What are the limitations of Balance Sheet or Statement of Financial Position?

In this answer the terms Balance Sheet and Statement of Financial position are used to mean one and the same thing

Statement of financial position or Balance sheet is the essential part of the complete set of financial statements. It is also one of the most sort after source of information for the users of financial statement for decision making purposes. It provides an insight into the financial status of the entity and can also provide vital information regarding the ability of the entity to stay in the business.

However, statement of financial position or balance sheet has limitations associated with the information contained in this financial statement. Although the limitations are situation dependent and their effect depends on the number of factors including the degree of reliance placed solely on the balance sheet but there are few limitations which exist in almost every statement of financial position. Some of the important limitations are discussed below:

  1. Although accounting standards, local or international, are made to help management to produce relevant and reliable information but this in itself in many cases prove a limitation. Strict instructions by the standards might not be a perfect fix for every situation and might push management to report something which is not that much meaningful as it should be.
  2. Balance sheet alone do not provide all of the information needed and you might have to look for ancillary information in other financial statements. For example to conduct ratio analysis you need figures from other financial statements as well.
  3. It does list down the asset business has but it does not tell how much money those assets can generate in the future
  4. Information is based on the past and might provide little help about the future.
  5. Most of the values reported in the statement of financial position is based on historical cost basis i.e. the item is reported on the basis of valuation conducted when the transaction took place instead of the current basis of valuation and thus information might be too old to be relevant and reliable for decision making purposes. This might limit your ability to understand the current worth of the business.
  6. Many assets which are internally generated are not recorded and reported in the balance sheet which limits the pure projection of entity’s capability to generate cash and cash equivalents. This is because the assets which do not fulfill the recognition principle will not be reported in the balance sheet. Because of this, person looking at the balance sheet might not get the complete understanding of entity’s strengths.
  7. One of the major limitations of balance sheet and any other financial statement is that only such information reported which can be quantified easily or at least reasonably. Vital qualitative information is left out almost completely!
  8. Statement of financial position relies on the other financial statements and many of the numbers are pulled from income statement or statement of changes in equity etc and thus any mistake, deliberate or not, in those financial statements will ultimately effect the balance sheet as well. Also the limitations of those other financial statements are also inherited by the balance sheet. Moreover, each financial statement cannot be considered in isolation and taken separately from other financial statements. Doing so might render useless and inaccurate information and interpretation about the entity.
  9. Many of the elements are reported on aggregate basis for which even the notes to the financial statements might not provide the complete and relevant information to understand what is included in the figure reported and what is the value of each item included in the total figure.
  10. Many of the items reported involve the use of estimation which might not be suitable and user might be interested in knowing how such estimates have been made and whether such estimates are still relevant after the financial statements have been published.
  11. The “off-balance sheet” financing tactics employed by those responsible to prepare financial statements seriously impairs the use of balance sheet as a reliable source of information for decision making purposes.
  12. It is not possible for the management to incorporate and report the effects of changing socio-economic circumstances in the financial statements and thus the numbers in the statement of financial position might not be an accurate representation in a given set of conditions surrounding the entity. This becomes even more important if the entity is operating in a politically or economically volatile environment.