Question

How is net income overstated or understated determined? Can someone explain with an example please.

Answer 1

Understatement of income refers to showing the income less than the actuals, it is made to avoid taxes and payment of the dividend or less distrubution of profits. On the other hand overstatement of income refers to showing more profit than actuals referred as window dressing in accounting term. It is made to obtain loan, or showing more lucurative than actuals.

The Basic and the foremost adjustment to determine the over or understatement of profit is done in stocks, here if there is a overstatement of the opening stock, socost of goods sold will be overstated and thus income will be understateds. Further if there is understatement of opening stock then COGS will be understated and thus the net income will be over stated. For Example : Let Opening stock =$ 1000 , Purchases = $ 2000 and closing = $ 500 , sales = $ 4000 , so COGS = Opening + purchase - closing = $ 1000 + 2000 -500 = $ 2500.

So Profit = Sales - COGS = $ 4000 - 2500 = $ 1500.

Now if the opening stock is over stated then , the COGS is also overstated and if COGS is over stated then Profit will be understated as to get profit , COGS is reduced from the sales.

I.e In above case, let opening stock is over stated by $500 , so COGS is overstated by $ 500 , so Net profit is understated by $500 as the COGS is reduced more by $500 from the sales.

In Same Way in case of closing stock, if it is overstated then Net profit will also be overstated as COGS is understated. the above example, $500 is reduced from COGS if it becomes $1000 , i.e overstated by $500 then the COGS will be less and the Profit will rise.

To Explain Further :  Net income for an accounting period depends directly on the valuation of ending inventory. This relationship involves three items:

A) As discussed above the company must be sure that it has properly valued its ending inventory. If the ending inventory is overstated, cost of goods sold is understated, resulting in an overstatement of gross margin and net income. Also, overstatement of ending inventory causes current assets, total assets, and retained earnings to be overstated.

B)  when a company misstates its ending inventory in the current year, the company carries forward that misstatement into the next year. This misstatement occurs because the ending inventory amount of the current year is the beginning inventory amount for the next year.

C) Further an error in one period’s ending inventory automatically causes an error in net income in the opposite direction in the next period