SUBJECT: Accounting 20 NC

Descriptive Title: Operation Auditing

Instructor: Alfredo R. Cabiso

LESSON NO. 2– Correction of Errors

Page Learning
|1 Objectives:
The students should be able to:
 Define error.
 Enumerate and describe th different types of errors.
 Identify the effects of errors in the accounts presented in the financial statements.
 Prepare adjusting journal entries to correct errors.

Errors
According to Philippine Standards on Auditing No. 240, error refers to unintentional
misstatement in financial statements including the omission of an amount or a disclosure,
including:
1. A mistake in gathering or processing data from which financial statements are prepared;
2. An incorrect accounting estimate arising from oversight or misinterpretation of facts;
3. A mistake in the application of accounting principles relating to measurement,
recognition, classification, presentation or disclosure.

Fraud
Fraud refers to the intentional act by one or more individuals among management, those
charged with governance, employee, or third parties, involving the use of deception to obtain an
unjust or illegal advantage

Prior Period Errors

Prior period errors are omissions from, and misstatements in, the entity’s financial statements
for one or more periods arising from a failure to use or misuse of reliable information that:
(a) was available when financial statements for those periods were authorized for issue; and
(b) could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements.

Such errors include the effects of mathematical mistakes, mistakes in applysing accounting
policies, oversights or misinterpretation of facts, and frau.

Accounting treatment of Prior Period Error

According to PAS 8 par 42, an entity shall correct prior period errors retrospectively in the first
set of financial statements authorized for issue after their discovery by:
a) restating the comparative amounts for the prior period(s) presented in which the error
occurred; or
b) if the error occurred before the earliest prior period presented, restating the opening
balances of assets, liabilities and equity for the earliest prior period presented

Basic concepts in correction of Errors

Errors affecting net income Effect in the net Relationship

income
If sales are overstated Overstated direct
If cost of sales is overstated understated inverse
If expenses are overstated Understated inverse

Errors affecting cost of sales Effect in cost of Relationship

sales
If beg. inventories are overstated overstated direct
If net purchases are overstated Overstated Direct
If ending inventories are Understated inverse
overstated
 Errors affecting working capital Effect in working Relationship
capital
If the current assets are overstated direct
overstated
If the current liabilities are Understated inverse
overstated

Page | 2
Types of Errors
1. Balance sheet or statement of financial position errors
2. Income statement errors
3. Combined statement of financial position and income statement errors
a. counterbalancing errors
b. non-counterbalancing errors

Balance sheet or statement of financial position errors

BS or SFP errors affect only the presentation of an asset, liability, or stockholders’ equity account

When the error is discovered in the error year, the company reclassifies the item to its proper position

If the error in a prior year is discovered in a subsequent period, the company should restate the SFP of
the prior year for comparative purposes.

Income statement errors

IS errors are errors affecting only the income statement accounts and may include improper
classification of revenue or expenses.

A company must make a reclassification entry when it discovers the error in the error year

If the error discovered pertains to a prior year, the company should restate the income statement of the
prior year for comparative purposes.

Combined statement of financial position and income statement errors

Errors affecting both the statement of financial position and income statement can be classified as:
1. Counterbalancing errors and
2. Non-counterbalancing errors

Counterbalancing errors
Counterbalancing errors are errors that will offset or be corrected over two accounting periods
Examples include the following:
Omissions of the following
1. Deferred expense (or prepayments under the expense method)
2. Deferred income (precollection underthe revenue method)
3. accrued expenses
4. accrued revenues

Overstatement or understatement of the following:

5. Sales not recorded in the first year and subsequently recorded the following year (or vice versa)
6. purchases not recorded in the first year and subsequently recorded the following year (or vice versa)
7. Error affecting ending inventory
 Non-counterbalancing errors
Non-counterbalancing errors do not offset in the next accounting period. Therefore, companies must
make correcting entries, even if they have closed the books.

Examples:
Page 1.
| 3Prepayments under the asset method
2. Precollection under the liability method
3. Error in recording depreciation
4. Improper capitalization of expense
5. Improper expensing of capital expenditures
6. Error in recording of proceeds of sale of an asset (e.g. PPE) as other income

Prepayments under the asset method

Example: The company paid one-year insurance premium of P12,000 effective April 1, 2020. The entire
amount was debited to asset account and no adjustment was made at the end of 2020.
Effect of the error 2020 2021
1. Insurance expense Understated Understated
2. Prepaid insurance Overstated Overstated
3. net income Overstated Overstated
4. Retained earnings after closing Overstated Overstated
5. working capital at the end of the year Overstated Overstated

Adjusting entries:
2020 2021
Insurance expense - 9,000 Insurance expense – 3,000
Prepaid insurance 9,000 Retained Earnings - 9,000
Prepaid insurance -12,000

Precollection under the liability method

Example: The company leased a portion of its building for P12,000. The terms of the lease is one year
ending April 30, 2021. Collection of rent was credited to unearned rent revenue account. At the end of
2020, no entry was made to take up the earned portion of the amount collected.
Effect of the error 2020 2021
1. Rent revenue Understated Understated
2. Unearned rent revenue Overstated Overstated
3. net income Understated Understated
4. Retained earnings after closing Understated Understated
5. working capital at the end of the yr. Understated Understated

Adjusting entries:
2020 2021
Unearned rent income - 8,000 Unearned rent income – 12,000
Rent income 8,000 Rent income - 4,000
Retained earnings 8,000

Error in recording depreciation

Example: depreciation expense in 2020 was understated by P2,000
Effect of the error 2020 2021
1. Depreciation expense Understated No effect
2. Accumulated depreciation Understated Understated
3. net income Overstated No effect
4. Retained earnings after closing Overstated overstated

Adjusting entries:
2020 2021
Depreciation expense - 2,000 Retained earnings – 2,000
Accumulated depreciation 2,000 Accumulated depreciation- 2,000
 Improper capitalization of expense
Example: Repairs expense on the building amounting to P10,000 had been charged to the building
account on January 1, 2020. Depreciation expense has been recorded in 2020 and 2021 based on the 4-
year remaining useful life of the building.
Effect of the error 2020 2021
1. Repairs expense Understated No effect
Page |2.
4 Depreciation expense Overstated Overstated
3. Net income Overstated Understated
4. Retained earnings after closing Overstated Overstated
5. Building (net) Overstated Overstated
6. Accumulated depreciation Overstated overstated

Adjusting entries:
2020 2021
Repairs expense - 10,000 Retained earnings – 10,000
Building 10,000 Building - 10,000

Accumulated depreciation - 2,500 Accum. Depreciation 5,000

Depreciation expense 2,500 Retained earnings 2,500
Depreciation expense 2,500

Improper expensing of capital expenditures

Example: Major improvements on building amounting to P50,000 had been charged to repairs expense
on January 1, 2020. Improvements have a life of 4 years.
Effect of the error 2020 2021
1. Repairs expense Overstated No effect
2. Depreciation expense Understated Understated
3. Net income Understated Overstated
4. Retained earnings after closing Understated Understated
5. Accumulated depreciation Understated understated

Adjusting entries:
2020 2021
Building - 50,000 Building – 50,000
Repairs expense 50,000 Retained earnings - 50,000

Depreciation expense - 12,500 Depreciation expense 12,500

Accum. Depreciation 12,500 Retained earnings 12,500
Accum. Depreciation 25,000

Error in recording of proceeds of sale of an asset (e.g. PPE) as other income

Example: On January 1, 2020 an equipment costing P50,000 was sold for P30,000. At the date of sale,
the equipment had an accumulated depreciation of P15,000. The cash received was recorded as other
income in 2018.

Effect of the error 2020 2021

1. Other income Overstated No effect
2. loss on sale Understated No effect
3. net income Overstated No effect
4. Retained earnings after closing Overstated Overstated
5. working capital at the end of the yr No effect No effect
6. Equipment Overstated overstated
 Adjusting entries:
2020 2021
Other income - 30,000 Retained earnings – 35,000
Accum. Depreciation 15,000 Accum. depreciation 15,000
Loss on sale 5,000 Equipment 50,000
Page | 5 Equipment 50,000

ILLUSTRATIVE PROBLEMS

Problems are uploaded for further discussions