What are the limitations of financial accounting?


Every strength is a weakness. In the previous section, we mentioned that financial accounting is mandatory and periodic, focuses on providing external stakeholders a financial information which is regulated, comparable, audited, general, comprehensive, synthetic, retrospective, accurate, external, objective, verifiable, reliable. But to achieve these qualities which are highly desirable from the perspective of external decision makers, it has to sacrifice other qualities which are highly desirable from the perspective of internal decision makers. First, financial accounting does not inform about transactions within the organization. Second, it lacks in flexibility and local adaptation. Third, it also lacks in timeliness and future orientation.


The growing importance of internal transactions

Financial accounting focuses on external transactions, so exchanges between the company and external stakeholders. As a consequence, it tells nothing about what happens within the organization. For small organizations, virtually all transactions are between the organization and third parties. But, as the organization grows, more and more transactions are internalized and therefore are not captured anymore by financial accounting. In other words, as a company grows, more and more transactions become out of sight if we rely on financial accounting only (Kaplan & Atkinson, 1998).

Again, this is consistent with the importance of not leaking information about underlying business models. Moreover, most external stakeholders are interested in whether rather than how a company creates value. Since they deal with it as a single entity, they evaluate it as a whole. But it greatly reduces its usefulness for managers who must understand the business model and the inner-workings or the companies, divisions, business units or departments they manage.


The importance of a detailed and diversified information to deal with contingencies

Companies operate in different environments, design different strategies to cope with these environments, often rely on different technologies and implement structures (Chenhall, 2003). They face different sets of risks and opportunities and have different strengths and weaknesses. All these differences that managers must understand to manage a business are obscured by financial accounting which provides (purposefully) a purely financial and generic information.

To make decisions, managers need an information which describes in adequate detail the operations they manage. They are less interested in comparability and more in local adaptation to their own specific context and needs. This often means that they should not only look at financial aggregates but also at dis-aggregated and non-financial information which shows the performance drivers upon which they can act (Kaplan & Norton, 1992, 1996).


The importance of time

Finally, financial accounting has been designed to give a periodic and objective account of past transactions with third parties. Such transactions have the advantage of leaving a paper trail which makes them verifiable and auditable. However, combined with the necessary lack of details about the underlying operations, this property makes it ill-suited for management purposes.

Financial statements are usually published every year, sometimes every quarter. But managers make decisions every month, week or day. They cannot wait for financial accounting to produce a set of reliable statements. Moreover, issues they must address can arise at any time; problems do not occur at regular intervals like financial statements. Therefore, managers need relevant information which can be produced swiftly and “on the spot”.

Finally, managers need to react quickly when issues arise and they need to predict the consequences of the decisions they make. When they run operations, they are more interested in having early signals about what is going on and about what will happen in the future than in an objective account of the past.


For all these reasons, the very qualities that make financial accounting adequate to serve stakeholders outside the organization make it inadequate to serve managers within the organization. This is to fill this gap that management accounting has been created.


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References

Chenhall, R. H. (2003). Management Control Systems Design Within Its Organizational Context: Findings from Contingency-Based Research and Directions for the Future. Accounting, Organizations & Society, 28, 127–169.

Kaplan, R. S., & Atkinson, A. A. (1998). Advanced Management Accounting. Upper Saddle River: Prentice-hall.

Kaplan, R. S., & Norton, D. P. (1992). The Balanced Scorecard–Measures that Drive Performance. Harvard Business Review, 70(1), 71–80.

Kaplan, R. S., & Norton, D. P. (1996). The Balanced Scorecard. Boston: Harvard Business School Press.