Question Tag: Limitations

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  • 2 Marks

FR – Nov 2023 – L2 – Q4c – Financial Statement Analysis

State two limitations of using financial ratios for company performance analysis.

State TWO (2) limitations of ratios.

  • Ratios ignore qualitative aspects of the firm.
  • Ratios ignore the price level changes due to inflation.
  • There is no standard definition of the ratios.
  • Differences in accounting policies may make ratios difficult to compare from company to company.
  • Creative accounting practices may make ratios meaningless.

(Any 2 points @ 1 mark each = 2 marks)

  • 10 Marks

AA – May 2021 – L2 – Q4c – Internal Audit and Its Relationship with External Audit

Explain limitations of the Internal Audit Unit and steps to ensure independence.

Internal audit is one of the supporting functions within an organisation. This function is set up reluctantly in many entities. It is most of the time denied the recognition and resources it requires to operate. Internal Auditors report administratively to the CEO’s of organisations even though they are required to functionally report to the Audit Committees of their respective organisations on professional issues.

Required:
Explain FIVE (5) limitations of the Internal Audit Unit and discuss steps that the Internal Audit Unit can initiate to remain independent even though they are employees of a company. (10 marks)

Limitations of the Internal Audit Unit:

  1. Employment Status: Internal auditors may be employees of the company they are auditing, creating pressure to not raise issues for fear of losing their jobs.
  2. Involvement in Operations: In smaller entities, internal auditors may be part of the finance function and may be reluctant to report deficiencies in systems they are involved in.
  3. Familiarity Threat: Long-standing relationships with colleagues may create a reluctance to raise concerns about friends or long-term associates.
  4. Lack of Resources: Internal audit units are often underfunded and denied the necessary resources to operate effectively.
  5. Lack of Qualified Personnel: Some internal audit units are not staffed with adequately qualified personnel, limiting their effectiveness.
    (5 points @ 1 mark each = 5 marks)

Steps to Ensure Independence:

  1. Separate Reporting Channels: Establish independent reporting lines between the internal audit unit and the Audit Committee instead of administrative reporting to the CEO.
  2. Independent Review: Engage an independent external body to review the work of the internal audit unit.
  3. Outsourcing: Consider outsourcing the internal audit function to a third-party service provider to reduce bias.
  4. Securing Resources: Liaise with management to ensure adequate funding and resources for the internal audit unit.
  5. Qualified Staff: Ensure that the internal audit unit is staffed with qualified and competent personnel to perform their duties effectively.
    (5 points @ 1 mark each = 5 marks)
  • 5 Marks

CR – Nov 2016 – L3 – Q4a – Analysis and interpretation of financial statements

Describe two uses of accounting ratios and explain three limitations of their use in appraising financial performance.

It has been suggested that ratio analysis is not necessarily the best way of assessing a company’s performance.

Required:
i) Describe two uses of accounting ratios other than performance assessment. (2 marks)
ii) Explain three limitations of the use of accounting ratios in the appraisal of financial performance. (3 marks)

i) Two uses of accounting ratios other than performance assessment:

  1. Assessing liquidity:
    • Ratios such as the current ratio and quick ratio help in evaluating the liquidity position of an entity, showing its ability to meet short-term obligations.
  2. Comparative analysis:
    • Ratios provide a means for comparing the financial performance of different entities, especially those in the same industry, making it easier to assess their relative financial strength.

ii) Three limitations of the use of accounting ratios in appraising financial performance:

  1. Inconsistent definitions:
    • Different companies might calculate ratios differently or use different accounting policies, leading to a lack of comparability between companies.
  2. Historical data:
    • Ratios are based on past financial information, which may not reflect the current or future financial condition of a company, especially in times of rapid market changes.
  3. Effect of inflation:
    • Ratios do not account for the effects of inflation, which can distort financial data, especially in industries with significant capital investment or high levels of inventory.
  • 3 Marks

: MA – May 2019 – L2 – Q1c – Transfer Pricing

Discuss the limitations of using negotiated transfer prices within a company.

When negotiated transfer prices are used in the company, the managers who are involved in the proposed transfer within the company meet to discuss the terms and conditions of the transfer. They may decide not to go through with the transfer, but if they do, they must agree to a transfer price.

Required:
Explain THREE (3) limitations of negotiated transfer prices. (3 marks)

Negotiated transfer prices suffer from the following limitations:

  • The transfer price which is the final outcome of negotiations may not be close to the transfer price that would be optimal for the organisation as a whole since it can be dependent on the negotiating skills and bargaining powers of individual managers.
  • They can lead to conflict between divisions which may necessitate the intervention of top management to mediate.
  • The measure of divisional profitability can be dependent on the negotiating skills of managers who may have unequal bargaining power.
  • They can be time-consuming for the managers involved, particularly where large numbers of transactions are involved.

(Any 3 points for 3 marks)

  • 6 Marks

MA – April 2022 – L2 – Q1b – Divisional performance

Discuss the impact of involving managers in financial target setting and the disadvantages of using financial indicators alone for performance assessment.

The manager of the fitness club in Papase is dissatisfied with the quarterly bonus system and does not perceive it to be fair. He argues that the financial targets are based on a regional view of all Gyakie fitness clubs and do not take account of specific local circumstances. For instance, the fitness club in Papase is located in a less affluent area of the region. Managers also complain about using solely financial indicators in setting targets. The manager of the fitness club in Papase would like to see participation from all fitness club managers in the development of quarterly financial and non-financial targets.

Required:

i) Discuss the potential impact on Gyakie for involving the fitness club managers in the preparation of their quarterly financial targets. (3 marks)

ii) Explain THREE (3) disadvantages of using financial performance indicators alone to assess performance. (3 marks)

i) Impact of Manager Involvement:

The managers’ involvement with setting the quarterly financial target could mean that the target will be more accurate and realistic. This is because the managers will be close to the operations of the fitness clubs and will be able to use their specialist knowledge to advise on regional variations to targets. For example, a national assumption of an increase of 10% in average revenue per customer may not be appropriate for the fitness club at Papase and should not automatically be factored into target setting. This involvement of managers could result in more accurate forecast information that can be used by the finance team in devising the financial targets. However, it is possible that the input of the managers may result in unrealistic financial targets. The managers may attempt to influence the targets to attain a bonus more easily. The fitness club managers may also not have an overall picture of the fitness club market or Gyakie’s strategic outlook.

ii) Disadvantages of Using Financial Indicators Alone:

  • Short-termism: Linking rewards to financial performance may tempt managers to make decisions that will improve short-term financial performance but may have a negative impact on long-term profitability. For example, a manager may decide to delay investment in order to boost the short-term profits of their division.
  • Internal Focus: Financial performance measures tend to have an internal focus. In order to compete successfully, it is important that external factors (such as customer satisfaction and competitors’ actions) are also considered.
  • Manipulation of Results: In order to achieve target financial performance (and hence their reward), managers may be tempted to manipulate results. For example, the recording of the costs incurred in the current year may be deferred to the next year’s accounts in order to improve current year performance.
  • 5 Marks

FM – April 2022 – L2 – Q4a – Introduction to Investment Appraisal

Explain the limitations of using the Payback period method in investment appraisals.

In investment appraisal, many methods are available for use by finance and project professionals. One of these methods is the Payback period, but stakeholders have often raised questions on the usefulness of this method due to a number of limitations inherent in the use of the method.

Required:
Explain FOUR (4) limitations of using the Payback period method in investment appraisals. (5 marks)

The limitations of using the Payback period method in investment appraisals include:

  1. Ignores the time value of money: The Payback period method does not consider the time value of money, which means it treats all cash flows as if they occur at the same time. This can lead to misleading conclusions about the value of future cash flows.
  2. Does not measure profitability: The method focuses only on how quickly an investment can recoup its initial cost, without considering the overall profitability of the project. Projects that generate higher returns in the long run may be overlooked if they have a longer payback period.
  3. Arbitrary choice of period: The decision on what constitutes an acceptable payback period is often arbitrary and may not align with the strategic objectives of the company or the economic realities of the project.
  4. Ignores cash flows after the payback period: The method does not take into account any cash flows that occur after the payback period. As a result, it may favor projects with quick returns but lower total returns, ignoring projects that could be more profitable in the long term.

(Marks allocation: 4 points @ 1.25 marks each = 5 marks)

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