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Unformatted text preview: CHAPTER 14 Accounts Payable and Other Liabilities Review Questions 14-1 Overstated earnings are associated with understated liabilities. To overstate earnings causes an overstatement of owners' equity. An overstatement of owners' equity must be accompanied by an understatement of liabilities or an overstatement of assets—otherwise the balance sheet totals would not be in agreement. As a specific example, a year-end cutoff error could cause an incoming shipment of merchandise on December 31 to be included in inventory but not to be recorded as a liability. The result would be overstated earnings and owners' equity offset by understated liabilities. In more general terms we can say that many transactions involve debits to expense accounts and credits to liability accounts. If such a transaction is not recorded at all, the earnings will be overstated and the liabilities understated. 14-2 The correct answer is (c)—overstatement of owners' equity. Lawsuits against CPA firms alleging negligence by the auditors leading to losses by stockholders or creditors almost always involve an overstatement of owners' equity accompanied by an overstatement of assets or understatement of liabilities or both. Thus, the financial statements give a misleading picture of health and solvency, and persons who contribute capital to the business sustain losses because of their reliance upon overly optimistic financial statements. 14-3 The employee who seeks to conceal fraud by deliberately omitting the recording of a large transaction would choose a transaction creating a liability rather than one creating an asset. The prior theft of assets by the employee means that total assets on hand are less than the total of liabilities and owners' equity. Failure to record a transaction that creates a liability of the same dollar amount as the theft would cause total assets to equal total recorded liabilities plus owners' equity. The understatement of liabilities conceals the shortage of assets resulting from the theft. 14-4 Adjustments proposed by the independent auditors more often than not have the effect of reducing recorded earnings for the following reasons. First, management is normally under some degree of pressure to report higher earnings. Earnings improvement pleases stockholders, reassures creditors, facilitates financing, and permits larger bonuses and other compensation. Consequently, management has an incentive to interpret every transaction in the most favorable light. There is a tendency to minimize bad news, and to postpone recognition of losses. The auditors may need to make downward adjustments in earnings and owners' equity to offset this optimistic bias on the part of management. A second reason is that the legal liability of auditors arises from overstatement of earnings, owners' equity, and assets, and understatement of liabilities. Lawsuits against CPA firms almost never arise because of understated earnings....
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This note was uploaded on 11/09/2010 for the course BUS 651 taught by Professor Shastr during the Spring '10 term at University of Louisville.
- Spring '10