Chapter 14, Problem 1RQ

If a corporation overstates its earnings, are its liabilities more likely to be overstated or understated? Explain.

To determine

Explain whether the overstatement of the income would result in the overstated liabilities or understated liabilities.

Explanation of Solution

Overstatement:

It refers to the situation where the amount of any item has been stated more than its actual figure. Overstated revenue results in an overstatement of profits. Similarly, overstated liability results in understating of shareholders’ equity.

Understatement:

It refers to the situation where the amount of any item has been stated less than its actual figure. Understated revenue results in an understatement of profits. The understated liability results in overstating of shareholders’ equity.

Explain whether the overstatement of the income would result in the overstated liabilities or understated liabilities:

Overstatement of the income would result in the understated liabilities. When the income of the company has increased then the shareholder’s fund would result in the overstated. The overstated shareholder fund would result in the understated of other liabilities in order to balance the liability side. When the profit earns for the company, then the resulted profit would decrease the overall balance of the liabilities. So there is an inverse relationship between the profit balance and the liabilities balance of the business.

Thus, the overstatement of income would lead to understated liabilities.