Colegio de San Gabriel Arcangel

Area E, City of San Jose del Monte, Bulacan

Lesson Module

Course Title: Intermediate Accounting 3 Level: Second Year

Course Code: AE17 Lesson No.: 5
Lesson Hours: 3

Objectives:

At the end of this Module, the student will be able to:

1. Identify the cause of errors in the financial statements
2. Identify the kinds of accounting errors
3. Prepare correcting entries
4. Present the effect of errors in prior period financial statements
5. Understand how discovered errors are accounted for; and
6. Restate financial statements of prior period that contain errors

Subject Matter: Errors and their Corrections

Procedures:
A. Motivation

B. Lesson Presentation

The financial statements must faithfully represent the effects of transactions and
other events the affect the financial position and performance of the enterprise. The
presence of errors and other misstatements may affect the measurement of the
financial statement elements and the evaluation of the decision makers. Thus,
these misstatements must be rectified and appropriate disclosure must be made so
that financial statement users will clearly understand what has happened.

Accounting errors may result from mathematical mistakes, failure to apply

appropriate accounting policies, misinterpretation of facts, fraud or oversights.
When errors are detected, actions have to be taken to free the financial statements
of the current period and those of the comparative prior period from any material
misstatements.
 Kinds of errors

1) Errors affecting only the accounts presented in the statement of financial

position
Example:
a) Notes receivable may have been debited instead of accounts receivable, or
b) Interest payable may have been credited instead of salaries payable

When the errors are detected currently, entries are made to correct the accounts
balances.

When the errors are discovered in the subsequent period, corrections are made
at that time

2) Errors affecting only the profit or loss accounts

Errors that affect only profit or loss accounts usually results from
misclassification of items
Example:
a) Interest revenue may be included in sales revenue
b) Office salaries may have been debited instead of sales salaries
c) Interest income may have been credited instead of dividend revenue

Errors of this kind require reclassification but do not affect profit

3) Errors affecting both profit or loss accounts and accounts in the statement of
financial position
a) Counterbalancing errors
Are those, which when not detected within the subsequent financial year
in which errors were committed, are automatically corrected as natural
part of the accounting process.

Most of the counterbalancing errors are the result of the year-end

adjustment mistakes

Effect on Effect on
Profit Profit
Type of adjustment error Current Year Next Year
Ending inventory overstated Overstated Understated
Ending inventory understated Understated Overstated
Failure to accrue expense at year end Overstated Understated
Overstated accrued expense at year end Understated Overstated
Failure to accrue revenue at year end Understated Overstated
Overstated accrued revenue at year Overstated Understated
end
Overstated year end prepaid expenses Overstated Understated
Understated year end prepaid expenses Understated Overstated
 Understated unearned revenue Overstated Understated
Overstated unearned revenue Understated Overstated

b) Non-counterbalancing errors
Also known as permanent errors are those that are not automatically
offset in the next accounting period
Example:
a) Failure to depreciate an item of property, plant and equipment or
amortize intangible assets

A correcting journal entry is necessary for a non-counterbalancing errors

Error Correction
Assume that an expenditure for a machinery was made in the amount of P20,000. This
amount was recorded as repair expense when it was found that such expenditure would
benefit the company for the remaining five-year life of the machinery, hence, should be
capitalized. Analysis could be as follows:

Wrong entry made Correct entry Correcting entry

Repair expense 20,000 Machinery 20,000 Machinery 20,000
Cash 20,000 Cash 20,000 Retained earnings 20,000

Note that the correction can not be made to repair expense account because the error
is detected in the subsequent year when the revenue and expense of the previous year
have been closed; thus, correction is made to the retained earnings account.

Further, it will be noted that it caused additional error in other accounts. Since the
expenditure was not capitalized the amount of depreciation for that period was
understated resulting to overstated profit for that period equivalent to the amount of
depreciation. With a remaining useful life of 5 years and assuming zero salvage value,
depreciation should have been increased by P4,000 (20,000 / 5). Additional correcting
entry therefore is

Retained earnings 4,000

Accumulated depreciation 4,000
C. Application
EXERCISE 1
An entity reported net income for 2017 - P3,000,000, 2018 - P4,000,000, 2019 -
P3,500,000. In an audit for the current year, the following errors were detected.

a) 12/31/2017 inventory overstated - P120,000

b) 12/31/2019 inventory understated - P210,000
c) 12/31/2017 accrued interest payable understated - P40,000
d) 12/31/2019 accrued interest payable overstated - P90,000
e) Depreciation for 2018 understated - P180,000
f) Depreciation for 2019 overstated - P30,000

The books for 2019 have not yet been closed

Required:
Prepare the correcting entries on 12/31/2019 and compute the corrected net income for
each year.

2017 2018 2019

Income 3,000,000 4,000,000 3,500,000
Overstated inventory - 12/31/17 (120,000) 120,000
Understated inventory - 12/31/19 210,000
Understated Accrued interest payable (40,000) 40,000
12/31/17
Overstated accrued interest payable 90,000
12/31/19
Understated depreciation 2018 (180,000)
Overstated depreciation 2019 30,000
Corrected income 2,840,000 3,980,000 3,830,000

Correcting entries
A. No adjustment
B. Inventory 210,000
Income summary 210,000
C. No adjustment
D. Accrued interest payable 90,000
Interest expense 90,000
E. Retained earnings 180,000
Accum. Depreciation 180,000
F. Accum. Depreciation 30,000
Depreciation expense 30,000
EXERCISE 2
An entity reported net income for 2017 - P1,500,000, 2018 - P2,000,000, 2019 -
P2,800,000. an audit disclosed the following:

a) Accounts receivable instead of notes receivable was debited in 2019 - P20,000

b) Purchase account was debited in 2019 instead of office supplies - P5,000
c) The physical inventory on 12/31/2017 was overstated - P10,000
d) The physical inventory on 12/31/2018 was understated - P15,000
e) Advances to suppliers were recorded as purchases but the merchandise was
received in subsequent year: 2017 - P30,000, 2018 - P40,000
f) Advances from customers recorded as sales but the goods were delivered in the
following year: 2017 - 25,000, 2018 - P50,000
g) Insurance premium for three years paid in 2017 was charged entirely to expense in
2017 - P15,000
h) Salaries accrued not recorded: 2017 - P30,000, 2019 - P60,000
i) Rent for 2 years was received in 2018 was entirely credited to income , P10,000
j) Unrecorded accrued interest receivable - 2018 - P10,000, 2019 - P25,000
k) Improvements on building had been charged to expense on January 1, 2018.
improvements have a life of 5 years - P100,000
l) On January 1, 2018, an equipment costing P40,000 was sold for P20,000. At the date
of sale, the equipment had an accumulated depreciation of P25,000. The cash received
was recorded as other income in 2018

The books for 2019 have not yet been closed

Required
Prepare the correcting entries on 12/31/2019 and compute the corrected net income for
each year.

2017 2018 2019

Income 1,500,000 2,000,000 2,800,000
Inventory, overstated in 2017 (10,000) 10,000
Inventory, understated in 2018 15,000 (15,000)
Advances recorded as purchases 30,000 (30,000)
40,000 (40,000)
Advances from customers recorded (25,000) 25,000
as sales (50,000) 50,000
Insurance premium for 3 years 10,000 (5,000) (5,000)
recognized as expense in 2017
Unrecorded accrued salaries (30,000) 30,000
(60,000)
Rent income for 2 years recorded as (5,000) 5,000
income in 2018
Unrecorded interest receivable 10,000 (10,000)
25,000
Improvements debited to expense 100,000
Depreciation (20,000) (20,000)
Overstatement in other income (15,000)
Corrected income 1,475,000 2,105,000 2,730,000