“Overstated” and “understated” are two words an accountant uses to comment on entries in accounts. Specifically, they both mean that the figure the comment refers to is incorrect. If something is overstated in the accounts then the real amount is less. Understated figures record a lower amount than the actual value.
Accountants use such terms as “overstated” and “understated” as part of an official formula which borders between trade terms and diplomacy. Usually, figures in a company’s accounts take account of probable events. For example, a company may decide to make provision against unpaid invoices to protect against the possibility of them not being paid and turning into bad debts. If, at a later stage, many of these unpaid invoices get paid, then the accountant would comment that the figure for bad debts in the previous period was overstated, and that income was understated, because it turned out to be better than expected.
Accountants often have to make judgment calls on many aspects of a company’s accounts, particularly concerning provisions for bad debts, pensions, or replacement of equipment. The guiding principle in these matters is that the accountant should err on the side of prudence. That means “assume the worst.” Assuming bad things will happen always causes provision to be overstated and thus profit to be understated.
Some businesses use a method of income smoothing which manipulates the way the events in the business are reported. The purpose of this is to shift some costs into good years, to enable the company to survive during bad years. Businesses that experience an exceptional sale in one year, which they won’t expect to happen again, might load payments into that financial year to reduce the increase in profit during that year and spread some of its benefits to other years. An example of this might be that the company may decide to write off all of its investment in older machinery and renew all their equipment while they have the money. The exceptional event that caused the peak in income would be a non-operational gain, like the sale of a property for more than its recorded value.
Cookie jar accounting
The technique of intentionally overstating and understating elements in the accounts is called “cookie jar accounting.” It deliberately overstates costs in good years and understates them in bad years, resulting in an actual overstatement of profit in the bad years and an understatement of profit in good years. Although these methods are deceitful, they are not illegal.