Limitations of Financial Accounting

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on September 4, 2021

What Is Financial Accounting?

Financial accounting, which is historical in nature, is mainly concerned with the recording of day-to-day business transactions. It is simply a post-mortem of past events.

Under financial accounting, business transactions are first recorded in the books of original entry. In turn, they are classified into the ledger and finally summarized by preparing a trial balance.

From the trial balance, the profit and loss account or income statement is prepared to ascertain the periodic profit or loss. Also, the balance sheet or position statement is prepared to ascertain the financial position of the business at the end of the accounting period.

Financial accounting only gives a general idea about the working of a business. As such, it allows managers to control, in a general way, the major functions of the business (e.g., finance, production, administration, and distribution).

However, financial accounting does not provide details about the operating efficiency of these divisions and major business functions.

As such, financial accounting is the language of the whole business. It speaks in monetary terms, it helps to maintain systematic records, it communicates results, and it ensures compliance with legal requirements.

Limitations of Financial Accounting

The limitations that financial accounting suffers from are summarized as follows:

1. No Provision for Material Control

Financial accounts do not contain detailed information about the materials consumed in a manufacturing concern.

Although financial accounts record the values of opening and closing stocks and the cost of raw materials purchased, they are silent as to the quantities of items of raw materials issued to different departments or jobs, as well as the price they were issued at.

Therefore, using financial accounts, it is not possible to ascertain the cost of raw materials consumed for the manufacture of a particular unit of output.

2. Non-availability of Detailed Particulars About Labour Cost

Financial accounts contain a record of the total wages paid to workers during a specified period, but they do not indicate the following:

  • Number of workers employed
  • Number of workers on different jobs or in different departments
  • Number of hours worked by each worker
  • Rate of wages
  • Total wages paid job-wise, product-wise, or department-wise
  • Separate records for direct and indirect wages
  • Wages of efficient and inefficient workers

Due to these factors, it is difficult to use financial accounts as a basis for determining whether increasing wages or increasing the number of workers would lead to a corresponding increase in the quantity of output.

3. Classification of Accounts in a General Manner

Under the financial accounting system, accounts are classified as personal, real, or nominal accounts. Such a classification of accounts does not help to determine the cost of production product-wise, job-wise, department-wise, work-order-wise, and so on.

4. No Classification of Costs into Direct and Indirect Items

In financial accounts prepared under the financial accounting system, costs are not classified as direct and indirect items, and they are not assigned or allocated to each product at each stage of production (or to each department or process).

5. Ascertainment of True Cost of Production Not Possible

Financial accounts keep a record of all the expenses of the business irrespective of whether they are relevant to the cost of production.

As such, the exact or true cost of a product, job, work order, or process cannot be ascertained from financial accounts. Additionally, it is not possible to decide whether or not all the relevant items of cost have been considered when ascertaining the total cost.

6. No Provision for a System of Standards

In a manufacturing concern that engages in production on a large-scale basis, managers will not be able to supervise personally every activity involved in manufacturing goods. As such, standards and targets must be fixed in advance for various activities.

Actual performance should be compared to pre-determined standards to identify the differences and develop corrective measures if performance falls below the standard. However, the financial accounting system has no provision for such a system of standards.

7. No Records for Wastages

Under the financial accounting system, no records are kept on the wastage of materials, man-hours, and machine hours that took place in the course of production. As such, no steps can be taken to eliminate or minimize the various types of wastage.

8. No Assistance in Fixing Selling Price and Calculating Tender Price

The financial accounting system fails to supply data regarding the true or exact cost of production. Due to this, manufacturers find it challenging to fix a competitive selling price for their products.

Oftentimes, manufacturers or contractors must submit quotations or tenders to a prospective customer for the supply of a large quantity of a product at some future date or for the execution of a contract. The quotation or tender price should be competitive.

A competitive quotation price or tender price can be determined based on historical cost data and changes anticipated over the previous cost levels.

Since financial accounting does not supply data relating to the true cost of production, the preparation of tenders and quotations is complex.

9. No Assistance in Cost Control

Financial accounting does not help to control costs since it does not provide for a system of cost control. This limitation arises due to the following reasons:

(a) In financial accounts, costs and expenses are recorded only after they have been incurred or spent. Hence, financial accounts do not leave any room for corrective action.

(b) Financial accounts do not have any techniques for checking the reasonableness of any given cost or expenditure.

(c) Financial accounts do not help to assign the responsibility for wastage or excessive cost to a particular individual or department.

10. Financial Accounts Deal Only with the Overall Profitability of the Business Concern

Financial accounts are designed to disclose the overall profit or loss of a business for a specified period. They do not deal with product-wise, job-wise, process-wise, or department-wise profitability.

For this reason, by considering financial accounts only, it is not possible to identify the unprofitable activities of the business. As such, the necessary steps cannot be taken to make them profitable or discontinue them.

11. No Provision for Comparison of Costs

Financial accounts do not provide data enabling a comparison of the costing results of a particular period with those of other periods of operation (either of the same business or other organizations in the same industry).

12. No Assistance in Planning and Decision-making

Financial accounting does not provide guidance and assistance to the management regarding mission-critical decisions relating to the organization’s operations. The management may require information for the following purposes:

  • To evaluate the profitability of alternative production methods
  • To select the most profitable product mix or sales mix
  • To make manufacturing or buying decisions
  • To make operational or shut-down decisions
  • To determine the level of sales required to earn the desired profit
  • To ascertain the effect of changes in selling price on profits
  • To determine the break-even point, margin of safety, and other indicators

Significantly, the financial accounting system does not provide data or assistance that could guide decisions on any of the above-mentioned matters. All of these limitations of the financial accounting system led to the development of cost accounting.

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