Which one of the following errors causes an overstatement of net income?

Question

BlackTom AI · Accepted Answer

To tackle the question, I will examine how each potential error affects net income and determine which one would lead to an overstatement.
Option 1: 'Failure to accrue revenue earned but not billed' — If revenue is earned but not billed and not accrued, that understates revenue and net income for the period. This error reduces both revenue and gross income, leading to an understatement of net income, not an overstatement.
Option 2: 'Failure to record collection of an account receivable' — Omitting the receipt of cash from customers leaves both assets (cash) and liabilities or equity unaffected in a way that could misstate cash flow, but not necessarily net income. In accrual accounting, recording the collection of an AR does not affect revenue or expenses at the time of cash collection; the revenue was recognized when earned. Therefore, failing to record the collection does not create an overstatement of net income; it may affect the balance sheet and cash flows, but not the income figure directly.
Option 3: 'Failure to record depreciation expense' — Depreciation is an expense recognized to allocate the cost of long-term assets over their useful life. Not recording depreciation expense understates expenses, which increases net income for the period beyond what it should be, i.e., it overstates net income. This is a classic error that inflates profitability because the wearing down of assets is not matched with revenue, violating the matching principle.
Option 4: 'Failure to record a portion of fees received in advance that is earned by year-end' — When fees are received in advance (deferred revenue) but not yet earned, recognizing revenue early would overstate net income, whereas here the scenario states only a portion that is earned by year-end is not recorded as revenue. If revenue earned is not recorded, net income would be understated for the portion earned. Therefore, failing to recognize earned revenue from advance payments would understate net income for the period rather than overstate it.
In summary, the key idea is that overstatement of net income occurs when expenses are understated or revenues are overstated. Among the options, failing to record depreciation expense directly reduces reported expenses, thereby inflating net income, making it the error that causes an overstatement. The other options either do not affect net income in the direction of overstatement or (in the case of unrecorded earned revenue from advances) would tend to understate net income or be neutral depending on timing. Therefore, the most plausible choice for causing an overstatement of net income is the failure to record depreciation expense.

Which one of the following errors causes an overstatement of net income?

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