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FINANCIAL ACCOUNTING AND REPORTING
Accountancy (Mondriaan Aura College)
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CHAPTER 16
ERROR CORRECTION
TECHNICAL KNOWLEDGE
To know the definition of prior period errors.
To understand the accounting treatment of prior period errors.
To be able to distinguish counterbalancing errors and non-counterbalancing errors.
To be able to prepare the necessary correcting entries for prior period errors.
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Introduction
Errors can arise in respect of the recognition, measurement, presentation or disclosure
of elements of financial statements,
Potential current period errors discovered in that period are corrected before the
financial statements are authorized for issue. However, material errors are sometimes
not discovered until a subsequent period, and these prior period errors are corrected in
the comparative information presented in the financial statements for that subsequent
period.
Prior period errors
Prior period errors are omissions 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 these periods were authorized for
issue.
b. Could reasonably be expected to have been obtained and taken into account in
the preparation and presentation of those financial statements.
Prior period errors include the effects of mathematical mistakes, mistakes in applying
accounting policies, oversights or misinterpretation of facts, and fraud.
Treatment of prior period errors
An entity shall correct material prior period errors retrospectively in the first set of
financial statements authorized for issue after their discovery.
A prior period error shall be corrected by retrospective restatement, meaning, if
comparative statements are presented, the prior year statements are restated to correct
the error.
The correction of a prior period error is an adjustment of the beginning balance of
retained earnings of the earliest period presented.
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Type of errors
a. Statement of financial position errors
b. Income statement errors
c. Combined statement of financial position and income statement errors
Statement of financial position errors
Statement of financial position errors affect the statement of financial position or real
accounts only, meaning, the improper classification of an asset, liability and capital
account.
In such a case, an entry is simply made to reclassify the account balances.
Illustration
a. Notes receivable is debited instead of accounts receivable.
b. Accounts payable is credited instead of notes payable.
c. Preference share capital is credited instead of ordinary share capital.
The pertinent reclassifying entries are:
a. Accounts receivable
XX
Notes receivable
XX
b. Accounts payable
XX
Notes payable
c.
XX
Preference share capital
XX
Ordinary share capital
XX
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Income statement errors
Income statement errors affect the income statement or nominal accounts only,
meaning, the improper classification of revenue and expense accounts.
These errors have no effect on the statement of financial position and on net income.
Thus, a reclassifying entry is necessary only if the error is discovered in the same year it
is committed.
Otherwise, if the error is discovered in a subsequent year, no reclassifying entry is
necessary because the nominal accounts for the current year are correctly stated.
Illustration
During 2017, the entity debited purchases instead of office supplies.
If the error as discovered in 2017, the reclassifying entry is:
Office supplies
XX
Purchases
XX
If the error is discovered in 2018, no reclassifying entry is made.
The office supplies account and purchases account are already closed in 2017.
Combined statement of financial position and income statement errors
These errors affect both the statement of financial position and Income Statement
because they result in a misstatement of net income
For example, if accrued salaries payable is overlooked, the effects are:
a. Salaries expense is understated (income statement error).
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b. Liability is understated (statement of financial position error)
c. Net income is overstated (income statement error).
d. Retained earnings account is overstated (statement of financial position error).
If depreciation is overstated, the effects are:
a. Depreciation is overstated (income statement errors).
b. Property, plant and equipment are understated (statement of financial position error).
c. Combined statement of financial position and income statement errors are classified
as counterbalancing errors and noncounterbalancing errors.
Counterbalancing errors
Counterbalancing errors are errors which, if not detected, are automatically
counterbalanced or corrected in the next accounting period.
In other words, these errors will be offset or corrected over two periods or these errors
correct themselves over two periods.
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Effects of counterbalancing errors
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1. The income statements for two successive periods are incorrect.
2. The statement of financial position at the end of the first period is incorrect
3. The statement of financial position at the end of the second period is correct.
Counterbalancing errors normally include the misstatement of the following:
a. Inventory, including purchases and sales
b. Prepaid expense
c. Accrued expense
d. Deferred income
e. Accrued income
Overstatement of ending inventory
On December 31, 2016, the physical count was overstated by P50,000.
If the books for 2017 have not been closed, the entry on December 31, 201l7 to correct
the error is:
Retained earnings
P50,000
Inventory, January 1, 2017
P50,000
The retained earnings account is debited because the net income of 2016 was
overstated.
The inventory account is credited because the ending inventory on December 31, 2016
was overstated.
If the books for 2017 have been closed, no entry is necessary because the error in 2016
is counterbalanced in 2017.
In other words, the ending inventory in 2016 becomes the beginning inventory in 2017.
Thus, if the beginning inventory of 2017 is overstated, cost of goods sold would be
overstated with a consequent understatement of net income.
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Understatement ending inventory
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On December 31, 2016, the physical count was understated by P50,000.
If the books for 2016 have not been closed, the entry to correct the error on December
31, 2017 is:
Inventory, January 1, 2017
P50,000
Retained earnings
P50,000
The inventory account is debited and the retained earnings account is credited because
the ending inventory of 2016 was understated with a consequent understatement of net
income.
If the books for 2017 have been closed, no entry is necessary because the 2016 error is
counterbalanced in 2017.
Understatement of purchases
The entity failed to record a merchandise purchased in 2016. The same was recorded in
2017. The physical inventory on December 31, 2016 was correctly stated.
If the books for 2017 have not been closed, the entry to correct the error on December
31, 2017 is:
Retained earnings
P50,000
Purchases
P50,000
The retained earnings account is debited because net income of 2016 was overstated.
The purchases account is credited because the purchase pertains to 2016 and the
same is recorded in 2017, thus resulting to overstatement of 2017 purchases.
If the books for 2017 have been closed, no entry is necessary because the 2016 error is
counterbalanced in 2017.
The purchases account in 2016 is understated while the purchases account in 2017 is
overstated. Thus, they equalize each other.
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Overstatement of purchases and ending inventory
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The entity recorded on December 31, 2016 P50,000 of purchases in transit to which
the entity had no title. The same merchandise was included in the inventory of
December 31, 2016.
If the books for 2017 have not been closed, the entries to correct the error on December
31, 2017 are:
1. Purchases
P50,000
Retained earnings
P50,000
2. Retained earnings
P50,000
Inventory, January 1, 2017
P50,000
In the first entry, the purchases account is debited because the purchase pertains to
2017 and was erroneously recorded in 2016.
The retained earnings account is credited because the net income of 2016 was
understated by reason of overstated purchases.
In the second entry, the retained earnings account is debited and the inventory account
is credited because the ending inventory of 2016 was overstated resulting to
overstatement of net income.
Actually, the net effect of the error is zero on net income and retained earnings.
If the books for 2017 have been closed, no entry is necessary because the 2016 error is
counterbalanced in 2017.
The purchases account in 2016 1s overstated and the purchases account in 2017 is
understated. Thus, they equalize each other.
The inventory on December 31, 2016 was overstated resulting to overstatement of net
income.
The inventory on January 1, 2017 was also overstated and thus overstating cost of
goods sold and understating net income.
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Understatement of sales
The entity failed to record sales of P50,000 in 2016. The same was recorded in 2017.
The physical inventory was correctly stated on December 31, 2016.
If the books for 2017 have not been closed, the entry to correct the error on December
31, 2017 is:
Sales
P50,000
Retained earnings
P50,000
The sales account is debited because the same pertains to 2016 and was recorded in
2017 thus overstating 2017 sales.
The retained earnings account is credited because the 2016 net income was
understated.
If the books for 2017 have been closed, no entry is necessary because the 2016 error is
counterbalanced in 2017.
The sales account of 2016 was understated and the sales account of 2017 was
overstated. Thus, they equalize each other.
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Overstatement of sales
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Understatement of ending inventory
The entity recorded on December 31, 2016 P50,000 of sales in transit and to which the
customer had no title.
The cost of the merchandise was P30,000 and the same was excluded from the
December 31, 2016 inventory.
If the books for 2017 have not been closed, the entries to correct the error on December
31, 2017 are:
1. Retained earnings
P50,000
Sales
P50,000
2. Inventory, January 1, 2017
P30,000
Retained earnings
P30,000
In the first entry, the retained earnings account is debited because the 2016 net income
was overstated.
The sales account is credited because the sale pertains to 2017 and was erroneously
recorded in 2016.
In the second entry, the inventory account is debited and the retained earnings account
is credited because the 2016 net income was understated by reason of understatement
of 2016 ending inventory.
If the books for 2017 have been closed, no entry is necessary because the 2016 error is
counterbalanced in 2017.
The sales account in 2016 was overstated and the sales account in 2017 was
understated and thus they counterbalance each other.
The understated ending inventory on December 31, 2016 becomes the beginning
inventory in 2017. Thus, they equalize the effect on net income.
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Failure to record prepaid expense
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On January 1, 2016, the entity purchased an insurance for two years for P50,000.
The payment was debited to an expense and no adjustment was made on December
31, 2016 for the prepaid insurance.
If the books for 2017 have not been closed, the entry to correct the error on December
31, 2017 is:
Insurance
P25,000
Retained earnings
P25,000
The insurance account is debited because the prepaid insurance on December 31,
2016 becomes an expense in 2017.
The retained earnings account is credited because the 2016 net income was
understated.
If the books for 2017 have been closed, no entry is necessary because the error is
counterbalanced.
The net income of 2016 was understated by reason of overstatement of insurance
expense while the net income of 2017 was overstated by reason of understatement of
insurance expense.
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Failure to record accrued expense
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On December 31, 2016, accrued rent expense of P60,000 was not recorded.
If the books for 2017 have not been closed, the entry to correct the error on December
31, 2017 1s:
Retained earnings
P50,000
Rent expense
P50,000
The retained earnings account is debited because the net income of 2016 was
overstated.
The rent expense is credited because the accrual of 2016 necessarily was paid in 2017
and the same was debited to rent expense, thus overstating the rent expense of 2017.
If the books for 2017 have been closed, no entry 1s necessary because the 2016 error
is counterbalanced in 2017.
The net income of 2016 was overstated by reason of understatement of rent expense
while the 2017 net income was understated by reason of overstatement of rent
expense.
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Failure to record a deferred income
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On January 1, 2016, the entity received rent for two years in the amount of P50,000.
The same was credited to rent income and no adjustment was made on December 31,
2016.
If the books for 2017 have not been closed, the entry to correct the error on December
31, 2017 is
Retained earnings
P25,000
Rent income
P25,000
The retained earnings account is debited because the 2016 net income was overstated.
The ret income is credited because the unearned income on December 31, 2016
becomes an income of 20017,
If the books for 2017 have been closed, no entry is necessary because the 2016 error is
counterbalanced in 2017. The 2016 rent income was overstated while the 2017 rent
income was understated. Thus, they counterbalance each other.
Failure to record accrued income
On December 31, 2016, accrued interest receivable of P50,000 was not recorded. If the
books for 2017 have not been closed, the entry to correct the error on December 31,
2017 is:
Interest income
P50,000
Retained earnings
P50,000
The interest income is debited because the interest accrual of 2016 necessarily was
received in 2017 and the same was credited to interest income, thus overstating the
2017 interest income.
The retained earnings account is credited because the 2016 income was understated.
If the books for 2017 have been closed, no entry 18 necessary because the 2016 error
is counterbalanced in 2017. The 2016 interest income was understated while the 2017
interest income was overstated. Thus, they equalize each other.
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Noncounterbalancing errors
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Noncounterbalancing errors are errors which, if not detected, are not automatically
counterbalanced or corrected in the next accounting peri0d.
In other words, if the net income of one year is understated or overstated, the net
income of subsequent year is not affected.
Effects of noncounterbalancing errors
1. The income statement of the period in which the error is committed is incorrect but
the succeeding income statement is not affected.
2. The statement of financial position of the year of error and succeeding statement of
financial position are incorrect until the error is corrected.
The best example of a noncounterbalancing error is the misstatement of depreciation.
Illustration
On January 1, 2016, the entity purchased an equipment with useful life of 5 years for
P500,000 but the same was debited to repair and maintenance.
If the books for 2017 have not been closed, the entries to correct the error on December
31, 2017 are:
1. Equipment
P500,000
Retained earnings
P500,000
2. Depreciation (500,000/ 5)
Retained earnings
P100,000
P100,000
Accumulated depreciation
P200,000
If the books for 2017 have been closed, the entries to correct the error on December 31,
2017 are:
1. Equipment
P500,000
Retained earnings
P500,000
2. Retained earnings
P200,000
Accumulated depreciation
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P200,000