ERROR CORRECTION

I. INTRODUCTION

An error correction is the correction of an error in previously issued financial statements. This can be an
error in the recognition, measurement, presentation, or disclosure in financial statements that are
caused by mathematical mistakes, mistakes in applying the Generally Accepted Accounting Principles
(GAAP) or oversight of details existing when the financial statements were prepared. 

Examples of accounting errors: 

 Misapplication of accounting policies: e.g. not recognizing sale upon transfer of goods to a
customer

 Fraud: e.g. overstating sales revenue by issuing fake invoices before the reporting date

 Misunderstanding of, or failure to notice, information at the time of preparation of financial

statements:

 e.g. not writing off a receivable who had been announced as insolvent before the authorization
of financial statements

 Arithmetical errors

 Omission of transactions and events from the financial statements.

Accounting errors distinguished from accounting change

Unlike accounting errors, accounting change is a revision in accounting principle, accounting estimate or
the reporting entity that can trigger changes in the reported revenue or other financial aspects of a
business.

Accounting errors distinguished from fraud 

Unlike accounting error, fraud is the intentional manipulation of financial statements to create a false
appearance of corporate financial health.

Detection and prevention of accounting errors

Unintentional accounting errors are common if the journal keeper is not careful or the accounting
software is outdated. The discovery of such errors usually occurs when companies conduct their month-
end book closings. Some companies may perform this task at the end of each week. Most errors, if not
all, can be corrected fairly easily.
An audit trail may be necessary if a material discrepancy cannot be resolved quickly. The normal method
to handle immaterial discrepancies is to create a suspense account on the balance sheet or net out the
minor amount on the income statement as "other.

Keeping track of invoices to customers and from vendors and ensuring they're entered immediately and
properly into the accounting software can help reduce clerical errors. A monthly bank reconciliation can
help to catch errors before the reporting period at the end of the quarter or fiscal year. A bank
reconciliation is a comparison of a company's internal financial records and transactions to the bank's
statement records for the company.

Companies can not prevent all errors, but with proper internal controls, they can be identified and
corrected relatively quickly.

Materiality of an accounting error in financial statement

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence

decisions that the primary users of general purpose financial statements make on the basis of those
financial statements, which provide financial information about a specific reporting entity. Materiality
should be assessed with respect to the misstatement’s impact on prior period financial statements and,
in the event prior period financial statements are not restated or adjusted, with respect to the impact of
the misstatement’s correction on the current period financial statements. 

II. PRIOR PERIOD ERROR

Prior period errors are omissions from, and misstatements in, an entity's financial statements for one or
more prior periods arising from a failure to use, or misuse of, reliable information that was available and
could reasonably be expected to have been obtained and taken into account in preparing those
statements. 

Prior period errors result from mathematical mistakes, mistakes in applying accounting policies,
oversights or misinterpretations of facts, and fraud.

Treatment for prior period errors

        Prior period errors must be corrected retrospectively in the financial statements. Retrospective
application means that the correction affects only prior period comparative figures. Current period
amounts are unaffected. Therefore, comparative amounts of each prior period presented which contain
errors are restated. Prior period financial statements should be restated when there is an error
correction. Restatement requires the accountant to:

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

 if the error occurred before the earliest prior period presented, restating the opening balances
of assets, liabilities and equity for the earliest prior period presented.
If the financial statements are only presented for a single period, then reflect the adjustment in the
opening balance of retained earnings.

If you correct an item of profit or loss in any interim period other than the first interim period of a fiscal
year, and some portion of the adjustment relates to prior interim periods, then do the following:

 Include that portion of the correction related to the current interim period in that period; and

 Restate prior interim periods to include that portion of the correction applicable to them; and

 Record any portion of the correct related to prior fiscal years in the first interim period of the
current fiscal year.

Disclosures relating to prior period errors include:

 the nature of the prior period error 

 for each prior period presented, to the extent practicable, the amount of the correction:

o for each financial statement line item affected, and

o for basic and diluted earnings per share(only if the entity is applying PAS 33) 

 the amount of the correction at the beginning of the earliest prior period presented if
retrospective restatement is impracticable, an explanation and description of how the error has
been corrected.

Financial statements of subsequent periods need not repeat these disclosures.

III. TYPES OF ERRORS

Income statement errors distinguished from statement of financial position errors

 Income Statement Errors

Original entry only impacted nominal accounts. No effect on net income –no restatement of retained
earnings is required. Record correcting entry for current period. If error occurred in prior year, no entry
required, but if comparative financial statements are presented, errors of prior periods should be
corrected for each year presented. Frequently, income statement errors are classification errors. Could
also be improper netting of revenues against expenses.

 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.

 Combined Statement of Financial Position and Income Statement Errors

These are errors that result in a misstatement of net income because they both affect the statement of
financial position and the income statement.

It can be classified as counterbalancing and noncounterbalancing errors.

 Other accounting errors:

o Subsidiary entries

Subsidiary entries are transactions entered incorrectly. Usually, this mistake isn’t found until you do your
bank reconciliation.

Example: you loan a client ₱2500 but enter it as a ₱25 transaction (and ₱25 withdrawal from your cash
account).

 Transposition errors

This mistake happens when two digits are reversed (or “transposed”). The error will show itself as a
mistake in data entry when you post a new recording. Though it’s a simple error, it can affect your
accounting significantly and result in financial losses—not to mention plenty of time trying to find this
tiny error.

Example: “52” instead of “25.” Or “2643” instead of “2463.”

 Rounding errors

Rounding a number off seems like it shouldn’t matter but it can throw off your accounting, resulting in a
snowball effect of errors. People can make this mistake, but it can also be a computerized error.

Example: “3” instead of “2.9” or “65.765” instead of “65.7646.”

 Entry reversal

Reversing accounting entries means that an entry is credited instead of being debited, or vice versa. The
issue is that you can’t spot this mistake in your trial balance—it will still be in balance regardless.

Example: a payment for home internet is entered as an invoice by mistake.

 Error of omission

This happens when a financial transaction isn’t recorded and so isn’t part of the documentation. Usually
the transaction, which could be an expense or sale of a service, is overlooked or forgotten.

Example: a photographer forgets to enter the ₱1000 cheque she received from shooting a wedding the
previous weekend.

 Error of commission

When an amount is entered as the right amount and the right account but the value is wrong, this is an
error of commission. This can mean that perhaps a sum is subtracted instead of added.

Example: a payment is applied to the wrong invoice. The amount owed by the client will be right in the
trial balance. But, the client’s subledger (or entry details) will be off.
  Error of principle

This is a transaction that doesn’t meet the generally accepted accounting principles (GAAP). It’s also
called an “input error” because, though the number is correct, it’s recorded in the wrong account.

Example: an asset is expensed which causes it to be recorded as a debit, instead of what it should be: an
asset.

 Duplication errors

Error of duplication is when an accounting entry is duplicated, meaning it's debited or credited twice for
the same entry. For example, an expense was debited twice for the same amount would be an error of
duplication.

 Compensating errors

Compensating error is when one error has been compensated by an offsetting entry that's also in error.
For example, the wrong amount is recorded in inventory and is balanced out by the same wrong amount
being recorded in accounts payable to pay for that inventory.

IV. IMPACT OF ERRORS ON FINANCIAL STATEMENT

Classification of combined statement of financial position and income statement errors 

A. Counterbalancing Errors

Errors that are automatically corrected in the next accounting period as a natural part of the accounting
process. These errors will be offset or corrected themselves over two periods.

Effects of Counterbalancing

1. The income statements for two successive periods are incorrect.

2. The statement of financial position at the end of the second period is correct

3. The statement of financial position at the end of the second period is correct

  (a) Overstatement of ending inventory

1. Overstatement of ending inventory will result to Understatement of Cost of Goods Sold

2. Understatement of Cost of Goods Sold will result in overstatement of Net Income

3. Overstatement of Ending Inventory will result to overstatement of asset

4. Overstatement of Net Income will result to overstatement of Equity

 If the book is not have been closed the entry to correct the error will be
Retained Earnings  xx

           Inventory                   xx 

  If the book has not been closed no entry is necessary because the error will be counterbalanced
in the next accounting period.

(b) Understatement of ending inventory

1. Understatement of Ending Inventory will result to Overstatement of Cost of Goods Sold

2. Overstatement of Cost of Goods will result to Understatement of the Net Income

3. The Understatement of Net Income will result in Understatement of the equity.

4. The Understatement of the Ending Inventory will result in Understatement of the asset

 If the book is not have been closed the entry to correct the error will be

Inventory                     xx

    Retained Earnings         xx

(c) Understatement of purchases

1. Understatement of purchases will result to overstatement of Cost of Goods Sold

2. Overstatement of Cost of Goods Sold will result to understatement of Net Income

3. Understatement of Net Income will result to Understatement of equity

  If the book is not have been closed the entry to correct the error will be:

Sales                                xx

      Retained Earnings         xx

  If the book is closed no entry is necessary because it will be counterbalanced in the next
accounting period.

(d) Overstatement of purchases and ending inventory

Entity recorded purchase in transit and the title is not yet to the entity. Merchandise was included in the
inventory.

1. Overstatement of purchase will result to an understatement of Net Income

2. Overstatement of purchase will result to an overstatement of assets

3. Overstatement of Ending Inventory will result to an overstatement of Net Income, 

4. Overstatement of Ending Inventory will result to understatement of cost of goods sold,

5. Understatement of cost of goods sold will result to overstatement of net income, 

6. Overstatement of net income will result to overstatement of equity and assets

  If the book not have been closed: To correct the error:

 Purchases                     xx 

Retained Earnings               xx

Retained Earnings       xx

Inventory account               xx

 If the book is closed: No entry required, because error will automatically counterbalanced itself
on the next accounting period . Thus, they will equalize each other.

(e) Understatement of sales

Takes place when:

The entity failed to record sales in the previous period but recorded in the following period.

1. Understatement of sales will result to an understatement of Net Income

  If the book is not have been closed: To correct the error:

Sales                              xx

Retained Earnings              xx

 If the book is closed: No entry required, because error is automatically counterbalanced itself on
the next accounting period. Thus, they will equalize each other.

(f) Overstatement of sales and understatement of ending inventory 

Takes place when:

Entity recorded sales in transit and to which the customer had no title. Cost of merchandise was
excluded from the inventory.

1. Overstatement of sales will result to an overstatement of Net Income

2. Understatement of Ending Inventory will result to an understatement of Net Income

3. Understatement of ending inventory will result to overstatement of cost of goods sold,

4.  Overstatement of cost of goods sold will result to understatement of net income,

5. Understatement of net income will result in overstatement of equity and assets.

 If the book is not have been closed: To correct the error:

Retained Earnings     xx

Sales                                         xx
Inventory Account    xx

Retained Earnings                   xx

 If the book is closed: No entry required, because error will automatically counterbalance itself in
the following year. Thus, they will equalize the effect on Net Income.

(g)  Failure to record prepaid expense

 Failure to recognize prepaid expenses at the end of the year will lead to overstatement of your
expense and understatement of net income in the same year. 

 If the book have not been closed, the entry to correct the error is:

Appropriate Account       xx

         Retained Earnings   xx

 If the book is closed: No entry required, because error will automatically counterbalance itself in
the following year. Thus, they will equalize the effect on Net Income.

(h)  Failure to record accrued expense

 Failure to record an accrued expense at the end of the year will understate a company's liability
on the balance sheet and related expense in the income statement and thus will overstate the
net income in the same year. 

 If the book have not been closed, the entry to correct the error is:

Retained Earnings    xx

       Appropriate Account   xx

 If the book is closed: No entry required, because error will automatically counterbalance itself in
the following year. Thus, they will equalize the effect on Net Income.

(i) Failure to record deferred income

 Omission of unearned income at year-end  will result in an overstatement of revenue, in effect;

the net income will likewise be overstated in the same year. 

 If the book have not been closed, the entry to correct the error is:

Retained Earnings    xx

       Appropriate Account     xx

 If the book is closed: No entry required, because error will automatically counterbalance itself in
the following year. Thus, they will equalize the effect on Net Income.
(j) Failure to record accrued income

 Failure to make adjustments for accrued revenue on the balance sheet causes understated
totals for the company’s assets, liabilities and net income.

 If the book have not been closed, the entry to correct the error is:

Appropriate Income   xx

      Retained Earnings  xx

 If the book is closed: No entry required, because error will automatically counterbalance itself in
the following year. Thus, they will equalize the effect on Net Income.

B. Noncounterbalancing Error

Errors that take more than one period to correct themselves, they will not automatically offset in the
next accounting period. It makes no difference whether books are closed or open, a correcting journal
entry is necessary. 

Effects of Noncounterbalancing Error

(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 succeeding statement of financial position is
incorrect until the error is corrected.

The best example of a noncounterbalancing error is the misstatement of depreciation. 

V. ACCOUNTABILITY PROCEDURE

Philippine Standard on Auditing(PSA) 240 requires both management and those charged with
governance as responsible for the prevention and detection of fraud and errors.

 Management is responsible to establish a control environment and to implement internal

control policies and procedures designed to ensure, among others, the detection and
prevention of fraud and error.

 Individuals charged with governance of an entity are responsible to ensure the integrity of an
entity’s accounting and financial reporting systems and that appropriate controls are in place.