qualitative Information is Ignored:

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Financial statements depict only those items of quantitative information that are expressed in
monetary terms.

But, a number of qualitative factors, such as the reputation and prestige of the management with
the public, cordial industrial relations and efficiency of workers, customer satisfaction, competitive
strength, etc., which cannot be expressed in monetary terms , are not depicted by the financial
statements.

However, these factors are essential for understanding the real financial condition and the operating
results of the business.

3. Financial Statements Mainly Show Historical Information:

As the financial statements are compiled on the basis of historical costs, they fail to take into
account such factors as the decrease in money value or increase in the price level changes. Since
these statements deal with past data only, they are of little value in decision-making.

4. Financial Statements are Based on Accounting Concepts and Conventions.

Accounting concepts and conventions used the preparation of financial statements make them
unrealistic.

For example the income statement prepared on the basis of the convention of conservatism fails to
disclose the true income, for it includes probable losses and ignores probable income.

Similarly the value of fixed asset is shown in the balance sheet on the ‘going concern concept’. This
means that the value of the asset rarely represents the amount of cash, which would be realized on
liquidation.

5. Personal Judgment Influence Financial Statements:

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Many items in the financial statements are left to the personal judgment of the accountant. For
example, the method of inventory valuation, the method of depreciation the treatment of deferred
revenue expenditure, etc., depend on the personal judgment of the accountant.

Definition of Financial Statement Analysis :

Financial Statement Analysis is an analysis which highlights important relationships between items
in the financial statements. Financial Statement analysis embraces the methods used in assessing
and interpreting the results of past performance and current financial position as they relate to
particular factors of interest in investment decisions. It is an important means of assessing past
performance and in forecasting and planning future performance.

According to Lev:

“Financial Statement Analysis is an information processing system designed to provide data for
decision making models, such as the portfolio selection model, bank lending decision models, and
corporate financial management models.”

Objectives of Financial Statement Analysis:

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The major objectives of financial statement analysis is to provide decision makers information about
a business enterprise for use in decision-making. Users of financial statement information are the
decision makers concerned with evaluating the economic situation of the firm and predicting its
future course.

Financial statement analysis can be used by the different users and decision makers to achieve the
following objectives:

1. Assessment of Past Performance and Current Position:

Past performance is often a good indicator of future performance. Therefore, an investor or creditor
is interested in the trend of past sales, expenses, net income, cast flow and return on investment.
These trends offer a means for judging management’s past performance and are possible
indicators of future performance.

2. Prediction of Net Income and Growth Prospects:

The financial statement analysis helps in predicting the earning prospects and growth rates in the
earnings which are used by investors while comparing investment alternatives and other users
interested in judging the earning potential of business enterprises. Investors also consider the risk
or uncertainty associated with the expected return.

The decision makers are futuristic and are always concerned with the future. Financial statements
which contain information on past performances are analysed and interpreted as a basis for
forecasting future rates of return and for assessing risk.

3. Prediction of Bankruptcy and Failure:

Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability
of business enterprises. After being aware about probable failure, both managers and investors can
take preventive measures to avoid/minimise losses. Corporate managements can effect changes in
operating policy, reorganise financial structure or even go for voluntary liquidation to shorten the
length of time losses.
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4. Loan Decision by Financial Institutions and Banks:

Financial statement analysis is used by financial institutions, loaning agencies, banks and others to
make sound loan or credit decision. In this way, they can make proper allocation of credit among
the different borrowers. Financial statement analysis helps in determining credit risk, deciding terms
and conditions of loan if sanctioned, interest rate, maturity date etc.

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

1. Not a Substitute of Judgement

An analysis of financial statement cannot take place of sound judgement. It is only a means to
reach conclusions. Ultimately, the judgements are taken by an interested party or analyst on his/
her intelligence and skill.

2. Based on Past Data

Only past data of accounting information is included in the financial statements, which are analyzed.
The future cannot be just like past. Hence, the analysis of financial statements cannot provide a
basis for future estimation, forecasting, budgeting and planning.

3. Problem in Comparability

The size of business concern is varying according to the volume of transactions. Hence, the figures
of different financial statements lose the characteristic of comparability.

4. Reliability of Figures

Sometimes, the contents of the financial statements are manipulated by window dressing. If so, the
analysis of financial statements results in misleading or meaningless.

5. Various methods of Accounting and Financing

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The closing stock of raw material is valued at purchase cost. The closing stock of finished goods is
value at market price or cost price whichever is less. In general, the closing stock is valued at cost
price or market price which ever is less. It means that the closing stock of raw material is valued at
cost price or market price whichever is less. So; an analyst should keep in view these points while
making analysis and interpretation otherwise the results would be misleading.

6. Change in Accounting Methods

There must be uniform accounting policies and methods for number of years. If there are frequent
changes, the figures of different periods will be different and incomparable. In such a case, the
analysis has no value and meaning.

7. Changes in the Value of Money

The purchasing power of money is reduced from one year to subsequent year due to inflation. It
creates problems in comparative study of financial statements of different years.

8. Limitations of the Tools Application for Analysis

There are different tools applied by an analyst for an analysis. Even though, the application of a
particular tool or technique is based on the skill and experience of the analyst. If an unsuitable tool
or technique is applied, certainly, the results are misleading.

9. No Assessment of Managerial Ability

The results of the analysis of financial statements should not be taken as an indication of good or
bad management. Hence, the managerial ability can not be assessed by analysis.
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10. Change of Business Condition

The conditions and circumstances of one firm can never be similar to another firm. Likewise, the
business condition and circumstances of one year to subsequent can never be similar. Hence, it is
very difficult for analysis and comparison of one firm with another.

Tools of financial analyse