An understatement is an expression that indicates something of significantly less severity or power than should reasonably be represented. For example, if someone's business goes under, forcing an owner to declare bankruptcy, it would be reasonable for that person to say something like, "This is a disaster;" an understatement might be, "We are having some minor difficulties." This type of expression is commonly used for comedy, in which it is considered a form of irony, though it should not be confused with the use of euphemisms.
There are a few different reasons for someone using an understatement, though it is frequently used to diffuse a potentially tense or stressful situation. Pilots controlling planes that have undergone serious technical malfunctions, for example, have often been heard making comments to other crew and passengers that severely understate the possibly catastrophic outcome of the situation. In this scenario, the pilot is able to remain calm, and can try to keep others from panicking, allowing events to unfold in a more constrained manner. This type of understatement serves a very real function, as the mood of the person in control can influence the reactions of others in a stressful event.
Understatement can also be used for comedic effect, typically as a form of irony. In general, irony refers to an event that occurs, which is the opposite of or highly unlike what is expected. An understatement is a comment that severely underplays the seriousness or traumatic nature of an event, and so it is unlike the expected response. In a film or television show, the heroes may find themselves surrounded by enemies in a situation that seems hopeless, at which point one might remark, "Well, we're in a bit of trouble." This is intended as a comedic line, since it downplays the situation in which they find themselves.
Although somewhat similar in structure, an understatement should not be confused with a euphemism. Euphemisms are typically used to offset a comment that might be considered rude or overly familiar, allowing someone to broach an uncomfortable subject in a way that retains politeness or formality. An understatement can certainly be used to not seem argumentative, but it does so by downplaying the nature of a situation. Euphemisms typically use a particular phrase or unrelated concept to convey a potentially sensitive meaning; an expression like "passed away" is often used instead of "dying" when talking to someone about a recently deceased relative.