Mark Anecito R. Perlas, CPA
1
AUDITING PROBLEMS
Accounting for Changes and Correction of Errors
__
Definition of Terms
• Accounting policies
specific principles, bases, conventions, rules and
practices adopted by an enterprise in preparing and presenting the financial statements.
• Fundamental errors are errors discovered in the current period with such
significance, that the financial statements of one or more prior periods can no longer be
considered to have been reliable at the date of their issue.
Reasons why Accounting Changes Occur:
1.
The accounting profession may mandate that a new accounting principle is to be used.
2.
Changing economic conditions
3.
Changes in technology and in operations
4.
New experience or new information may prompt companies to change its estimate of
revenues or expenses.
TYPES OF ACCOUNTING CHANGES
1.
Change in Accounting Principles/Policies
This is a change from one generally accepted accounting principle to another generally
accepted accounting principle. Adoption of a new principle in recognition of events that have
occurred for the 1st time is not a change in accounting principle. There is no change in
accounting principle when the depreciation method adopted for a newly acquired asset is
different from the method or methods used for previously recorded assets of similar class.
A change from a principle that is not generally accepted to one that is generally
accepted is considered to be an error correction than a change in accounting principle.
Accounting Procedure:
Benchmark treatment
A change in accounting policy/principle should be applied retroactively unless the
amount of any resulting adjustment that relates to prior periods is not reasonably determinable.
Any resulting adjustment should be reported as an adjustment to the opening balance of the
retained earnings. Comparative information should be restated unless it is impracticable to do
so.
2.
Change in Accounting Estimate
This is a change that occur as a result of new information or acquisition of additional
experience. Changes in estimates are viewed as normal recurring corrections and adjustments
or the natural result of the accounting process. Retroactive treatment is prohibited.
Accounting Procedure:
a. Report current and future financial statements on the new basis.
b. Present prior period financial statements as previously reported.
c.
Make no adjustment to current period opening balances.
NOTE: Whenever it is impossible to determine whether a change in principle or a change in
estimate has occurred, or if an asset is affected by both a change in principle and a change in
estimate during the same period, the change should be accounted for as a change in estimate
rather than a change in principle.
CORRECTION OF ERRORS
No company whether large or small is immune from errors. Errors may be intentional or
unintentional. Intentional errors are significant because of the presence of fraud or intent to
deceive. These errors are made for the purpose of concealing fraud or misappropriation,
evading taxes, manipulating or window-dressing the company's financial statements.
Mark Anecito R. Perlas, CPA
2
Unintentional errors were not deliberately committed. They result from carelessness or
ignorance on the part of the company's personnel or it may result from poor internal control.
The risk of material errors may be minimized through the installation of good internal
control and the application of sound accounting procedures. Prior period adjustments, also
called fundamental errors are reported in the current year as adjustment in the beginning
balance of the Retained Earnings account. Prior period statements should be restated to
correct the error when comparative statements are prepared.
Accounting Procedure:
1.
If detected in the period the error occurred, correct the accounts through normal
accounting cycle adjustments.
2.
If detected in subsequent period, adjust errors by making prior period
adjustments directly to Retained Earnings or restate the beginning balance of the
Retained Earnings account.
3.
Correct all previously presented prior period statements.
Examples of Accounting errors:
a.
A change from an accounting principle that is not generally accepted to an accounting
principle that is generally accepted.
b.
Mathematical mistakes
c.
Mistake in the application of accounting of accounting principle
d.
Oversight
e.
Misuse of facts
f.
Incorrect classification of expense as an asset or vice versa
g.
Changes in estimates which are not prepared in good faith
TYPES OF ERRORS
1.
Balance Sheet Errors
This type of error refers to improper classification of real accounts such as assets,
liabilities or stockholders' equity accounts. They have no effect on net income
2.
Income Statement Errors
This type of error affects only the presentation of nominal accounts in the Income
Statement. It involves the improper classification of revenues and expenses accounts, hence,
only the details of the Income Statement are misstated. A reclassifying entry is necessary only
if the error is discovered in the same year it is committed. It has no effect on the Balance sheet
and in the Income Statement. If the error is discovered in a subsequent year, no classification
entry is necessary.
3.
Combined Balance Sheet and Income Statement errors
This affects both the balance Sheet and the Income Statement because they result in
the misstatement of net income.
Classifications of Combined Balance Sheet and Income Statement Errors:
a.
Counter Balancing Errors
• Errors which if not detected are automatically offset or corrected over two
periods. Restatement is necessary even if a correcting journal entry is not
required.
• Effect:
Net Income of two successive periods are misstated. The amount of
misstatement in one period is equal to but opposite in effect in the income of the
next period.
• Counterbalancing errors include the misstatements of the following accounts:
1. Inventories to include the following
a. Purchases
b. Sales
2. Prepaid expenses
3. Deferred Income
4. Accrued expense
5. Accrued Income
Mark Anecito R. Perlas, CPA
3
GUIDELINES
• Books are open
1. If the error is already counterbalanced and the company is in the
second year, an entry is necessary to correct the current period and to
adjust the beginning balance of the Retained earnings.
2. If the error is not yet counterbalanced, an entry is necessary to adjust
the beginning balance of the Retained earnings and correct the current
period.
• Books are closed
1. If the error is already counterbalanced, no entry is necessary.
2. If the error is not yet counterbalanced, an entry is necessary to adjust
the present balance of the Retained earnings.
Counterbalancing error in
an
ASSET
(e.g.
Prepayments,
Accrued
Income, Inventory, end,
Accounts
Receivable
/Sales,
Advances
to
suppliers)
Counterbalancing error in
a
LIABILITY
(e.g.
Unearned
Income,
Accrued
Expense,
Accounts
Payable/Purchases,
Advances
from
customers)
b.
Effect to the net income
of the year of incurrence
Effect to the net income
of the subsequent year
DIRECT
INDIRECT
INDIRECT
DIRECT
Non Counter Balancing Errors
• Errors which take longer than two periods to correct themselves. This type of
error is carried over to the subsequent accounting period until corrected or until
the balance sheet item involved is removed from the accounts by sales,
retirement or other means of disposal.
Counterbalancing error in
an ASSET
Counterbalancing error in
a LIABILITY
Effect to the net income
of the year of incurrence
Effect to the net income
of the subsequent year
DIRECT
NO EFFECT
INDIRECT
NO EFFECT
GUIDELINES IN ERROR ANALYSIS
1.
What accounts are affected?
2.
How were these accounts affected?
Was there an understatement or an
overstatement?
3.
What was the erroneous entry made or what was the entry omitted?
4.
What is the correct entry?
5.
What is the necessary adjusting or correcting entry?
END
Mark Anecito R. Perlas, CPA
4
Sample Case
Problem 1
BADANG Corporation reported the following amounts of net income for the years ended
December 31, 2017, 2018 and 2019:
2017
2018
2019
P127,000
150,000
128,500
You are performing the audit for the year ended December 31, 2019. During your examination,
you discover the following errors:
a. As a result of errors in the physical count, ending inventories were misstated as follows:
December 31, 2018
December 31, 2019
P14,000 understated
P23,000 overstated
b. On December 29, 2019, BADANG recorded as a purchase, merchandise in transit, which
cost P15,000. The merchandise was shipped FOB Destination and had not arrived by
December 31. The merchandise was not included in the ending inventory.
c. BADANG records sales on the accrual basis but failed to record sales on account made
near the end of each year as follows
2017
2018
2019
P4,000
5,000
3,500
a. The company failed to record accrued office salaries as follows:
December 31, 2017
December 31, 2018
P10,000
14,000
b. On March 1, 2018, a 10% stock dividend was declared and distributed. The par value of the
shares amounted to P10,000 and market value was P13,000. the stock dividend was
recorded as follows:
Miscellaneous expense
Common stock
Retained earnings
P13,000
10,000
3,000
c. On July 1, 2018, BADANG acquired a three-year insurance policy. The three-year premium
of P6,000 was paid on that date, and the entire premium was recorded as insurance
expense.
d. On January 1, 2019, BADANG retired bonds with a book value of P120,000 for P106,000.
The gain was incorrectly deferred and is being amortized 10 years as a reduction of interest
expense on other outstanding obligations.
Questions:
1.
What is the adjusted net income for the year ended December 31, 2017?
2.
What is the adjusted net income for the year ended December 31, 2018?
3.
What is the adjusted net income for the year ended December 31, 2019?
4.
What adjusting entry should be made on December 31, 2019 to correct the error
described in item B?
Mark Anecito R. Perlas, CPA
5.
5
The adjusting entry on December 31, 2018 to correct the error described in item E
should include a debit to
Problem 2
Long established a retail business in 2017. Early in 2020, Long entered into negotiations
with Short with the intent to form a partnership. You have been asked by Long and Short
to check Long’s books for the past three years to help Short evaluate the earnings potential
of the business.
The net income reported on statements submitted to you were as follows:
Year ending 12/31
2017
Income, pretax
P63,000
2018
2019
P 70,763
P 61,880
During the examination of the accounts, you found the data given below:
For year ended Dec. 31
2017
2018
2019
Omission from the books
a. Accrued expenses at end of year
P 15,120
P 14,658
P 32,368
8,470
9,842
b. Earned (uncollected) revenue at end
of year
c. Prepaid expenses at end of year
1,400
6,314
d. Unearned revenue (collected in advance)
at end of year
4,270
Goods in transit at end of year omitted from
inventory
e. Purchase for which the entry had been made
(ownership passed)
f.
18,270
21,640
11,970
13,710
Purchase for which the entry had not been made
(ownership not passed)
Other points requiring considerations:
g. On January 1, 2019, sold operational equipment for P31,500 that originally cost P35,000
on January 1, 2017. Cash was debited for P31,500 and equipment was credited for
P31,500. The asset sold was depreciated in 2017 and 2018 but not on the 2019 on the
basis of a 10-year life and no residual value.
h. No allowance for bad debts has been set up. An analysis of accounts receivable as of
December 31, 2019, indicates that the allowance account should have a balance of
P14,000, of which P3,500 relates to 2017, P4,900 to 2018, and P5,600 to 2019.
Mark Anecito R. Perlas, CPA
6
Questions
1. Adjusted net income of 2017 is:
a. P 85,834
b. P 82,334
c. P 52,094
d. P 39,466
c. P 80,157
d. P 76,769
c. P 51,082
d. P 42,682
c. P 21,640
d. P 35,350
2. Adjusted net income of 2018 is:
a. P 81,669
b. P 81,081
3. Adjusted net income of 2019 is:
a. P 86,502
b. P 56,682
4. Inventory at year-end is understated by:
a. P 3,370
b. P 7,930
5. Accrued expenses at year-end is:
a. Overstated by P17,710
b. Understated by P32,368
c. Understated by P31,908
d. Understated by P17,710