Error Correction

Lets start this episodes tutorial by defining todays subject of discussion: Prior period errors are omissions from and misstatements in the entitys financial statements for one or more periods arising from a failure to use or misuse of reliable information. There are three types of errors and we will discuss each in detail. I. Statement of Financial Position Errors Statement of Financial Errors, as the name suggests, affect the statement of financial position or permanent accounts only resulting to improper classification of an asset, liability and equity account. To correct such error, a reclassification entry is simply made as illustrated in the following example. Evitta Corporations accountant made a mistake in recording the years credit sales by debiting Notes Receivable instead of Accounts Receivable for P 160,000. The following entry will be made upon discovery of the mistake: Accounts Receivable Notes Receivable II. Income Statement Errors Income Statement Errors affect income statement or temporary accounts. These errors do not affect net income and the statement of financial position. A correcting entry is only necessary if the error is discovered in the current year. Since the temporary accounts are closed every accounting period, an income statement error has no effect on subsequent periods. Suppose the accountant of Posh Nails Co. mistakenly credited Rent Income for P 111,000 in its 2013 Income Statement. This amount represents interest earned on the companys Investment in Bonds. If the error is discovered in 2013, the following correcting entry is made: Rent Income 111,000 Interest Income 111,000 If error is discovered subsequently in 2014, NO ENTRY will be made. III. Combined Statement of Financial Position and Income Statement Errors Combined Statement of Financial Position and Income Statement Errors result to misstatement of net income. 160,000 160,000

They can be either: 1) Counterbalancing 2) Noncounterbalancing A. We first discuss counterbalancing errors: These are errors that automatically corrects in the next accounting period, if left undetected. Such errors affect the current and immediately subsequent period thus offsetting its effect over the two periods. The effect of such error is as follows: a. Income statement of years 1 and 2 are misstated. b. Statement of financial position of year 1 is misstated. c. Statement of financial position of year 2 is correctly stated. The following example illustrates the effect of counterbalancing errors. (a) On 12/31/2013, that the physical count used as basis for recording inventory was overstated by P 75,000. (b) On 12/31/2014, accrued salaries expense of P30,000 was not recorded. The effect of these errors on net income over the 3-year period is broken down as follows: 2013NI Overstatement of 2013 EI Overstatement of 2014 BI because of (a) Unrecorded accrued expenses in 2014 Overstated 2015 Salaries Expense because of (b) Overstated by 75,000 Understated by 45,000 Overstated by 75,000 2014 NI 2015 NI

Understated by 75,000

Overstated by 30,000

Understated by 30,000 Understated by 30,000

*The net effect of these errors on net income is ZERO. The 2014 understatement can be broken down into two (1) Understatement of 75,000 to correct the error in 2013 and (2) an overstatement of 30,000 as a resulted of a new error which is subsequently offset by the 2015 understated NI. (a) The overstatement of 2013 EI inventory also resulted to the overstatement of 2014 BI. Thus, 2013 NI is overstated while 2014 NI is understated by the same amount. The effect of this error is thus cancelled in 2014. While 2013 and 2014 Income Statement are both misstated, Retained Earnings balance in the 2014 statement of financial position is correctly stated because of the offsetting errors of the 2013 and 2014 net income closed to that account. (b) Unrecorded expenses in 2014 resulted to overstatement of 2014 NI. However, these expenses will be paid in the subsequent year and thus, a higher amount of expense will be recorded in the

year of payment, 2015. Higher expense recognized in 2015 will understate the years NI. Again, the effect of the error will offset over the two years. B. We now move to Noncounterbalancing errors. Unlike the first type of error we discussed, noncounterbalancing errors are not automatically corrected because misstatement in year 1 has no effect on year 2. Its effects are as follows: a. Income Statement for of year 1 is misstated. b. Subsequent Income Statements are correctly stated. c. Statement of Financial Position of year 1 and all subsequent years are misstated until the error is corrected. Lets discuss the matter deeper through the following example: On December 31,2013, the auditor of ABS-CBN Corporation discovered an error in recording the years depreciation. Instead of using the sum of years digit method, the accountant used the straight line method. The related equipment is purchase at the beginning of 2013 for P1,200,000 with an estimated life of 5 years. Depreciation under the two methods: Straight Line 240,000 Sum of Years 400,000

If the books have not been closed, the correcting entry is: Depreciation Expense 160,000 Accumulated Depreciation 160,000 If the books have been closed, the correction entry is: Retained Earnings 160,000 Accumulated Depreciation 160,000 *Note that the entry above ignore income tax effects.