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9 limitation of accounting ratios

Ratio is the quantitative relation between two amounts showing the number of times one value contain or is contained within the other. In auditing ratio are used when performing analytical procedures which is one method of collecting audit evidence.

The limitations of accounting ratios include the following:

  • Heterogeneity or homogeneity; a company may have various divisions operating in many industries. This can make it difficult to find comparative industry ratios to use for comparison purposes
  • Need to determine whether the result of the ratio analyses are consistent: one set of ratio may indicate a problem, whereas another set may indicate that the potential problem is only short term in nature
  • The use of alternative accounting methods: companies frequently have latitude when choosing certain accounting methods. Ratios obtained from financial statements that employ different accounting methods may not be comparable unless adjustments are made
  • Management assumptions, basis of estimation and judgement: IFRS is principle based; it requires significant judgement from management of entities, this could result in material differences in the financial statements of the entities. It can also further limit the financial analyses of financial statements with accounting ratios unless further adjustments are made to the accounts
  • Use of historical cost data: decision about future expectation are based on historical data, which in some cases, make it difficult and insensitive to reaching economic decision that are likely to take into consideration changes in underlying variables that determine company’s performance
  • Inflation can distort the financial statement: the inflation can distort financial statements (particularly the statement of financial position). Any any statement in the financials caused by inflation can be passed on to the ratios
  • Lack of comparative figures for the new entity: in the company first year of trading, there will be no comparative figures, hence no indicator to compare with
  • Use of industrial average: comparison against industry average may not be subjected to the factors that are not common in the industry
  • Difference in ratio definitions may make it difficult to compare ratios from different sources: difference in ratio definitions make it difficult to compare ratios from different sources. There can be many different ways to compute the same ratio. this can cause confusion or different answers.

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