correction of EOFS chapter 6 i t of error correc TOPIC: ove errors its typesand the concept ect, ‘This chapter discus LEARNING ‘OBJECTIVES: ‘After studying this chapter 1. Define error. 2. Enumerate an‘ 3, Identify the effe statement 4 Prepare adjusting journal entries to correct errOFs ERRORS Fmor rele to an unintentional misstatement in financial statemeng including the omission of an amount ora disclosure, including: 1. A mistake in gathering or processing data from which financl 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 eve Fraud refers to the intentional act by one or more individuals among manage those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. you should be able to: ifferent types of errors. Jd describe the dierent YPES Of TT in the fang .cts of errors in the act Prior Period Errors Prior period parca Errors are omissions from, and misstatements in, the entity financial statements for one or 3 oF more prior af i use ormisuseof reliable information that" 9 ising from a failure to (a) was available when finan authorized or isue;and “SYCMERS for those periods were (©) could reasonably be expected to have been obtained and taken into stants Such errors Inc applying accounting policies seers tatematical mistakes, mistakes in 3 Poles, neigh or mneerate eek fraud. 108 z~ |1 6 ~ Correction of Errors accounting Treatment of Prior Period Error According to PAS 8 par 42, “an entity shall correct material prior period rors retrospectively in the first set of financial statements authorized for sue after their discovery by: (a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or () 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. Limitations on retrospective restatement Aprior period error shall be corrected by retrospective restatement except to the extent that it is impracticable to determine either the period-specific effects or the cumulative effect ofthe error. hen it is impracticable to determine the period-specific effects of an error ‘on comparative information for one or more prior periods presented, the entity shall restate the opening balances of assets, liabilities and equity for the earliest period for which retrospective restatement is practicable (which maybe the current period). When itis impracticable to determine the cumulative effect at the beginning of the current period of an error on all prior periods, the entity shall restate the comparative information to correct the error prospectively from the earliest date practicable. Basic Concepts in Correction of Errors Effect in the Errors affecting net income: Netincome Relationship IfSalesare overstated Overstated Direct IfCost of sales is overstated Understated Inverse IfExpenses are overstated Understated Inverse Effect in Errors affecting cost of sales: Cost ofSales Relationship Beginning inventories are overstated Overstated Direct {Net purchases are overstated Overstated Direct 'TEnding inventories are overstated Understated Inverse Working capital Working capital is the capital of a business that is used in its day-to-day mane operations, computed as the current assets minus the current liabilities. tn Effect in jirerSaffecting working capital: working capital Relationship ih current assets are overstated Overstated Direct Current liabilities are overstated Understated Inverse 109Chapter 6 - Correction of Errors ‘TYPES OF ERRORS Balance sheet or statement of financial position errors Income statement errors : ti a Combined statement of financial postion and income statemene a. Counterbalancing errors b. Non-counterbalancing errors Statement of Financial Position or Balance Sheet Errors Statements of Financial Position or balance sheet errors affect oa presentation of an asset, liability, or stockholders’ equity account, When the erroris discovered in the ertor year, the company. Teclassitis item to its proper position. Ifthe error ina prior year is discovered in a subset ‘quent period the company should restate the stat Nement of financial position of the prior year comparative purposes, Example: ‘and ofP1,000,000 was erroneously debited to notes receivable. Reclassifying entries: Land 1,000,000, Notes receivable 1,000,000 Mlustration: ‘Statement of Financial Position ‘Error otopenten erate Company reported ne neo thes tne of operation as follows: eee 2020 5,000,000 Iman audit of the fina the following errors 2021 6,000,000 eas 710000 was erroneously debited tn accounts 2) Notes payable of 15,000 was 3) Land of 100,000 was erroneously a account, srroneously credited to accounts payable. lebited to investment property cember 31,2020 and 2021 2. Prepare adjusting entries assuming see dete (©) 2021, and (¢) 2022, ' €rFors were discovered in (a) 110chapter 6 ~ Correction of Errors ‘SOLUTION: Requirement No. 1 Net Income Retained Earnings 2020 2021 = 20202024 Unadjusted balances 5,000,000 6,000,000 5,000,000 11,000,000 3) NRunderand AR over, NIunaffected 0 o 0 0 2) NP under and AP over but NI is unaffected 0 0 0 0 3) Land under, investment property over but NIis unaffected oo oo ‘Adjusted balance = 2:000,000_ 6,000,000 _ 5,000,000 _ 23,000,000, Requirement No. 2 Adjusting entries if errors are discovered in Year 2020: Notes receivable 10,000 Accounts receivable 10,000 Accounts payable 15,000, Notes payable 15,000 Land 100,000 Investment property 100,000 2021: Land 100,000 Investment property 100,000 2022: Land 100,000 Investment property 100,000 Note: In 2021 and 2022, there are no adjusting entries for the errors on the notes receivable and payable because they are assumed to have been settled or received at the end of those years. INCOME STATEMENT ERRORS Income statement errors are errors affecting only the income statement accounts and may include improper classification of revenues or expenses, Acompany must make a reclassification entry when it discovers the error in the error year, {the error discovered pertains to a prior year, the company should restate income statement of the prior year for comparative purposes. Since these errors involve two nominal accounts, net income and retained "trnings during the period are unaffected. alichapter 6 ~ Correction of Errors — 1B : u tatoo in edited instead ILLUSTRATION: met ‘900 in 2021 was cre “ting, Rent income amout income. it 2021 See 2022 __—— 0 ; | the year of error usCorrection of Errors chante ILLUSTRATION 1: Combined and Counterbalancing Errors self Sacrifice Company reported net income fora two-year period as follows: 2020 120,000 2021 180,000 jnanaudit of the financial statement for the year ended December 31, 2020, the following errors are discovered: 1) The company paid one-year insurance premium of P18,000 effective May 1, 2020. The entire amount was debited to expense account and no adjustment was made at the end of 2020. 2) The company leased a portion of ts building for P24,000. The term of the lease is one year ending june 1, 2021. Collection of rent was credited to rent reventie account. At the end of 2020, no entry was made to take up the unearned portion of the amount collected. 3) Accrued salaries expense of P12,000 was not recorded at the end of 2020. 44) Accrued interest receivable of P15,000 was not recorded at the end of 2020. Required: 1. Compute for the adjusted net incomes in 2020 and 2021 and Retained ‘earnings as of the years ended December 31, 2020 and 2021. 2. Give the effect of the error in the 2020 working capital. 3. Prepare adjusting entries assuming errors were discovered in (a) 2020, (b) 2021, and (c) 2022 SOLUTION: Requirement No. 1 Net Income Retained Earnings 2020 ©2021. = 20202024 Unadjusted balances 120,000 180,000 120,000 300,000 1)Ins.Exp.over, NIunder «6,000 (6,000) 6,000 Rey over, NI over (10,000) 10,000 (10,000) 3) Salaries expense under, Nlover (12,000) 12,000 (12,000) 4) Int. income under, NI under 15,000 _ (15,000) _15,000 Adjusted balance 119,000 ___181,000__119,000__300,000 Effect on the working capital (WC) Over or (under) 2020 1) Ins. Exp. over, Prepaid insurance under, WC under (6,900) 2)Rev over, Unearned revenue under, WC over 10,000 3)Salaries expense under, Salaries payable under, WCover 12,000 Vint. income under, Rent receivable under, WC under 15,000) Effect on the Working capital -overstated by 1,000 a7Chapter ee Requirement No. 2 : : Adjusting entries if error is discovered in: 0 2020: Prepaid Ins. (18,000/12 4) 6,000 insurance Expense 10,000 Rent Revenue (24,000/12 x 5) ‘Unearned Rent Revenue 42,000 corre 10,000 salaries expens® 12,000 vacerued salaries payable a Interest receivable 15,000 Interest income : 6,000 2021: ‘Insurance Expens® (18,000/12%4) pe Retained earnings Retained earnings 10,000 fet 10,001 Rent Revenue (24,000/12 x5) 0 Retained earnings idea pee Salaries expense x Interest income 15,000 Retained earnings 15,000 2022: Noadjusting journal entries ed and Counterbalancing Errors Illustration 2: Combine set income fora two-year period as follows self-Sacrifice Company reporte 2020 120,000 2021 180,000 In an audit of the statement for the year ended December 31, 2020, the following errors are discovered: : 1) Adan to supplier in 2020 were recorded as purchases but the a mercans was received in the following year, P20,000 vances oe customers in 2020 recorded as sales in 2020 but the 7% ewer dived in the following year, P50,000 , 2020, the ending inventory wa: eh ‘ending inventory was overstated by ®250 1. Compute for the adj usted net incomes i : eami mes it ne : eaangs = ofthe years ended Decams nite and 2021 and Reta! S Prepare aac ror in the 2020 seria un adjusting entries assumit eee) b) (b) 2021, and (c) 2022. ing errors were discovered in (8)er 6 = ComeCtION Of Errors chant srlON: so1tiTio Fequirement No. T Net Incon 2020 iynadjusted batanees 120,000 1) Purchases over, NI under 20,000, sales over, NI over (50,000) ny, inventory over, Nlover _ (25,000) Aajusted balance 65,000 Effect on the working capital (Wc) 1) Purchases over, Advances to supplier under, WC under 2) Sales over, advances from customer under, WC over, 3) Ending inventory over, WC over Effect on the Working capital -overstated by Requirement No. 2 “Adjusting entries if error is discovered in: 2020: Advances to supplier Purchases Sales ‘Advances from customers Cost of sales Merchandise inventory end Purchases Retained earnings 2021: Retained earnings Sales Retained earnings Mase. inventory beginning 2022: Noadjusting journal entries No} OUNTERBALANCING ERRORS Non-counter balancing errors do not offset in the correcting entries, Therefore, companies must make ¢ the books. 119 Retained & Oa ined Earnings 2020 2021 140,000 120,000 300,000 (20,000) 20,000 50,000 (50,000) 25,000 (25,000) 35,000 65,000 __ 300,000 Over or (under) 2020 (20,000) 50,000 25,000 55,000 20,000 20,000 50,000 50,000 25,000 25,000 20,000 20,000 50,000 50,000 25,000 25,000 mrext accoul ‘even ifthey have closedChapter 6 — Correction of Errors Examples: ‘i Prepayments under the asset metho Precollection under the liability method Error in recordi depreciation Improper capitalization of expen: Improper expensing of capital expenditures Error in recording of proceeds of sale of an asset (e.g, PPE) a, income oyaeNe Prepayments under the Asset Method ‘The Company paid one-year insurance premium of P12,000 et 2021. The entire amount was debited to asset account and no: made at the end of 2021. fective py adjustment Effect of the error: 2021 | 2027 [. Insurance expense 2. _ Prepaid insurance oO oO 3. _Net income oO 0 4. Retai ied earnings after closing 0 oO 5. Working capital at the end of the year 0 oO Legend: 0- Overstated U- Understated 3 Reatea Adjusting entries 2021 2022 Insurance 9,000 Insurance 3,000 expense* expense*= Prepaid 9,000 Retained 9,000 insurance earnings™** Prepaid 12,000 insurance *C2000/32%9) —— *(129000/12%3)(12,000/1229) Precollection under the Liability Method ‘The company leased a portion of its lease is one year ending April 3 Effect of the error: 2021 | 2022 | 1. Rent revenue U vu [2 “Unearned rent revenue o [0 3._Net income To | 4._ Retained earnings after closing U ut 5._Working capital at the end of the year U uv Tee Ordre NE | 120Chapter 6 ~ Correction of Errors Adjusting entries: 2021 2022 vaear rene 9,000 Unearned rentincome 12,000 Rent income* 8,000 _Rentincome** 4,000 Retained earnings*** 8,000 +(12,000/12 x8) **(2,000/12%4) _***(42,000/12 x8) Error in Recording Depreciation (e.g. understated) Depreciation expense in 2021 was understated by P2,000. Hifect of the error: 2021 | 2022 1. Depreciation expense U a 2,_Accumulated depreciation U uv 3._Net income 0 mi 4,_Retained earnings after closing oO 0 Tegend: 0- Overstated U- Understated K=No effect Adjusting entries: 2021 2022 Dep'n expense 2,000 Retained earnings 2,000 2,000 Accumulated depreciation 2,000 ‘Accumulated depreciation Improper Capitalization of Expense Repairs expense on thi the building account 1¢ building amounting to P10,000 had been charged to ‘on January 1, 2021. Depreciation expense has been recorded in 2021 and 2022 based on the 4 year remaining useful life of the building. Effect of the error: ‘2021 | 2022 1._ Repairs expense v x 2. Depreciation expense 0 0 3,_Net income 0 U 4._ Retained earnings after closing, 0 0 5. Building (net) 0 0 6._Accumulated depreciation 0 0 Legend: (0- Overstated T- Understated No effect Adjusting entries: 2021 2022 Repairs expense 10,000 Retained earnings 10,000 Building 10,000 Building 10,000 Accumulated 2,500 ‘Accumulated 5,000 depin dep’n Depreciation expense 2500 Retained 2,500 earnings 2,500 (10,000/4) Depreciation expense aijon of ErOts chapter 6 ~Corecton ofS tures Improper Expensing of CPI oT nging to P50,000 had been ca, Major improvements on bull ingaonrvernents havea oe Ce ee ont Daas Effect of the error:___— 0 : [at -xpense iT x i = vo U U — U m7 in . cum fee 6 Accumulated depreciation Tegend: ———-O- Overstated U-tinderstated TN aay Aang -_ Building 50,000 Building 50,000 Repairs expense 50,000 Retained 500% earnings Dep’n expense 12,500 Dep'n expense 12,500 ‘Accumulated depreciation 12,500 Retained earnings 12,500 (50,000/4) ‘Accumulated depreciation 25,000 Error in recording of proceeds of sale of an asset (e.g. PPE) as other income On January 1, 2021, an equipment costing P50,000 was sold for P30,000. 4 the date of sale, the equipment had an accumulated depreciation of P1500 ‘The cash received was recorded as other income in 2021. Effect of the error: 2021 | 2022 T._Otherincome o [x 2._Loss on sale xX 3. Net income . x 4. Retained earnings after dosing 0 0. S. Working capital atthe end of the year x x 6. Equipment. oO 7._Accumulated depreciation ° 0 Tegend:——O- Overstated Wondered Nolet Adjusting entries 2021, ther income 30,000 Retained on ecumsatd cepa 35000 soca | S2ent on sale 5,00 oi lenin 7 Gaoes) e Eauipment soe pment ame 50000 +(30,000 + 000) 1221 of Errors _ jo E ee eee chapter 6 - Correct ILLUSTRATION: Combined and Noncounter Balancing Errors setesacrifce Company reported net income for a two-year period as follows: 2020 6,000,000 2021 8,000,000 ‘ement for the year ended December 31, 2020, the In an audit of the st following errors are discovered: ance premium of P240,000 effective 1) The Company paid one-year April 1, 2020. The entire amount was debited to asset account and no Adjustment was made at the end of 2020. 2) The company leased a portion ofits building for P480,000. ‘The term of thelease is one yearending April 30, 2021, Collection of rent was credited tounearned rent revenue account. Atthe end of 2020, no entry was made to take up the earned portion of the amount collected, 3) Depreciation expense in 2020 was understated by P12,000. 44). Depreciation expense in 2021 was overstated by P14,000. 5) Bad debts expense of P11,000 was not recorded in 2020. Required: 1. Compute for the adjusted net incomes in 2020 and 2021 and Retained carnings as of the years ended December 31, 2020 and 2021. 2. Give the effect of the error in the 2020 working capital. 3. Prepare adjusting entries assuming errors were discovered in (a) 2020, (b) 2021, and (c) 2022. Solution: Requirement No. 1 Net Income Retained Earnings 2020 2021 2020 2021 Unadjusted balances 6,000,000 8,000,000 6,000,000 14,000,000 41) Ins. Exp. under, NI over (180,000) (60,000) (180,000) (240,000) 2)Rev under, NI under 320,000 160,000 320,000 480,000 3) Depr under, NI over (12,000) (12,000) (42,000) 4) Depr over, NI under 14,000 14,000 5) BD exp under, NI over __(11,000 (11,000) __(11,000) Adjusted balance 6.117,000__ 8,114,000 _ 6,117,000 _ 14,231,000 Effect on the working capital (WC) Over or (under) 2020 1) Ins, Exp. under, Prepaid insurance over WC over 180,000 2)Rev under, unearned rent revenue over, WC under (320,000) 3) Depr under, Accum. Depreciation under, WC unaffected 4) WC in 2020 is unaffected 5) BD exp under, allowance for bad debts under, WC over 11,000 Effect on the Working capital -understated by (129,000) 123Adjusting entries if error is discovered in: 2020: 2021: 2022; 180,000 Insurance Expense Prepaid Insurance (240,000/12 x 9) Unearned Rent Revenue 320,000 Rent Revenue Depreciation expense 12,000 Accumulated Depreciation Bad debts expense 11,000 Allowance for bad debts Retained earnings 180,000 Insurance Expense (240,000/12 x 3) 60,000 Prepaid Insurance Unearned Rent Revenue 160,000 Rent Revenue Unearned Rent Revenue 320,000 Retained earnings Retained earnings 12,000 ‘Accum. Depreciation ‘Accum. Depreciation 14,000 Depreciation expense Retained earnings 11,000 Allowance for bad debts Retained earnings 240,000 Prepaid insurance Unearned Rent Revenue 480,000 Retained earnings Retained earnings 12,000 ‘Accumulated. Depreciation Accumulated Depreciation 14,000 Retained earnings Retained earnings 11,000 Allowance for bad debts 14 240.009, 160,009 320,000 12,000 14,000 11,000 240,000 480,000 12,000 14,000 11,000