How to Figure Out What Is Going to Be Understated or Overstated in Accounting

Expense Errors

As a general rule of thumb, overstated expenses will understate net income and
understated expenses will overstate income. Expenses often are accrued and deferred,
which complicates matters. If an expense is accrued when it didn't need to be, it understates
income. For example, if the accountant accrues interest expense at the end of the year and
it turns out the interest expense doesn't need to be paid, net income is understated.
Likewise, expenses that are deferred unnecessarily overstate net income.

Revenue Errors

If revenues are overstated, so is net income and vice versa. However, accountants
must keep a close eye on errors regarding deferred and accrued revenue. Deferred revenue
occurs when a company receives cash for a product or service that they haven't delivered
yet. If the accountant unnecessarily defers revenue, it understates net income. Accrued
revenue means the company has earned the revenue but hasn't received the cash yet. If
accrued revenue is recorded unnecessarily, net income is overstated.

Inventory Errors

Errors surrounding inventory balance affect the cost of goods sold account and net
income. An accountant calculates cost of goods sold by adding inventory purchases and
subtracting the ending inventory balance from the beginning inventory balance. If the value
of ending inventory is overstated, that means the cost of goods sold is understated and net
income is overstated. The opposite effect occurs for errors in the beginning balance of
inventory; overstating beginning inventory means the cost of goods sold is overstated and
net income is understated.

Effect on Equity

Income statement errors don't necessarily affect assets and liabilities, but they do
affect equity. At the end of the accounting period, the accountant closes out net income to
retained earnings. Retained earnings represents the earnings and equity the company has
accumulated. If net income is overstated for the period, retained earnings also will be
overstated and vice versa.