AUDITING PROBLEM

TOPIC 2: CORRECTION OF ERROR

ERRORS
According to Philippine Standards on Auditing No. 240, "error refers to an 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, employees,
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 prior 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 applying accounting policies, oversights or
misinterpretations of facts, and fraud.

Accounting Treatment of Prior Period Error

According to PAS 8 par 42, "an entity shall correct material 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.

Retrospective Restatement – is correcting the recognition, measurement and disclosure of amounts of elements of
financial statements as if a prior period error had never occurred. (If comparative statements are presented, the prior year
statements are restated to correct the error.

Limitations on retrospective restatement

A prior 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 of the error.

Impracticable to determine the period – The entity shall restate the opening balances of the assets, liabilities, and
specific effects of an error equity for the earliest period for which retrospective restatement is
practicable.
Impracticable to determine the The entity shall restate the comparative information to correct the error
cumulative effect at the beginning of the prospectively from the earliest date practicable.
current period of an error

BASIC CONCEPTS IN CORRECTION OF ERRORS

Effect in the Net Effect in the Retained

Errors affecting Net Income Relationship
Income Earnings
If Sales are overstated Overstated Overstated Direct
If Cost of Sales is overstated Understated Understated Inverse
If Expenses are overstated Understated Understated Inverse

Errors affecting Cost of Sales Effect in Cost of Sales Effect in Net Income Relationship
If Beginning Inventories are overstated Overstated Understated Direct
If Net Purchases are overstated Overstated Understated Direct
If Ending Inventories are overstated Understated Overstated Inverse

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Working capital (WC = CA – CL)

Working capital is the capital of a business that is used in its day-to-day trading operations, computed as the current assets
minus the current liabilities.

Errors affecting Cost of Sales Effect in Cost of Sales Relationship

If Current Asset are overstated Overstated Direct
If Current Liabilities are overstated Understated Inverse

TYPES OF ERRORS
Current Period Errors
AS TO PERIOD OF OCCURRENCE
Prior Period Errors
Balance Sheet or Statement of Financial Position Errors
Income Statement Errors
AS TO ELEMENTS AFFECTED Combined Statement of Financial Position and Income Statement Errors
a. Counterbalancing Errors
b. Non-counterbalancing Errors

Current Period Errors – are errors committed during the current period. If discovered after the reporting date but before the
financial statements are authorized for issue- should be corrected as adjusting events after the reporting period.

STATEMENT OF FINANCIAL POSITION OR BALANCE SHEET ERRORS (REAL ACCOUNTS)

Statements of Financial Position or balance sheet errors affect only the presentation of an asset, liability, or stockholders' equity
account.
The error discovered in the The company should
Error year Reclassifies the item to its proper position
Subsequent period Restate the statement of financial position of the prior year for comparative purposes.

INCOME STATEMENT ERRORS

Income statement errors are errors affecting only the income statement accounts and may include improper classification of
revenues or expenses.
The error discovered in the The company should
Error year Reclassification entry
Prior year Restate the statement of financial position of the prior year for comparative purposes.

Since these errors involve two nominal accounts, net income and retained earnings during the period are unaffected.

COMBINED STATEMENT OF FINANCIAL POSITION AND INCOME STATEMENT ERRORS

Errors affecting both the statement of financial position and income statement can be classified as:
a. Counterbalancing errors and
b. Non-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 Prepayment under the expense method)
2. Deferred income (Pre-collection under the revenue method)
3. Accrued expenses
4. Accrued revenue

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.

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 Year 1 Year 2
Working Retained Working Retained
Net Income Net Income
Capital Earnings Capital Earnings
Omissions of the
following:
Accrued Overstated Overstated Overstated Understated Correct Correct
Expenses
Accrued Income Understated Understated Understated Overstated Correct Correct
Deferred Understated Understated Understated Overstated Correct Correct
Expenses
Deferred Income Overstated Overstated Overstated Understated Correct Correct

Year 1 Year 2
Working Retained Working Retained
Net Income Net Income
Capital Earnings Capital Earnings
Understated/Overstated
of the following:
Purchase – under Overstated Overstated Overstated Understated Correct Correct
Sales – under Understated Understated Understated Overstated Correct Correct
Ending Inventory – Understated Understated Understated Overstated Correct Correct
under

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:
1. Prepayments under the asset method
2. Pre-collection 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