PRACTICAL AUDITING Prepared by: Roda R.

Santos

Module 2
MISSTATEMENTS IN THE FINANCIAL STATEMENTS

EXPECTED LEARNING OUTCOMES

After reading this chapter, you should be able to

a) distinguish errors from fraud;

b) state how an auditor should deal with errors and fraud;
c) classify errors into counterbalancing and non-counterbalancing;
d) formulate audit adjusting entries for identified misstatements in the client-prepared financial
statements;
e) prepare working paper for correction of errors; and
f) restate financial statements which previously contained misstatements.

Errors and Fraud

An auditor obtains reasonable assurance about whether the financial statements are free
of material misstatements. Misstatements occur because of errors and/or fraud. Errors are
unintentional misstatements or omissions in financial statements. Fraud, in contrast, Is an
intentional misrepresentation of a material fact that includes fraudulent financial reporting and
misappropriation of assets. Fraudulent financial reporting takes the form of intentional
misstatements or omission of amounts or disclosures in financial statements with the intention of
deceiving the users to achieve a desired effect. Examples of this type include manipulation of
records, falsification, alteration of documents, and intentional misapplication of accounting
policies. Misappropriations are actually theft and are usually committed by employees. Examples
are embezzling cash, stealing inventory or causing payments for goods and services that are not
received.

Evaluation of Misstatements Identified During the Audit

Other errors are not discovered immediately and were reflected on the financial
statements issued in the prior periods. When errors of this kind are discovered, careful analysis
is necessary to determine the required action to rectify the account balances. Such errors are
called prior period errors.

Prior period errors are omissions from and misstatements in the entity's financial
statements for one or more prior periods arising from a failure to use, or misuse of, reliable
information that was available when financial statements for those periods were authorized for
issue and could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements. Such errors include the effects of
mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations
of facts, and fraud (par. 5, PAS 8).

Errors that affect income and expense accounts are either non counterbalancing or
counterbalancing. A non-counterbalancing error is not rectified until the asset or liability affected
has been disposed of or settled, or a correcting entry has been made. Examples of this type are
errors affecting depreciation, intangible assets or non-current liabilities,

A counterbalancing error is one which, when not detected within the subsequent financial
year, is automatically corrected, because the error in the period it was committed is offset by is
offset by a misstatement in the subsequent reporting period. Counterbalancing errors include the
following:

⮚ Misstatement in prepaid expense that expires or is consumed in the subsequent year;

⮚ Misstatement in unearned revenue that is earned in the subsequent year;
⮚ Misstatement in accrued expense that is paid in the subsequent year;
⮚ Misstatement in accrued income that is collected in the subsequent year;
⮚ Misstatement in ending inventory;
PRACTICAL AUDITING Prepared by: Roda R. Santos

⮚ Error in sales cutoff; and

⮚ Error in purchases cutoff

Counterbalancing errors that are committed during the current reporting period shall likewise
be corrected immediately to free the financial statements of any material misstatements. Financial
statements are considered to be not reliable and therefore not complying with Philippine Financial
Reporting Standards (PFRSs) if they contain material errors or immaterial errors made
intentionally to achieve a particular presentation.

To emphasize, current period errors discovered before the issuance of the financial
statements are immediately corrected, whether the errors are counterbalancing or non-
counterbalancing.

The auditor shall prepare audit adjustments to correct material prior period errors in the first
set of financial statements authorized for issue after their discovery. Complying with IAS 8 also
means that prior period financial statements shall likewise be restated. Such corrections require:

(a) Restating the comparative amounts for the prior period(s) presented in which the error
occurred; or

(b) If the error occurred before the earliest prior period presented, restating the opening
balance of assets, liabilities and equity for the earliest prior period presented.

Thus, if errors committed in 2016 were discovered in the process of examining the financial
statements for the year ended December 31, 2017, the 2016 financial statements shall be
restated for comparative purposes, without regard as to whether or not the 2017 financial
statements are affected. If the error committed in 2016 affects 2017 accounts, additional audit
adjustments would be necessary to rectify the accounts in 2017.

Other than restating the prior period financial statements, when necessary, an entity shall
disclose the following:

(a) the nature of prior period error;

(b) for each prior period presented, to the extent practicable, the amount of the correction

1. for each financial statement line item affected; and

2. (if the company is required to present earnings per share) for basic and diluted
earnings per share;
(c) the amount of the correction at the beginning of the earliest prior period presented; and
(d) if retrospective restatement is impracticable for a particular prior period, the circumstances
that led to the existence of that condition and a description of how and from when the error
has been corrected.
PRACTICAL AUDITING Prepared by: Roda R. Santos

MULTIPLE CHOICE

Items 1 and 3 are based on the following information:

Robi Corporation reported profit for the years 2016 and 2017 at P550,000 and P700,000,
respectively. Your audit of the company's accounts disclosed the need for adjustments as follows:
2016 2017
Overstatement of ending inventories due to error in pricing P 29,000 P 33,000
Omission of depreciation on newly acquired equipment 15,000 15,000
Understatement of commission receivable 22,000 18,000
A purchase of merchandise was not recorded until the following 60,000
year, and also was not included in the ending inventory.

1. The adjusted profit for 2017 was

A. P677,000.
B. P700,000
C.P710,000
D. P737,000

2. What is the effect of the foregoing errors on total assets at December 31, 2017?

A. P30,000 overstated
B. P36,000 overstated
C. P45,000 overstated
D. P66,000 overstated

3. What is the effect of the foregoing errors on retained earnings at December 31, 2016?

A. P22,000 overstated
B. P38,000 understated
C. P67,000 overstated
D. P82,000 overstated

4. Magic Company failed to recognize accruals and prepayments during its first year of
operations. The pretax earnings, accruals and prepayments at the end of the year were:
Pre-tax profit P 5,000,000
Items not recognized at year end were as follows:
Prepaid insurance 200,000
Accrued wages 250,000
Rent revenue collected in advance 300,000
Interest receivable 100,000

The correct amount of pre-tax profit should be

A. P 4,750,000
B. P 4,950,000
C. P 5,000,000
D. P 5,250,000

5. Bee Gees Company's statements for 2016 and 2017 included errors as follows:
Year Ending Inventory Depreciation
2016 P 200,000 understated P 50,000 understated
2017 P 300,000 overstated P 100,000 overstated

For how much should retained earnings be retroactively adjusted at January 1, 2018?

A. P 250,000 increase.
B. P 250,000 decrease.
PRACTICAL AUDITING Prepared by: Roda R. Santos

C. P 400,000 decrease.
D. P 200,000 decrease.

Items 6 and 7 are based on the following information:

The Beatles Manufacturing Company began operations on January 1, 2016. Financial statements
for the years ended December 31, 2016 and 2017, contained the following errors:
2016 2017
Ending inventory P16,000 understated P15,000 overstated
Depreciation expense 6,000 understated
Insurance expense 10,000 overstated 10,000 understated
Prepaid insurance 10,000 understated

In addition, on December 31, 2017, fully depreciated machinery was sold for P10,800 cash, but
the sale was not recorded until 2018. There were no other errors during 2016 or 2017 and no
corrections have been made for any of the errors.

6. Ignoring income taxes, what is the total effect of the errors on 2017 profit?

A. P 30,200 overstated.
B. P 11,000 overstated.
C. P 5,800 overstated.
D. P 1,800 understated.

7. Ignoring income taxes, what is the total effect of the errors on the amount of working capital at
December 31, 2017?

A. P 4,200 overstated.
B. P 5,800 understated.
C. P 6,000 understated.
D. P 9,800 understated.

8. The Clarity, Inc. has determined its 2017 profit to be P 5000000 In an initial audit of the
company's financial statements, you determined the following:

● Revenue received in advance in 2017 of P250,000 was credited to a revenue account

when received. Of the total, P50,000 was earned in 2017, P120,000 will be earned in
2018, and the remainder will be earned in 2019. No adjustment was made at the end of
2017.

● P150,000 unrealized loss on FVPL (financial assets at fair value through profit or loss) in
2017 was erroneously debited to other comprehensive income account.

What is the corrected profit for the year 2017?

A. P 4600000
B. P 4650000
C. P 4850000
D. P 4930000

Items 9 through 11 are based on the following information:

9. The Vitality Company showed pre-tax income of P 2500000 for the year ended December 31,
2017. On your year-end verification of the transactions of the Company, you discovered the
following errors:

● P 1000000 worth of merchandise was purchased in 2017 and included in the ending
inventory. However, the purchase was recorded only in 2018.
PRACTICAL AUDITING Prepared by: Roda R. Santos

● A merchandise shipment valued at P 1500000 was properly recorded as purchases at

year end. The merchandise was inadvertently omitted from the physical count, since it has
not arrived by December 31, 2017
● Value added tax for the fourth quarter of 2017, amounting to P500,000, was included in
the Sales account.
● Rental of P300,000 on an equipment, applicable for six months, was received on
November 1, 2017. The entire amount was reported as revenue upon receipt.
● Rent paid on building covering the period from July 1, 2017 to July 1, 2018, amounting to
P 1200000 was paid and recorded as expense on July 1, 2017. The company did not
make any adjustment at the end of the year.

The corrected pretax profit for 2017 should be

A. P 2,400,000
B. P 2,900,000
C. P 3,000,000
D. P 3,400,000

10. What is the net effect of the foregoing errors on the total assets at December 31, 2017?

A. P 600,000 understated
B. P 1,100,000 understated
C. P 1,500,000 understated
D. P 2,100,000 understated

11. What is the total understatement of the total liabilities at December 31, 2017?

A. P 3,200,000
B. P 1,700,000
C. P 1,500,000
D. P 1,200,000

12. On January 1, 2016, Erik Corporation acquired a machine at a cost of P200,000 It was to be
depreciated on the straight-line method over a five-year period with no residual value. Because
of a bookkeeping error, no depreciation was recorded in Erik's 2016 financial statements. The
oversight was discovered during the preparation of Erik's 2017 financial statements. Depreciation
expense on this machine in 2017 should be

A. P 0 .00
B. P 40,000
C. P 50,000
D. P 80,000

13. Upon inspection of the records of Compact Company, the following facts were discovered for
the year ended December 31, 2017:

● A fire insurance premium of P 40,000 was paid and charged as insurance expense in
2017. The fire insurance policy covers one year from April 1, 2017.

● Inventory on January 1, 2017 was understated by P80,000

● Inventory on December 31, 2017 was understated by P120,000

● Expenses of P55,000 incurred during December were recorded when paid in January
2018.

● On December 5, 2017, Compact credited to sales a cash advance of P100,000 received

from a customer for goods delivered in January 2018. The company's gross profit on sales
is 40%.
PRACTICAL AUDITING Prepared by: Roda R. Santos

● The profit of Compact Company for the year ended December 31, 2017, before any
adjustment for the above information, is P 1550000

What is Compact Company's corrected profit for the year ended December 31, 2017?

A. P 1,365,000
B. P 1,425,000
C. P 1,445,000
D. P 1,505,000

14. Leslie Inc. has correctly determined the following information related to operations for 2017:
Revenue from sales P 7,000,000
Expenses 4,000,000
Income before income taxes 3,000,000

In reviewing the records, you discovered the following items:

● During 2017, the company discovered an error in depreciation in 2016. The correction of
this error, which has not been recorded, will result in an increase in depreciation for 2016
of P 200,000.

● During 2017, the company sustained a loss of P400,000 because of flood, which
destroyed its inventory. The company charged retained earnings and credited inventory
for P400,000.
How much is the correct profit before tax for the year 2017?

A. P 2,400,000
B. P 2,600,000
C. P 3,000,000
D. P 3,400,000

15. Accrued salaries payable of P70,000 were not recorded at December 31, 2016. Prepaid
insurance of P30,000 at December 31, 2017 were erroneously treated as expense. Neither of
these errors was discovered nor corrected. The effect of these two errors would cause

A. 2017 profit to be understated P100,000 and December 31, 2017 retained earnings to
be understated P30,000.
B. 2016 profit and December 31, 2016 retained earnings to be understated P70,000 each.
C. 2016 profit to be overstated P40,000 and 2017 profit to be understated P30,000.
D. 2017 profit and December 31, 2017 retained earnings to be understated P30,000 each.

Items 16 and 17 are based on the following information:

Nokia Company purchased pressing machinery that cost P54,000 on January 4, 2015. The entire
cost was recorded as an expense. The machinery has a nine-year life and a P50,400 depreciable
cost. The error was discovered on December 20, 2017.

16. Ignoring income tax considerations, Nokia's statement of comprehensive income for the year
ended December 31, 2017 should show depreciation expense in the amount of

A. P 48,400.
B. P 32,700.
C. P 16,800.
D. P 5,600.

17. Before the correction was made, the January 1, 2017, retained eamine understated by

A. P54,000.
PRACTICAL AUDITING Prepared by: Roda R. Santos

B. P48,400.
C. P42,800.
D. P37,200

18. A company using a periodic inventory system neglected to record a purchase of merchandise
on account at year-end. This merchandise was omitted from the year end physical count. How
will these errors affect assets, liabilities, and stockholders' equity at year end and profit for the
year?
Assets Liabilities Shareholders' Equity Profit
A. No effect Understate Overstate Overstate
B. No effect Overstate Understate Understate
C. Understate Understate No effect No effect
D. Understate No effect Understate Understate

19. Fuschia Company is a calendar year corporation. Its financial statements for the years 2017
and 2016 contained errors as follows:
2017 2016
Ending inventory P300,000 overstated P400,000 understated
Depreciation expense 500,000 understated 200,000 overstated
Rent income ? 350,000 overstated
Unearned rent income 350,000 understated

Assume that no correcting entries were made at December 31, 2016. By how much will 2017
profit before income taxes be overstated because of the foregoing errors?

A. P850,000
B. P800,000
C. P750,000
D. P250,000

20. Assume that no correcting entries were made in both 2016 and 2017. For how much was the
retained earnings understated or overstated as of December 31, 2017?

A. P 600,000 overstated
B. P 800,000 overstated
C. P 1,050,000 overstated
D. P 200,000 understated