Explain three (3) limitations of the balance sheet, and suggest the fundamental

Question

Explain three (3) limitations of the balance sheet, and suggest the fundamental manner in which a company can overcome each such limitation. Provide a rationale for your suggestions. Suppose you are the senior financial analyst at your company, and at the end of each month you are required to analyze the company’s profitability. Prepare a report to management that identifies ratios that are important to a company’s profitability. Assume that the ratios are unfavorable. Recommend to management one (1) way in which it can improve the company’s profitability ratios.

Explanation / Answer

A balance sheet is often described as a "snapshot of a company's financial condition. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business' calendar year. There are three primary limitations to balance sheets including the fact that they are, the use of estimates, and the omission of valuable things.

Recording at historical cost - Fixed assets are shown in the balance sheet at historical cost less depreciation up to date. Depreciation affects the carrying value of an asset on the balance sheet. The historical cost will equal the carrying value only if there has been no change recorded in the value of the asset since acquisition. Therefore, the balance sheet does not show true value of assets. Historical cost is criticized for its inaccuracy since it may not reflect current market valuation.

Use of estimates - Some of the current assets are valued on estimated basis, so the balance sheet is not in a position to reflect the true financial position of the business. Intangible assets like goodwill are shown in the balance sheet at imaginary figures, which may bear no relationship to the market value. In general, legal intangibles that are developed internally are not recognized, and legal intangibles that are purchased from third parties are recognized. Therefore, there’s disconnect – goodwill from acquisitions can be booked, since it is derived from a market or purchase valuation. However, similar internal spending cannot be booked, although it will be recognized by investors who compare a company's market value with its book value.

Omission of valuable things - Finally, the balance sheet cannot reflect those assets which cannot be expressed in monetary terms, such as skill, intelligence, honesty, and loyalty of workers.

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