The Balance Sheet

Limitations of the Balance Sheet

In financial accounting, a balance sheet or statement of financial position summarizes the financial balances of a sole proprietorship, business partnership, corporation, or other business organization, such as an LLC or an LLP. Assets, liabilities, and ownership equity are listed on a specific date, such as the end of its financial year. 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 one that applies to a single point in time in a business calendar year. Balance sheets have three primary limitations: they are recorded at historical cost, use estimates, and omit valuable information, such as intelligence.

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

Four depreciation methods Different methods of depreciation affect the carrying value of an asset on balance sheets.

Some of the current assets are valued on an 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 as imaginary figures, which may not relate to the market value.

The International Accounting Standards Board (IASB) offers some guidance (IAS 38) as to how intangible assets should be accounted for in financial statements. In general, legal intangibles that are developed internally are not recognized, and legal intangibles that are purchased from third parties are recognized. 

Therefore, there is a 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.

Finally, the balance sheet can not reflect assets that cannot be expressed in monetary terms, such as workers' skills, intelligence, honesty, and loyalty.