Monetary Expression

The financial statements require information that can be presented in a monetary unit. But a business may encounter several important economic events which may influence the business decisions in a significant manner but which may not be quantifiable in monetary terms. For example, financial statements do not convey any direct information about the character, motivation or experience of management or employees, neither do they contain any disaggregate information on the quality of research and development efforts nor the extent of a company's marketing efforts. They also fail to convey any detailed information on product lines, machinery efficiency or future plans. Also absent is information on organization structure, informal communication channels within and outside a company, and assessments on the importance of specific individual's talents. All these events exert a considerable influence on the business but unfortunately do not find a place in the financial statements.

Simplification and Summarization

Financial statements summarize complex and diverse financial information for the purpose of simplification in presentation. Simplification is necessary and is reflected in  classifying the various economic events into a manageable number of categories. Summarization is also necessary to keep the quantity and detail of financial statements within reasonable bounds. Simplification and summarization is further justified on cost efficiency grounds. But such simplification and summarization are at the expense of clarity and detail potentially useful in our analysis. Simplification and summarization inherent in accounting make it impossible for the end-user to make any analysis and in turn make it imperative for them to reconstruct the events and transactions for analysis.

Judgment and Incentives

Preparation of financial statements heavily rests on the personal judgment skills of the accountant. If the judgment is imperfect or incorrect, it results in variability in the quality and reliability of accounting numbers. Since financial statements are intended for general purpose, the accountant's judgements are influenced by their view of a typical user's requirements and expectations. These requirements and expectations do not necessarily coincide with those of another user with a specific task in mind. Accounting is also a social science and therefore, is at least partially determined by human factors, including incentives. No assessment of financial statement quality or reliability is complete without considering these incentives. While the overriding purpose of accounting is supplying information useful in business decisions, we must recognize that many parties are involved in the accounting function, each having their own individual interest in mind. These are some of the examples of how financial reports might reflect management's interests:

Added to this, parties external to a company also may have their set of agenda and expectations. Governments want accounting to promote policies encouraging inflation control, good labor relations, continued economic growth, antitrust oversight, and equitable taxes. Accounting practitioners want accounting to increase the market for their services, maintain positive relations with clients, and assist clients in reaching their objectives. These biased interests do not, and should not affect objectives of accounting. Accounting regulatory agencies must represent society and ensure that accounting objectives mesh with society. Still we must be aware of strong personal incentives at stake trying to bend practice to favor other interests.

Estimates

The use of estimates is an inherent part of the preparation of financial statements. Greater use of estimates increases the uncertainty inherent in financial statements. Estimates are required for many items including:

1. Amount and timing of cash collections on receivables.

2. Expected selling prices and sales volume for inventory items.

3. Benefit period and salvage value of depreciable assets.

4. Future warranty claims.

5. Portion complete and remaining costs of long-term sales contracts.

6. Income and property taxes.

7. Loss reserves.

There is a strong link between frequency of reporting, the length of period covered and the degree of accounting uncertainty. Many business transactions and events require a long period of time for completion and determination of results. For example, long-term depreciable assets benefit several periods extending years into the future. The longer the benefit period, the more tentative are estimates of their salvage value, benefit period and payback pattern. This acts as a limitation on analyzing the financial statements.

Historical Cost Measurement

Accounting aims to report fair and objective information. Since the value of an asset determined through arm's length bargaining is usually fair and objective, use of historical cost values in financial statements is common. These historical cost values enjoy objectivity, but the consequence of this objectivity, when values subsequently change, impairs the usefulness of financial statements. Historical cost balances do not, in most cases, represent current market values. Yet, users of financial statements desire a balance between objectively determined values and the most current market values of assets and liabilities. Thus, while we must be aware of and adjust to valuation bases other than cost, historical cost measures represent a pragmatic compromise to a difficult circumstance.

Unstable Monetary Unit

Accounting reports generally deal with items expressed only in monetary terms. The use of money and historical cost as the measurement base poses two problems - what happens to values that cannot be expressed in financial terms; and what happens when the value of money itself changes, Addressing the second question, the purchasing power of money experiences periodic fluctuations with a typically declining trend. The monetary unit has not retained its attribute as a "standard of value" and, consequently, adding account balances across years can yield serious distortions. Accounting Practice recognizes this limitation. Yet, no reporting requirements currently exist for adjusting financial statements for changes in purchasing power.

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