What Is Understated in Accounting?
Financial statements are very useful to users, but they are sometimes not fully accurate. Accountants generally use historical costing for a lot of the accounts, which creates a uniform way of doing accounting and understanding these statements. However, this strategy also creates the understatement of certain assets on the balance sheet.
Other People Are Reading
-
Historical Costing
-
To figure out what accounts are undervalued, you must first understand which accounts are accounted for using historical costs. An account such as cash is presented at fair market value, so it will not be undervalued. Other accounts, such as inventory, goodwill, trademarks, and property, plant and equipment, have a good potential to be understated. Liabilities are almost always fairly reported because there is a lot less judgment involved in valuing them. They are all based on what the company's obligation is to its creditor, which is pretty concrete.
Land
-
The value of land on a balance sheet doesn't change, so if land was bought a number of years ago, it will probably be understated in accounting. If a company bought land 100 years ago at a cost of $1 million and still owns it, the cost of the land on the books will still be $1 million. The company cannot increase the value of the land because that is not allowed under generally accepted accounting principles (GAAP). The land that was bought 100 years ago will most likely cost a lot more today than it did back then because of a few factors, one of which is inflation.
-
Equity Investments
-
Equity stakes are accounted for on the balance sheet using three factors: the initial investment, the stake's net income and the stake's dividends. First, the initial investment is recorded on the balance sheet at cost. Then, the owner's portion of the investment's net income is added on to the investment. Finally, if any dividends are paid out, that decreases the investment account by the portion of the owner's dividends. This accounting process leads to that account being understated often. For example, Company A purchases a $1 million stake of Company B. Company B has a windfall of profits and pays out a $1 million dividend to Company A. The value of the investment on Company's A balance sheet is now zero even though Company A still has a claim on Company B's assets and future income.
Brand Value
-
Under GAAP, a company cannot record the value of its brand on the balance sheet. Therefore, the brand value of the company is understated and not accounted for using traditional accounting principles. Some analysts use a third party's estimate of brand value to add to a company's value, but these are estimates and so not that accurate.
-
References
- Photo Credit Jupiterimages/BananaStock/Getty Images
