Understated vs Overstated accounting

Understated vs Overstated accounting is a scenario in which financial records reflect false information.

The Primary Purpose of accounting is to record transactions so as to reflect the true and fair picture of profits, assets, debts, and capital. However, the terms Overstatement and Understatement mean defeating the objectives of record keeping.

Understatement

Understatement refers to a recording of a lower value than the actual transaction amount.

• Eliminate recording of any expenses. This understatement is most often occurs with operating expenses to reflect higher operating profits
• Purposeful failure to record the disposals of assets
• Not recording depreciation or amortization relating to the non-current assets

Overstatement

Overstatement refers to recording the value of a transaction as higher than its actual. Some of the common Overstatements are

• Inflating the revenue balances
• Recording Fictitious gain through the sale of non-current assets.
• Exaggerating the value of assets such as Investments, Fixed assets like Land, etc.

Either of these acts turns out to be detrimental to the financial health of the business. These are temporary amenities that result in the window dressing of the financial records.

What’s the reason for Understatement or Overstatement?

Good Financial position implies successful business and increased market value of the shares. This improves the brand value and reputation and increases credit ratings.

Often, the compensation and perks of top management correlate with financial performance, so these methods are used.

For instance, a CEO’s compensation arrangements read like this: The CEO receives 5% of the increased sales compared with the prior year as a bonus.

Financial Frauds: We know financial frauds happen worldwide at companies like Enron (2001), WorldCom (2002), Satyam (2009), Tyco International (2002), etc. These are some of the examples. Generally, these financial frauds begin on a small scale, are not intended for long duration, and often involve relatively lower amounts of money. The Fraudsters scale the fraud models because of the financial perks from them.

How do I find the Understated vs Overstated accounting errors?

Overstatement and Understatement errors are found by finding risk points and establishing good internal checks and controls.

Internal audits and inspections will help to uncover these errors to a great extent. There is a need to introduce an element of surprise into these audits.

Further, these errors often follow a pattern, such as recording a fixed amount of transactions on a periodical basis, targeting a specific general ledger account, and involving management override of controls.

What are the consequences of detecting such errors?

These errors seem rewarding at times. However, inappropriate financial health isn’t sustained in the long run, and these errors result in a loss of public faith and confidence in the business.

These Frauds might invite government sanctions and increase the regulatory watch. It might even attract huge penalties. Frequently, there can be personal actions. For instance, if these errors pertain to the individual interests of top management, then the actions go beyond the corporate bodies and pass rulings against the board of directors or chief operating officers. It can lead to disqualifying those individuals from taking any positions in the corporates.

Thus, the consequences are detrimental to the interests of the company.

How to correct understatement and overstatement errors?

We can correct the overstatement and understatement by adjusting for the transactions which are unrecorded or inflated. In other words, it’s as simple as registering a transaction that’s reverse as the original one. For instance, we can correct the fictitious revenue transactions by reversing those. The rectification of these errors should not cease at that point. The subsequent steps involve:

• Focusing on understanding the fundamental reasons for happening of such frauds and fixing those gaps by implementing robust internal controls.
• Imparting training to employees.
• Conducting independence checks and devising solid integrity policies.

But the best way is to avoid these errors from happening.

Questions Corner

What does understate mean in accounts?

The word understatement in accounts refers to the practice of recording a transaction at a lower value than its true worth. For instance, an entity might avoid disclosing legal expenses incurred in a lawsuit to prevent revealing an adverse outcome.

What is an overstatement of income?

Overstatement of Income is increasing the income balance by recording fictitious sales transactions. These overstatements are intentional and carefully laid out so that they don’t get attention and go unnoticed.

For instance, the fictitious sales recorded towards the end of the period are reversed as bad debts. The quantitative value doesn’t pose to be significant at the individual transaction level.

What is the understatement of liabilities?

Understatement of Liabilities means either not recording or partially recording the liability transactions within the accounting books. Every fraud entails a financial incentive, such as an increase in market prices, brand value, improved credit ratings, etc.

Can we ignore the overstated vs understated accounting?

Overstatement or understatement is damaging to the business stakeholders. Either of these approaches results in false business records.

Investors, creditors, banks, and financial institutions rely on these financial records as inputs in making various decisions. These hurt the business’s standing and goodwill.

Key Takeaways

Overstatement and Understatement are the different ways of falsifying business records to present improvised financial health. The primary motive is economic incentives. The word overstatement means recording transactions over and above their actual worth or documenting unreal transactions, whereas understatement means quite the opposite. Understatement results in either not recording or partially recording the transactions, such as losses, expenses, and liabilities.

The entity needs to understand the risks and mitigate those by devising strong checkpoints. Fraudsters keep evolving and discovering new ways to window-dress their financial position. So, frequent audits and internal inspections should be conducted to keep an eye on these malpractices.