Question

What are the implications if expenses are understated and net income is overstated? Would decisions made by internal and external users be skewed?

Answer 1

What are the implications if expenses are understated and net income is overstated? Would decisions made by internal and external users be skewed?

Answer:

Implication of understated and net income is overstated:

This would have financial and regulatory impacts in financial statement. So the question would be what kind of financial impacts can happen-

a) Expense understated directly impacts the net income presented

b) Understatement of expense would lead to understatement of liability as well. Understatement of liability would mean that the Company is not presenting the actual cash outflow that has already accrued. Hence reflecting distorted net asset position of the Company

c) The cashflow statement is prepared to reflect the cash and cash equivalent position of a Company and would show the liquidity condition of the Company. By understating the expense the whole purpose of Cash flow statement would be defeated

d) The ratio which are based on net income and liability would reflect a wrong figure. The Company's ratios provide a lot of information of the Company's financial position. By understating the expense, these ratio will give a wrong picture and can be deceiving

e) A lot of time the Company's debt have financial covenants which needs to be maintain inorder to continue the borrowing arrangement with the lender. By understating the expense, the Company or the lender will not be able to access if it is meeting the financial covenants in the borrowing arrangement. The lender can recall the entire borrowing if it finds the Company tampering with the financial statement by understating the expenses.

f) The earnings per share of the Company will be reflected erroneous giving a distorted picture to the reader of financial statement

Regulatory impacts could be:

a) Since expense are understated and net income is higher, the tax liability would be higher than actual tax liability and the Company would be in a disadvantage position. It would not be able to gain tax benefit for the expenses made by it. The Company would make more cash outflow than it is actually requried to do.

b) Understatement of expense can raise internal control issues in the Company. There could be questions raised on the corporate governance, accountability and realiablity of the financial statement and the Company.

c) The regulatory bodies would investigate the matter as and when it comes to their notice. This would lead the Company to get into regulatory investigation and would have to provide various explanations and documents to the various bodies

d) The auditors may qualify the report on the amount being material or on the intention for understating the expense.

e) The understatement of expense can be treated as a fraud committed by the Company and would attract fraud audit, loss of Company's reputation, criminal case against the management and the Company.

f) There could also be financial sanctions levied on the Company for understatement of expenses.

g) The Company may end up paying higher dividend that permitted by the statutory laws resulting in penalties

Would decisions made by internal and external users be skewed?

Yes the decisions would be skewed. The internal and external user and their skewed decision can be:

a) Investor: The investor would rely of figures like EPS, ratios, net income, balance sheet position, cash flow condition to make investment or to continue their expectation. Further, the also compare the position with the competitors. Under statement of expense would present a better picture of the Company than it actually is. Maybe seeing the actual position of the Company an investor would not continue its invest but because of the wrong data it has or continued to invest.

b) Banker: The Banker would have given loan basis the financial statement. Its risk coverage would measured on this basis. Wrong financial statement and its related data would make them take wrong decision

c) Management of the Company: The management would have wrong picture about its position in comparison to its competitors, it would end up taking wrong decision for capital or other expenditures it may commit to seeing the financial position of its company. The management can end up declaring higher dividend and employee bonus etc then it should.

d) Regulators: The regulators rely a lot on the financial position like tax liability, stock exchange regulators for monitoring share price fluctuations etc.

e) Analyst: The analyst would provide credit ratings to the company basis the financial position and that of its competitors. The investment analysis made by them basis the financial position of the Company would also be distorted.