Examples of adjustments of errors

When errors affecting income are discovered, careful analysis is necessary to determine the required action to correct the account balances. As indicated, most errors will be caught and adjusted prior to closing the books. The few material errors not detected until subsequent periods and those that have not already been counterbalanced must be treated as prior-period adjustments. See also ‘Types of errors‘.

The following sections describe and illustrate the procedures to be applied when error adjustments require prior-period adjustments. It is assumed that each of the errors is material. Errors that are discovered usually affect the income tax liability for a prior period. Amended tax returns are usually prepared either to claim a refund or to pay any additional tax assessment. For simplicity, the examples ignore the income tax effects of errors.

Assume that ABC Supply Depot, Inc., began operations at the beginning of 2X11. An auditing firm is engaged for the first time in 2X13. Before the accounts are adjusted and closed for 2X13, the auditor reviews the books and accounts and discovers the errors summarized below.An error in previously issued financial statements

Each error adjustment is discussed in the following captions (1) to (9), at the end a summary table is provided with the effects of these errors before adjusted on the reporting periods 2×13 and 2×12.

(1) Understatement of merchandise inventory: It is discovered that the merchandise inventory as of December 31, 2X11, was understated by $1,000. The effects of the misstatement were as follows:

Income statement

Balance sheet

2×11

Cost of goods sold overstated (ending inventory too low)

Net income understated

Assets understated (inventory too low)

Retained earnings understated

2×12

Cost of goods sold understated (beginning inventory too low)

Net income overstated

Balance sheet items not affected, retained earnings understatement for 2X11 begin adjusted by net income overstatement for 2X12

Because this type of error counterbalances after two years, no correcting entry is required in 2X13.

If the error had been discovered in 2X12 instead of 2X13, an entry would have been made to correct the account balances so that operations for 2X12 would be reported accurately. The beginning inventory for 2X12 would have been increased by $1,000, the amount of the asset understatement and retained earnings would have been credited for this amount, representing the income understatement in 2X11. The correcting entry in 2X12 would have been as follows:

Merchandise inventory

1,000

Retained earnings

1,000

This correcting entry is the same whether the company uses a periodic or a perpetual inventory system.

As seen with error (2), the correcting entry is sometimes different, depending on what type of inventory system the company uses.


(2) Failure to record merchandise purchases: It is discovered that purchase invoices as of December 28, 2X11, for $850 had not been recorded until 2X12. The goods had been included in the inventory at the end of 2X11. The effects of failure to record the purchases were as shown in 4 (b) in ‘Types of errors‘.

Income statement

Balance sheet

2×11

Cost of goods sold overstated (purchases too low)

Net income overstated

Liabilities understated (Accounts payable too low)

Retained earnings overstated

2×12

Cost of goods sold overstated (purchases too high)

Net income understated

Balance sheet items not affected, retained earnings overstatement for 2X11 begin adjusted by net income understatement for 2X12

Because this is a counterbalancing error (see ‘Types of errors‘), no correcting entry is required in 2X13.

If the error had been discovered in 2X12 instead of 2X13, a correcting entry would have been necessary.

In 2X12, purchases was debited and accounts payable was credited for $850 for merchandise acquired in 2X11 and included in the ending inventory of 2X11. Retained earnings would have to be debited for $850, representing the net income overstatement for 2X11, and purchases would have to be credited for the same amount to reduce the balance in 2X12. The correcting entry in 2X12, assuming the company uses a periodic inventory system, would have been as follows:

Retained earnings

850

Purchases

850

If the company had used a perpetual system, the incorrect purchase would have been debited directly to the inventory. Accordingly, the correcting entry would have been made in 2X12:

Retained earnings

850

Inventory

850

 


(3) Failure to record merchandise sales: It is discovered that sales on account of $1,800 for the last week of December 2X12 had not been recorded until 2X13. The goods sold were not included in the inventory at the end of 2X12.The effects of the failure to report the revenue in 2X12 follow:

Income statement

Balance sheet

2×12

Revenue understated (sales too low)

Net income understated

Assets understated (accounts receivable too low)

Retained earnings overstated

When the error is discovered in 2X13, sales is debited for $1,800 and retained earnings is credited for this amount, representing the net income understatement for 2X12. The following entry is made:

Sales

1,800

Retained earnings

1,800

(4) Failure to record accrued expense: Accrued sales salaries of $450 as of December 31, 2X11, were overlooked in adjusting the accounts. Sales salaries is debited for salary payments. The effects of the failure to record the accrued expense of $450 as of December 31, 2X11, were as presented in ‘Types of errors‘.

Income statement

Balance sheet

2×11

Expenses understated (sales salaries too low)

Net income overstated

Liabilities understood (accrued salaries not reported)

Retained earnings overstated

2×12

Expenses overstated (salaries too high)

Net income understated

Balance sheet items not affected, retained earnings overstatement for 2X11 begin adjusted by net income understatement for 2X12

No entry is required in 2X13 to correct the accounts for the failure to record the accrued expense at the end of 2X11, the misstatement in 2X11 having been counterbalanced by the misstatement in 2X12.

However, if comparative income statements were presented in 2X13, then the amounts reported for sales salaries in 2X11 and 2X12 would be adjusted. If the error had been discovered in 2X12, an entry would have been required to correct the accounts for the failure to record the accrued expense at the end of 2X11, if the net income for 2X12 is not to be misstated. If accrued expenses are to be properly recorded at the end of 2X12, retained earnings would be debited for $450, representing the net income overstatement for 2X11, and sales salaries would be credited for the same amount, representing the amount to be subtracted from salary expenses in 2X12. The correcting entry made in 2X12 follows:

Retained earnings

450

Sales Salaries

450

 


(5) Failure to record prepaid expense: It is discovered that other general expense for 2X11 included taxes of $275 that should have been deferred in adjusting the accounts on December 31, 2X11. The effects of the failure to record the prepaid expense were as follows:

Income statement

Balance sheet

2×11

Expenses overstated (miscellaneous general expenses too high)

Net income overstated

Assets understated (prepaid taxes not reported)

Retained earnings overstated

2×12

Expenses understated (miscellaneous general expenses too low)

Net income understated

Balance sheet items not affected, retained earnings understatement for 2X11 begin adjusted by net income overstatement for 2X12

Because this is a counterbalancing error (see ‘Types of errors‘), no entry to correct the accounts is required in 2X13.

If the error had been discovered in 2X12 instead of 2X13, a correcting entry would have been necessary. If prepaid taxes had been properly recorded at the end of 2X12, other general expense would have to be debited for $275, the expense relating to operations of 2X12, and retained earnings would have to be credited for the same amount, representing the net income understatement for 2X11. The following correcting entry would have been made in 2X12:

Other general expense

275

Retained earnings

275

 


(6) Failure to record accrued revenue: Accrued interest on notes receivable of $150 was overlooked in adjusting the accounts on December 31, 2×11. The revenue was recognised when the interest was collected on 2×12. The effects of the failure to record the accrued revenue are as follows:

Income statement

Balance sheet

2×11

Revenue understated (interest income too low)

Net income understated

Assets understated (interest receivable not reported)

Retained earnings overstated

2×12

Expenses overstated (interest income too high)

Net income overstated

Balance sheet items not affected, retained earnings understatement for 2X11 begin adjusted by net income overstatement for 2X12

Because the balance sheet items at the end of 2X12 were correctly stated, no entry to correct the accounts is required in 2X13.

If the error had been discovered in 2X12 instead of 2X13, an entry would have been necessary to correct the account balances. If accrued interest on notes receivable had been properly recorded at the end of 2X12, interest income would have to be debited for $150, the amount to be subtracted from receipts of 2X12, and retained earnings would have to be credited for the same amount, representing the net income understatement for 2X11. The correcting entry in 2X12 would have been as follows:

Interest income

150

Retained earnings

150

 


(7) Failure to record unearned revenue: Fees of $225 received in advance for miscellaneous services as of December 31, 2X12, were overlooked in adjusting the accounts. Other income had been credited when fees were received. The effects of the failure to recognize the unearned revenue of $225 at the end of 2X12 were as follows:

Income statement

Balance sheet

2×12

Revenue overstated (Other income too high)

Net income overstated

Liabilities understated (unearned service fees not reported)

Retained earnings overstated

An entry is required to correct the accounts for the failure to record the unearned revenue at the end of 2X12 if the net income for 2X13 is not to be misstated. If the unearned revenue was properly recorded at the end of 2X13, retained earnings would be debited for $225, representing the net income overstatement for 2X12, and other income would be credited for the same amount, representing the revenue that is to be identified with 2X13. The correcting entry follows:

Retained Earnings

225

Other income

225

 


(8) Failure to record depreciation: Delivery equipment was acquired at the beginning of 2X11 at a cost of $6,000. The equipment has an estimated 5-year life. Its depreciation of $1,200 was overlooked at the end of 2X11 and 2X12. The effects of the failure to record depreciation for 2X11 were as follows:

Income statement

Balance sheet

2×11

Expenses understated (depreciation of delivery equipment too low)

Net income understated

Assets overstated (accumulation depreciation of delivery equipment too low)

Retained earnings overstated

2×12

Expenses not affected

Net income overstated

Assets overstated (accumulated depreciation of delivery equipment too low)

Retained earnings overstated

It should be observed that the misstatements arising from the failure to record depreciation are not counterbalanced in the succeeding year.

Failure to record depreciation for 2X12 affected the statements as follows:

Income statement

Balance sheet

2×12

Expenses understated (depreciation of equipment too low)

Net income overstated

Assets overstated (accumulated depreciation of delivery equipment too low)

Retained earnings overstated

When the omission is recognized, retained earnings must be decreased by the net income overstatements of prior years and accumulated depreciation must be increased by the depreciation that should have been recorded. The correcting entry in 2X13 for the depreciation that should have been recognized for 2X11 and 2X12 is as follows:

Retained earnings

2,400

Accumulated depreciation—Delivery equipment

2,400


(9) Incorrectly capitalizing an expenditure: Operating expenses of $2,000 were paid in cash at the beginning of 2X11. However, the payment was incorrectly recorded as the purchase of equipment. The “equipment” was assumed to have an estimated 5-year life with $0 residual value, and depreciation of $400 was recognized at the end of 2X11 and 2X12. The effects of this incorrect capitalization of expenditure were as follows:

Income statement

Balance sheet

2×11

Expenses understated (operating expense too low, partially offset by depreciation expenses)

Net income overstated

Assets overstated (asset, net of accumulated depreciation, is recorded when there should not be an asset)

Retained earnings overstated

2×12

Expenses overstated (depreciation too high)

Net income understated

Assets overstated (asset is still incorrectly recorded, though the net amount is less)

Retained earnings overstated

When the error is discovered, retained earnings must be decreased by the net income overstatement of 2X11 (partially offset by the net income understatement in 2X12) and the accounts related to the “equipment” (Equipment – Accumulated depreciation) must be eliminated. The adjusting entry in 2X13 is as follows:

Retained earnings

1,200

Equipment — Accumulated depreciation

800

Equipment

2,000

In summary the effects of these errors on the financial statements, before any correcting entries, are indicated as follows: A plus sign (+/+) indicates an overstatement and a minus sign (-/-) indicates an understatement.

The following table shows an overview of the effect of errors in these transactions (1) – (9):

At the end of 2×13

At the end of 2×12

Transaction

Balance sheet

Income statement

Balance sheet

Income statement

Account

Retained earnings

Account

Net income

Account

Retained earnings

Account

Net income

(1)

Examples of adjustments of errorsExamples of adjustments of errors

Cost of goods sold

-/-

+/+

(2)

Examples of adjustments of errorsExamples of adjustments of errors

Cost of goods sold

+/+

-/-

(3)

Examples of adjustments of errorsExamples of adjustments of errors

Sales

+/+

+/+

Accounts receivable

-/-

-/-

Sales

-/-

-/-

(4)

Examples of adjustments of errorsExamples of adjustments of errorsExamples of adjustments of errorsExamples of adjustments of errorsExamples of adjustments of errors

Selling expense

+/+

-/-

(5)

General expense

-/-

+/+

(6)

Other income +/+

+/+

(7)

Other income

-/-

-/-

Current liabilities

-/-

+/+

Other income +/+

+/+

Non-current assets

+/+

+/+

Non-current assets

+/+

+/+

(8)

Non-current assets

+/+

+/+

Non-current assets

-/-

+/+

Selling expense

-/-

+/+

(9)

Non-current assets

+/+

+/+

Non-current assets

+/+

+/+

Operating expense

+/+

-/-

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