An understated balance sheet does not always mean unrecorded debt and fraud. While one of the most common balance sheet understatements that auditors are searching for is unrecorded debt, there are other frequent areas of concern in the assets, liabilities and equity sections of the balance sheet where understatement could occur.
The textbook example of an understated balance sheet involves a company committing financial statement fraud by neglecting to record loans to the company in the accounting records, thus understating liabilities, and usually, assets as the offset. It is important to note that this is not the only way that liabilities can be understated. Errors in valuation of estimates, forgotten accruals, and improperly recorded deferred revenue arrangements can also cause liabilities to be under-recorded and the balance sheet to be understated.
By accelerating deprecation on fixed assets, asset values are prematurely decreased and the balance sheet becomes understated. This is sometimes an issue in smaller companies, as under tax laws, many small businesses are entitled to accelerated deprecation of business assets. However, if the company is stating that the financial statements are prepared in accordance with generally accepted accounting principles, then these methods are not allowed for book purposes. In this case, the company may wish to consider tax-basis financial statements or keeping separate GAAP and tax books.
Misclassification of Assets
Any time that an asset is incorrectly classified as an expense, assets and equity are both understated on the balance sheet. While usually auditors are concerned with the incorrect classification of expenses as assets, both mistakes can be important. This situation can arise if the company has determined a threshold for capitalization that is excessively high. For example, let's say a company has determined that only purchases greater than $10,000 should be recorded as assets and purchases less than $10,000 should be expensed as incidental costs. If $5,000 is material to the company, then purchases that fall in between $5,000 and $10,000 will be misclassified.
Errors in Equity Recording
By recording stock sales purely at par, and not at cost, a company's equity balance can be understated. In many cases, common stock is held at a nominal par value and the price paid over par is recorded as additional paid-in capital (APIC). If a company incorrectly accounts for this transaction and does not book the APIC entry, the company's equity balance will be understated and the company's balance sheet may not balance.