Unlike wage-earning individuals, companies don’t count all of their revenue as earnings. When reporting its earnings, a business is able to subtract out expenses and cost of goods to arrive at the actual profit it made. The final earnings that a company reports form the basis for the amount of tax it must pay, and it provides potential investors with valuable information about the health of the company. A company might accidentally overstate earnings because of an accounting mistake or by fraudulently preparing its financial statements.
Financial statements for firms operating in the United States are prepared according to the accrual method, which recognizes transactions when they impact the company. Sometimes a customer will pay for a product before receiving it. Although the company has received the cash, no transaction has taken place and the company must be able to return the payment should the customer change her mind. Once the customer receives the product and the transaction is complete, the payment stops being a liability and must be recorded as revenue. Recording payments for services not rendered will overstate earnings.
When a customer or client does not pay for a product when it's provided, the purchase is made on account. The company reports this by making an entry to the appropriate revenue and receivable accounts. When the customer or client makes payment, the company then adds the cash to its account and clears off the receivable. If a company fails to clear its receivables, it will overstate its earnings.
Since earnings are determined by subtracting out expenses, a company that understates its expenses will necessarily overstate its earnings. Understating expenses can occur in a number of ways, including poor document management that fails to track receipts for expenses. Fraudulent understating of expenses might involve collusion with service providers to falsify documents.
Capital assets with useful lives longer than one year, such as buildings and vehicles, must be amortized and depreciated over their lifespan rather than expensed when purchased -- though Section 179 of the Internal Revenue Code allows some capital assets to be expensed when purchased, subject to asset eligibility and deduction limits. Reporting and tax standards provide standard lifespans for common capital assets that companies must use for calculating depreciation. If a company uses a longer lifespan, it will record a lesser depreciation expense each year, causing expenses to be understated. Inadequate depreciation, then, results in overstated earnings.
While overstating expenses can help businesses raise money from investors and bolster performance-based compensation, companies end up paying higher taxes for these overstated earnings. A company can report different earnings on its tax filings than it does on its financial statements and avoid paying taxes on the overstated income, but then it must record the discrepancy and risk drawing extra attention to its earnings.
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