What Does Understatement Mean in Accounting?

by Chris Hamilton, Demand Media

An understatement in accounting refers to business assets given a valuation lower than their fair market value or a devaluation of liabilities to less than their actual cost. Either results in an inaccurate measurement of a business' financial position. This can cause the owner to make improper business investments and change his tax liabilities. Although understatement commonly takes place on balance sheets, the effects of erroneous accounting will affect the income, cash-flow and owner's equity statements of a small business.


Small-business assets include cash, inventory, accounts receivable, prepaid expenses, property and equipment. Liabilities include accounts payable, income taxes, lease obligations, and short and long-term debt. Because assets equal total liabilities plus the owner's equity on a balance sheet, an understatement of liabilities will increase assets and owner's equity. This may make the business' financial position seem stronger than it is. An understatement of assets will lower profits, making the business seem weaker than it is. Understatements would have the same effect on an income statement. On a cash-flow statement, an understatement of liabilities would increase cash flow, and an understatement of assets would decrease cash flow.


Small businesses usually experience an understatement because of accounting errors, such as miscalculating the value of inventory or incorrectly totaling sales. Small-business owners should use a double entry bookkeeping system to make sure assets and liabilities match. They should use financial software to prevent errors in calculations. Small business owners should ideally hire a professional accountant to handle their books to provide them with a shield from liability because of accounting errors.


Some businesses owners may fraudulently make understatements of liabilities on their balance sheets to show more profits to investors. They may understate their assets to lower their federal and state taxable income. Business owners who use this method will usually keep two sets of books, one for official purposes and the other to keep track of their actual finances.


Small-business owners may be tempted to adjust their income and expenses on Internal Revenue Service Form 1040, Schedule C, which will lower their liability for income and self-employment taxes. However, the IRS and state governments conduct audits of small businesses, and these agencies may find irregularities in accounting statements. Business owners who deliberately understate their assets may face criminal prosecution and will pay interest on all tax owed.

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