Limitations of financial accounting

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on June 22, 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 the past events. Under financial accounting, business transactions are first recorded in the books of original entry, then classified into ledger and finally summarised by preparing Trial Balance.
From trial balance, the Profit and Loss Account or Income Statement is prepared to ascertain the periodic profit or loss and Balance Sheet or Position Statement is prepared to ascertain the financial position of the business as at the end of the accounting period. Financial accounting gives only a general idea about the working of the business and permits the management to control, in a general way, the major functions of the business viz., finance, production, administration and distribution. But it does not give details regarding the operating efficiency of these divisions.
Financial accounting is the language of the whole business. It speaks in monetary terms. It helps in keeping systematic records. It communicates the results and meets the legal requirements. Financial
accounting suffers from the following limitations or deficiencies:

Limitations of Financial Accounting

Limitations from which financial accounting suffers may be summarised as follows:

1. No provision for material control:

Financial accounts do not contain detailed particulars of materials consumed in a manufacturing concern. Although, the financial accounts record the value of opening and closing stocks and the cost of raw materials purchased, they are silent as to the quantity of the various items of raw material issued to different departments or jobs and the price at which they have been issued. Therefore, the cost of raw material consumed for the manufacture of a particular unit of output cannot be ascertained from financial accounts.

2. Non-availability of detailed particulars about labour cost:

Financial accounts contain the record of the total wages paid to the workers during a specified period but they are silent as to number of workers employed, number of workers engaged 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 etc. Financial accounts also do not contain separate records for direct and indirect wages. Further, no distinction is made between the wages of efficient and inefficient workers.
As such it becomes difficult to ascertain as to whether the increase in the wage rates of workers or increase in the number of workers has led to a corresponding increase in the quantity of output or not.

3. Classification of accounts in a general manner:

Under financial accounting system, accounts to be prepared are classified into personal, real and nominal accounts. Such a classification of accounts does not help in ascertaining the cost of production product-wise, job-wise, department-wise, work-order-wise, etc.

4. No classification of costs into direct and indirect items:

In financial accounts prepared under the financial accounting system, costs are not classified as to direct and indirect items and 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 whether or not these are relevant to cost of production. As such, the exact or true cost of a product, job, work-order or process cannot be ascertained from financial accounts nor can we decide as to whether or not all the relevant items of cost have been considered in ascertaining the total cost.

6. No provision for a system of standards:

In a manufacturing concern carrying on production on a large scale basis, its manager generally finds himself unable to supervise personally each and every activity involved in the manufacturing of goods. As such standards and targets have to be fixed in advance for various activities of the manufacturing concern.
The actual performance is to be compared with the pre-determined standards in order to find out the differences and to provide for their analysis and remedial action, in case the performance is below standard. Financial accounting system has no provision for such a system of standards.

7. No records for wastages:

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

8. No assistance in fixation of selling price and calculation of tender price:

Financial accounting system fails to supply data regarding the true or exact cost of production on account of which the manufacturer finds himself unable to fix a competitive selling price for his products. Many times, a manufacturer or a contractor has to submit quotations or tender 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 price or the tender price should be competitive. A competitive quotation price or tender price can be determined with reference to the past cost data and changes anticipated over the previous cost levels. Since financial accounting system does not supply data relating to true cost of production, the preparation of tenders and quotations becomes a difficult job.

9. No assistance in cost control:

Financial accounting system does not help the management in controlling costs since it does not provide for a system of cost control. This limitation arises on account of the following reasons:
(a) In financial accounts, costs and expenses are recorded only after these have been actually incurred or spent. Hence, financial accounts do not leave any room for taking corrective action.
(b) Financial accounts do not have any technique to check the reasonableness of any cost or expenditure.
(c) Financial accounts do not help in fixing the responsibility on any individual for any wastage or excessive cost.

10. Financial accounts deal only with the overall profitability of the business concern:

Financial accounts of a business concern are so designed as to disclose the overall profit or loss of that business concern for a specified period. Financial accounts do not deal with the product-wise, job-wise, process-wise, department-wise profitability of the business. Hence, the unprofitable activities of the business are not disclosed and the necessary steps cannot be taken to make them profitable or to discontinue them.

11. No provision for comparison of costs:

Financial accounts do not provide data for the comparison of the costing results of a particular period with that of other periods of operation of the same business concern or with that of other concerns in the same line of industry.

12. No assistance in planning and decision-making:

Financial accounting system does not provide any guidance and assistance to the management in taking various important decisions relating to the operations of an undertaking. The management may require information for the following purposes:
(a) Evaluation of the profitability of the alternative methods of production
(b) Selection of the most profitable product-mix or sales-mix
(c) Manufacture or buy decision
(d) Operate or shut-down decision
(e) Determination of sales required to earn desired profits
(f) Ascertainment of the effect of changes in selling price on profits
(g) Determination of the Break-even Point, Margin of Safety, etc.
Financial accounting system does not provide the required data and assistance for the purpose of making decisions on the above-mentioned matters. All these limitations of financial accounting system have led to the development of cost accounting system.

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