Understated

In accounting, understated describes a balance, a transaction or a disclosure recorded or reported below the amount that should have been recorded or reported. It names a direction rather than a cause: the reported figure is short, whether that came from an amount posted too low, an entry posted to the wrong side, or a transaction never recorded at all.

That direction sits inside a defined term. Under generally accepted auditing standards, a misstatement is a difference between the reported amount, classification, presentation or disclosure of a financial statement item and what the applicable financial reporting framework requires for that item to be presented fairly, and misstatements can arise from fraud or error (AU-C 450, Evaluation of Misstatements Identified During the Audit, .04). Understated names the half of that difference where the reported figure is the smaller one, and under that definition whether a given difference matters at all is a separate materiality judgment. Audits of issuers work from a closely parallel definition that folds materiality into it, where a misstatement, if material individually or in combination with other misstatements, causes the financial statements not to be presented fairly in conformity with the applicable financial reporting framework (PCAOB, AS 2810, Evaluating Audit Results, .A2).

Understated and Overstated

Overstated is the same measurement pointing the other way, with the reported figure above what the framework requires.

An understatement rarely stands alone. Because every entry has two sides, an omission leaves both of them wrong. An accrual never posted leaves the expense short and the liability short with it, while an amount posted to the wrong account leaves one account short and another long. Either way the subtotals move, and an expense left out of the period understates expenses and overstates pretax income by the same amount. The direction also decides which way an auditor tests, since understatement is the completeness question and overstatement the occurrence or existence question, a split worked through in vouching.

Correcting an Understated Account

An understated account is corrected by adding to it on the side its balance already sits on: a debit for an understated asset or expense, a credit for an understated liability, equity or revenue, following the normal balance rule set out in debit vs credit. The other side of the entry lands wherever the missing amount belonged.

Say a client’s December utility invoice, paid in January, was never accrued at the close.

December as recorded
  Utilities expense                     46,200
  Accrued liabilities                    8,500

Unrecorded December utility invoice      1,800

Correcting entry
  Debit   Utilities expense              1,800
  Credit  Accrued liabilities            1,800

December as corrected
  Utilities expense                     48,000
  Accrued liabilities                   10,300

Both accounts were short by the same amount, and one entry lifts each to where it belonged. Until it is posted, net income is overstated for the period.

Nothing in the totals flags this. A trial balance tests only that total debits equal total credits, so a transaction never recorded, or an understatement offset by an unrelated error of the same size, leaves both columns equal and the listing ties. Which errors a tie will never catch is set out in trial balance.

Understatement Is a Defined Amount in the Penalty Rules

In the accuracy-related penalty rules the word carries a measured definition rather than a described one. For purposes of the substantial understatement threshold, an understatement is the excess of the tax required to be shown on the return for the taxable year over the tax imposed which is shown on the return, reduced by any rebate (26 U.S.C. 6662(d)(2)(A)).

It becomes a substantial understatement of income tax once it exceeds the greater of 10 percent of the tax required to be shown on the return for the taxable year, or $5,000, and a taxpayer claiming the section 199A deduction is measured against 5 percent in place of that 10 percent (26 U.S.C. 6662(d)(1)). Corporations other than S corporations and personal holding companies are measured on their own thresholds in the same paragraph. What the accuracy-related penalty then costs is worked through in an audit without receipts.

So a short ledger account and an understatement under that section measure different things. One compares an account to what the reporting framework requires, the other compares the tax shown on a return to the tax required to be shown.

Common Questions

Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own closing work through a trial task and have its own reviewer read what comes back.