Suggest one (1) consequence of improperly classifying an account type (e.g., if an expense is classified...

Suggest one (1) consequence of improperly classifying an account type (e.g., if an expense is classified as an asset or an asset is classified as an expense). Describe the effect on at least two (2) of the four (4) major financial statements: Profit & Loss (Income) Statement, Statement of Retained Earnings, Balance Sheet, and Statement of Cash Flow.

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Expert Solution

Consequence: The feature of an asset is it is not recurring in nature and it gives benefit for long time. The feature of an expense is it is recurring in nature and it gives short-term benefits. Therefore, assets and expenses are not equal and should be classified differently – assets should be recorded in balance sheet; expenses should be recorded in income statement. If such classification is improper, the financial statements do not provide true and fair picture which ultimately hampers the interest of stakeholders.

Effect: Suppose an asset of $2,000,000 is purchased in X1 year. Since it will be in operation for long time, it must be recorded in the balance sheet; but unfortunately it is recorded in the income statement of X1 year which brings net income to a net loss; [Net income = Total revenues – Total expenses]; if it is recorded correctly, there should not be any loss. Getting loss means the company is losing market value, share price decreases, dividends can’t be offered, and shareholders do not get worth of their shares. This thing creates a weak balance sheet, since the amount of total assets drops which increases asset turnover ratio unethically; and stockholders’ equity drops because of decreasing retained earnings.

ekkarill92 answered 1 year ago

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