The level of real income of a firm can be distorted by the reporting of depreciation and interest expense. During periods of low inflation, the level of reported depreciation tends to ________ income, and the level of interest expense reported tends to ________ income.
A) understate; overstate
B) understate; understate
C) overstate; understate
D) overstate; overstate

Question

Quizplus · Accepted Answer

During periods of low inflation, the reported depreciation tends to overstate the true economic depreciation as the actual replacement cost of the assets may be lower than the historical cost of the assets. On the other hand, the reported interest expense tends to understate the true economic interest expense as the nominal interest rate may be lower than the real interest rate, which accounts for inflation. Therefore, both factors tend to distort the level of real income reported by a firm, with depreciation understating it and interest expense overstating it.

The Level of Real Income of a Firm Can Be