Module 1 Correction of Errors

AUDITING & ASSURANCE: CONCEPTS AND APPLICATIONS 1
MODULE 1: CORRECTION OF ERRORS

Glen De Vera De Leon, CPA, MBA, AFBE, FRIAcc, Ph. D
TOPIC OVERVIEW:
This chapter discusses errors, its types and the concept of error corrections.
LEARNING OBJECTIVES:
After studying this chapter, you should be able to:
1. Define error.
2. Enumerate and describe the different types of errors.
3. Identify the effects of errors in the accounts presented in the financial statements.
4. Prepare adjusting journal entries to correct errors.
ERRORS
According to Philippine Standards on Auditing No. 240, “error refers to the unintentional misstatement in
financial statements including the omission of an amount or a disclosure, including:
1. A mistake in gathering or processing data from which financial statements are prepared;
2. An incorrect accounting estimate arising from oversight or misinterpretation of facts;
3. A mistake in the application of accounting principles relating to measurement, recognition,
classification, presentation or disclosures.
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:
(a) was available when financial statements for those periods were authorized for issue; and
(b) 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.
Accounting Treatment of Prior Period Error

According to PAS 8, par. 42, an entity shall correct material prior period errors retrospectively in the first
set of financial statements authorized for issue after their discovery by:
(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 balances of
assets, liabilities and equity for the earliest prior period presented.
Limitations on retrospective restatement

A prior period error shall be corrected by retrospective restatement except to the extent that it is
impracticable to determine either the period-specific effects or the cumulative effect of the error.
When it is impracticable to determine the period-specific effects of an error on comparative information
for one or more prior periods presented, the entity shall restate the opening balances of assets, liabilities
and equity for the earliest period for which retrospective restatement is practicable (which may be the
current period).
When it is impracticable to determine the cumulative effect at the beginning of the current period of an
error on all prior periods, the entity shall restate the comparative information to correct the error
prospectively from the earliest date practicable.
1
Basic Concepts in Correction of Errors
Errors affecting Net Income: Effect in Net Income Relationship
If Sales are overstated Overstated Direct
If Cost of sales are overstated Understated Inverse
If Expenses are overstated Understated Inverse
Errors affecting Cost of Sales: Effect in Cost of Sales Relationship

If Beginning inventories are overstated Overstated Direct
If Net purchases are overstated Overstated Direct
If Ending inventories are overstated Understated Inverse
Working Capital
Working capital is the capital of a business that is used in its day-to-day trading operations, computed as
the current assets minus current liabilities.
Errors affecting Working Capital: Effect in Working Capital Relationship
If the current assets are overstated Overstated Direct
If the current liabilities are overstated Understated Inverse
TYPES OF ERRORS
1. Balance sheet or statement of financial position errors
2. Income statement errors
3. Combined statement of financial position and income statement errors:
a. Counterbalancing errors
b. Non-counterbalancing errors
Statement of Financial Position or Balance Sheet Errors
Statement of Financial Position or Balance Sheet errors affect only presentation of an asset, liability or
stockholders’ equity account.
When the error is discovered in the error year, the company reclassifies an item to its proper position.
If the error in a prior year is discovered in a subsequent period, the company should restate the statement
of financial position of the prior year for comparative purposes.
Example:
Land of ₱ 1,000,000 in 2015 was erroneously debited to notes receivable.
Reclassifying entries:
Land 1,000,000
Notes Receivable 1,000,000
Illustration: Statement of Financial Position Error

U Can Be A Topnotcher Company reported net income for the first two years of operation as follows:
2014: 5,000,000 2015: 6,000,000
In an audit of the financial statement for the year ended December 31, 2015, the following errors are
discovered (all errors were made in 2014):
1) Notes receivable of ₱10,000 was erroneously debited to accounts receivable.
2) Notes payable of ₱15,000 was erroneously credited to accounts payable.
3) Land of ₱100,000 was erroneously debited to investment property account.
Required:
1. Compute for the adjusted net incomes in 2014 and 2015 and Retained earnings as of the years
ended December 31, 2014 and 2015.
2. Prepare adjusting entries assuming errors were discovered in (a) 2014, (b) 2015, and (c) 2016.
2
SOLUTION:
Requirement No. 1
Net Income Retained Earnings
2014 2015 2014 2015
Unadjusted balances 5,000,000 6,000,000 5,000,000 11,000,000
1) NR under and AR
over, NI unaffected 0 0 0 0
2) NP under and AP over
but NI is unaffected 0 0 0 0
3) Land under, investment property
over but NI is unaffected 0 0 0 0
Adjusted balance 5,000,000 6,000,000 5,000,000 11,000,000
Requirement No. 2
Adjusting entries if errors are discovered in:
Year:
2014:
Notes receivable 10,000
Accounts receivable 10,000
Accounts payable 15,000

Notes payable 15,000
Land 100,000
Investment property 100,000
2015:
Land 100,000
2016:
Land 100,000
Note:
In 2015 and 2016, there are no adjusting entries for the errors on the notes receivable and payable because
they are assumed to have been settled or received at the end of those years.
INCOME STATEMENT ERRORS

Income statement errors are errors affecting only the income statement accounts and may include
improper classification of revenues or expenses.
A company must make a reclassification entry when it discovers the error in the error year.
If the error discovered pertains to a prior year, the company should restate the income statement of the
prior year for comparative purposes.
Since these errors involve two nominal accounts, net income and retained earnings during the period are
unaffected.
3
Illustration: Income Statement Error
Rent income amounting to ₱10,000 in 2015 was credited instead of interest income.
Effect of the error: 2015 2016
1. Rent income O X
2. Interest income U X
3. Net income X X
4. Retained earnings after closing X X
5.Working capital at the end of the year X X
Legend: O-Overstated U-Understated X-No effect
Reclassifying entries on:

2015 2016
Rent income 10,000 No adjusting entry
Interest income 10,000
Illustration: Income Statement Errors

Dare to Dream Company reported net income for the first two years of operation as follows:
2014: 3,000,000 2015: 4,000,000
In an audit of the financial statement for the year ended December 31, 2015, the following errors are
discovered:
1) Interest expense of ₱ 20,000 in 2014 was erroneously debited to rent expense.
2) Office supplies expense of ₱25,000 in 2014 was erroneously debited to purchases.
3) Rent income of ₱30,000 in 2014 was erroneously credited to miscellaneous income.
Required:
1. Compute for the adjusted net incomes in 2014 and 2015 and Retained Earnings as of the years
ended December 31, 2014 and 2015.
SOLUTION:
Requirement No. 1
2014 2015 2014 2015
1) Int. expense under,NI
over and rent expense over, NI under 0 0 0 0
2) Supplies expense under, NI over
and purchases over, NI under 0 0 0 0
3) Rent income under, NI under
Miscellaneous income over, NI over 0 0 0 0
Adjusted Balance 3,000,000 4,000,000 3,000,000 7,000,000
Requirement No. 2
Adjusting entries if errors are discovered in:
2014:
Interest expense 20,000
Rent expense 20,000
Office supplies expense 25,000

Purchases 25,000
4
Miscellaneous income 30,000
Rent income 30,000
2015: No adjusting entries

2016: No adjusting entries
Note:
In 2015 and 2016, no adjusting entries for the errors because the effect of the error will offset when
closed to the retained earnings.
Combined Statement of Financial Position and Income Statement Errors

Errors affecting both the statement of financial position and income statement can be classified as:
1. Counterbalancing errors and
2. Non-counterbalancing errors
Counterbalancing Errors
Counterbalancing errors are errors that will offset or be corrected over two accounting periods. Examples
include the following:
Omissions of the following:
1. Deferred expense (or Prepayments under the expense method).
2. Deferred income (Pre-collection under the revenue method).
3. Accrued expenses
4. Accrued revenues
Overstatement or Understatement of the following:
5. Sales not recorded in the first year and subsequently recorded the following year (or vice versa).
6. Purchases not recorded in the first year and subsequently recorded the following year (or vice
versa).
7. Error affecting ending inventory.
Omission of deferred expense

The company paid one-year insurance premium of ₱12,000 effective April 1, 2015. The entire amount
was debited to expense account and no adjustment was made at the end of 2015.
1. Insurance expense O U
2. Prepaid insurance U X
3. Net income U O
4. Retained earnings after closing U X
5.Working capital at the end of the year U X
Adjusting entries:
2015 2016
Prepaid insurance* 3,000
Insurance expense 3,000 Insurance expense 3,000
Retained earnings 3,000
*(12,000/12 x 3)
Omission of deferred income

The company leased a portion of its building for ₱12,000. The term of the lease is one year ending April
30, 2016. Collection of rent was credited to rent revenue account. At the end of 2015, no entry was made
to take up the unearned portion of the amount collected.
1. Rent revenue O U
2. Unearned rent revenue U X
3. Net income O U
5
4. Retained earnings after closing O X
5.Working capital at the end of the year O X
Adjusting entries:
2015 2016
Rent income* 4,000
Unearned rent income 4,000 Retained earnings 4,000
Rent income 4,000
*(12,000/12 x4)
Nonrecording Of Accrued Expense

Accrued salaries expense of ₱4,000 was not recorded at the end of 2015.
1. Salaries expense U O
2. Salaries payable U X
3. Net income O U
5.Working capital at the end of the year O X
Adjusting entries:
2015 2016
Salaries expense 4,000
Salaries payable 4,000 Retained earnings 4,000
Salaries expense 4,000
Nonrecording of Accrued Revenue

Accrued rent receivable of ₱8,000 was not recorded at the end of 2015.

1. Rent income U O
2. Rent receivable U X
3. Net income U O
Adjusting entries:
2015 2016 after closing
Rent receivable 8,000
Rent income 8,000 Rent income 8,000
Retained earnings 8,000
Sales not recorded in the first year and subsequently recorded the following year.
Sale of merchandise on account on December 29, 2015 amounting to ₱20,000 was not recorded until it
was collected on January 2016. The merchandise was properly excluded in the ending inventory in 2015.
1. Sales U O
2. Accounts receivable U X
3. Net income U O
6
Adjusting entries:
2015 2016
Accounts receivable 20,000 Sales 20,000

Sales 20,000 Retained earnings 20,000
Purchases not recorded in the first year and subsequently recorded the following year.
Purchase of merchandise on account on December 27, 2015 amounting ₱50,000 was not
recorded until it was paid on January 2016. The merchandise was properly included in the ending
inventory 2015.
Effects of the error: 2015 2016
1. Purchases U O
2. Accounts payable U X
3. Net income O U
5. Working capital at the end of the year O X
Legend: O – Overstated U – Understated X – No effect
Adjusting entries:
2015 2016
Purchases 50,000 Retained Earnings 50,000
Accounts Payable 50,000 Purchases 50,000
Error affecting ending inventory (e.g. overstatement)

On December 31, 2015, the ending inventory was overstated by ₱5,000.
Effects of the error:

2015 2016
1. Cost of sales U O
2. Ending inventory O X
3. Net income O U
5. Working capital at the end of the year O X
Adjusting entries:
2015 2016
Cost of Sales 5,000 Retained Earnings 5,000
Merchandise Inventory 5,000 Mdse. Inventory-beg. 5,000
Notes on adjusting entries:

 The adjusting entries in the year of error will included a nominal account and a real
account.
 The adjusting journal entries during the second year after the year of error included a
nominal account and retained earnings.
For comparative purposes, restatement is necessary even if a corrected journal entry is not
required.
7
Illustration 1: Combined and Counterbalancing Errors Self-
Sacrifice Company reported net income for a two-year period as follows:
2014 120,000 2015 180,000
In an audit of the financial statement for the year ended December 31, 2014, the following errors
are discovered:
1) The company paid one-year insurance premium of ₱18,000 effective May 1, 2014. The entire
amount was debited to expense account and no adjustment was made at the end of 2014.
2)The company leased a portion of its building for ₱24,000. The term of the lease is one year
ending June 1, 2015. Collection of rent was credited to rent revenue account. At the end of 2014,
no entry was made to take up the unearned portion of the amount collected.
3) Accrued salaries expense of ₱12,000 was not recorded at the end 0f 2014.
4)Accrued interest receivable of ₱15,000 was not recorded at the end of 2014.
Required:
1.Compute for the adjusted net incomes in 2014 and 2015 and Retained earnings as of
the years ended December 31, 2014 and 2015.
2. Give the effect of the error in the 2014 working capital.
SOLUTION:
Requirement No. 1
2014 2015 2014 2015
Unadjusted balances 120,000 180,000 120,000 300,000
1) Ins. Exp. over, NI under 6,000 (6,000) 6,000
2) Rev over, NI over (10,000) 10,000 (10,000)
3) Salaries expense under, NI over (12,000) 12,000 (12,000)
4) Int. income under, NI under 15,000 (15,000) 15,000
Adjusted balance 119,000 181,000 119,000 300,000
Effects on the working capital (WC) Over or (under)

2014
1) Ins. Exp. over, Prepaid Insurance under, WC under (6,000)
2) Rev over, Unearned revenue under, WC over 10,000
3) Salaries expense under, Salaries payable under, WC over 12,000
4) Int. Income under, Rent receivable under, WC under (15,000)
Effect on the Working capital –overstated by 1,000
Requirement No.2
Adjusting entries if error is discovered in:
2014: Prepaid Insurance (18,000/12 x 4) 6,000
Insurance Expense 6,000
Rent Revenue (24,000/12 x 5) 10,000

Unearned Rent Revenue 10,000
Salaries Expense 12, 000

Accrued Salaries Payable 12,000
8
Interest Receivable 15,000
Interest Income 15,000
2015: Insurance Expense (18,000/12 x 4) 6,000

Retained Earnings 6,000

Rent Revenue (24,000/12 x 5) 10,000

Salaries Expense 12,000
2016: No adjusting journal entries
Illustration 2: Combined and Counterbalancing Errors

Self-Sacrifice Company reported net income for a two-year period as follows:
2014 120,000 2015 180,000
In an audit of the financial statement for the year ended December 31, 2014, the following errors
are discovered:
1) Advances to supplier in 2014 were recorded as purchases but the merchandise was received
in the following year, ₱20,000.
2) Advances from customers in 2014 recorded as sales in 2014 but the goods were delivered in
the following year,₱50,000.
3) On December 31, 2014, the ending inventory was overstated by ₱25,000.
Required:
1. Compute for the adjusted net incomes in 2014 and 2015 and Retained earnings as of the
years ended December 31, 2014 and 2015.
2. Give the effect of the errors in the 2014 working capital.
3. Prepare adjusting entries assuming errors were discovered in (a) 2014, (b) 2015, and (c)
2016.
SOLUTION:
Requirement No. 1
2014 2015 2014 2015
Unadjusted balances 120,000 180,000 120,000 300,000
1) Purchases over, NI under 20,000 (20,000) 20,000
2) Sales over, NI over (50,000) 50,000 (50,000)
3) Ending inventory over, NI over (25,000) 25,000 (25,000)
Adjusted balance 65,000 235,000 65,000 300,000
Effects on the working capital (WC)

Over or (under)
2014
1) Purchases over, Advances to supplier under, WC under (20,000)
2) Sales over, advances from customer under, WC over 50,000
3) Ending inventory over, WC over 25,000
Effect on the Working capital –overstated by 55,000
Requirement No.2
9
2014: Advances to supplier 20,000
Purchases 20,000
Cost of Sales 50,000

Merchandise Inventory end 50,000
Salaries Expense 25, 000

Accrued Salaries Payable 25,000
2015: Purchases 20,000


Sales 50,000

Mdse. Inventory beginning 25,000
2016: No adjusting journal entries
NON-COUNTERBALANCING ERRORS
Non-counter balancing errors do not offset in the next accounting period. Therefore, companies
must make correcting entries, even if they closed the books.
Examples:
1. Prepayment under the asset method
2. Precollection under the liability method
3. Error in recording depreciation
4. Improper capitalization of expense
5. Improper expensing of capital expenditures
6. Error in recording of proceeds of sale of an asset (e.g. PPE) as income
Prepayment under the Asset Method

The Company paid one-year insurance premium of ₱12,000 effective April 1, 2015. The entire
amount was debited to asset account and no adjustment was made at the end of 2015.
1. Insurance expense U U
2. Prepaid insurance O O
3. Net income O O
4. Retained earnings after closing O O
5. Working capital at the end of the year O O
Adjusting entries:
2015 2016
Insurance Expense* 9,000 Insurance Expense** 3,000
Prepaid Insurance 9,000 Retained Earnings*** 9,000
Prepaid Insurance 12,000
*(12,000/12 x 9) **(12,000/12 x 3) ***(12,000/12 x 9)
Precollection under the Liability Method
10
The company leased a portion of its building for ₱12,000. The term of the lease is one year
ending April 30, 2016. Collection of rent was credited to unearned rent revenue account. At the
end of 2015, no entry was made to take up the earned portion of the amount collected.
1. Rent revenue U U
2. Unearned rent revenue O O
3. Net income U U
4. Retained earnings after closing U U
5. Working capital at the end of the year U U
Adjusting entries:
2015 2016
Unearned Rent Income 8,000 Unearned Rent Income 12,000
Rent Income* 8,000 Rent Income** 4,000
Retained Earnings*** 8,000
*(12,000/12 x 8) **(12,000/12 x 4) ***(12,000/12 x 8)
Errors in Recording Depreciation (e.g. understated)

Depreciation expense in 2015 was understated by ₱2,000.
1. Depreciation expense U X
2. Accumulated depreciation U U
3. Net income O X
Adjusting entries:
2015 2016
Dep’n Expense 2,000 Retained Earnings 2,000
Accumulated Depreciation 2,000 Accumulated Depreciation 2,000
Improper Capitalization of Expenses

Repairs expense on the building amounting to ₱10,000 had been charged to the building account
on January 1, 2015. Depreciation expense has been recorded in 2015 and 2016 based on the 4
year remaining useful life of the building.
1. Repairs expense U X
2. Depreciation expense O O
3. Net income O U
5. Building (net) O O
6. Accumulated depreciation O O
Adjusting entries:
2015 2016
Repairs Expense 10,00 Retained Earnings 10,000
0
Building 10,000 Building 10,000

Depreciation Expense 2,500 Retained Earnings 2,500
11
(10,000/4) Depreciation Expense 2,500
Improper Expensing of Capital Expenditures

Major improvements on building amounting to ₱50,000 had been charged to repairs expense on
January 1, 2015. Improvements have a life of 4 years.
1. Repairs expense U X
2. Depreciation expense U U
3. Net income U O
4. Retained earnings after closing U U
5. Building (net) U U
6. Accumulated depreciation U U
Adjusting entries:
2015 2016
Building 50,000 Building 50,000
Repairs Expense 50,000 Retained Earnings 50,000
Depreciation Expense 12,500 Depreciation Expense 12,500

Accumulated Depreciation 12,500 Retained Earnings 12,500
(50,000/4) Accumulated Depreciation 25,000
Errors in recording of proceeds of sale of an asset (e.g.) PPE as of income

On January 1, 2015, an equipment costing ₱50,000 was sold for ₱30,000 on the date of sale, the
equipment had an accumulated depreciation of ₱15,000. The cash received was recorded as other
income in 2015.
Effects of the error:

2015 2016
1. Other income O X
2. Loss on sale U X
3. Net income O X
5. Working capital at the end of the year X X
6. Equipment O O
7. Accumulated depreciation O O
Adjusting entries:
2015 2016
Other Income 30,000 Retained Earnings* 35,000
Loss on sale (squeeze) 5,000 Equipment 50,000
Equipment 50,000 *(30,000 + 5,000)
Illustration: Combined and Non-counterbalancing Errors

Self-Sacrifice Company reported net income for a two-year period as follows:
2014 6,000,000 2015 8,000,000
12
In an audit of the following statement for the year ended December 31, 2014, the following
errors are discovered:
1) The Company paid one-year insurance premium of ₱240,000 effective April 1, 2014. The
entire amount was debited to asset account and no adjustment was made at the end of 2014.
2) The company leased a portion of its building for ₱480,000. The term of the lease is one year
ending April 30, 2015. Collection of rent was credited to unearned rent revenue account. At the
end of 2014, no entry was made to take up the earned portion of the amount collected.
3) Depreciation expense in 2014 was understated by ₱12,000.
4) Depreciation expense in 2015 was overstated by ₱14,000.
5) Bad debts expense of ₱11,000 was not recorded in 2014.
Required:
1. Compute for the adjusted net incomes in 2014 and 2015 and Retained earnings as of the
years ended December 31, 2014 and 2015.
2. Give the effect of the error in the 2014 working capital.
3. Prepare adjusting entries assuming errors were discovered in (a) 2014, (b) 2015, and (c)
2016.
SOLUTION:
Requirement No. 1
2014 2015 2014 2015
1) Ins. Exp. over, NI under (180,000) (60,000) (180,000) (240,000)
2) Rev under, NI under 320,000 160,000 320,000 480,000
3) Depr under, NI over (12,000) (12,000) (12,000)
4) Depr over, NI under 14,000 14,000
5) BD exp under, NI over (11,000) (11,000) (11,000)
Adjusted balance 6,117,000 8,114,000 6,117,000 14,231,000
Effects on the working capital (WC)
Over or (under)
2014
1)Ins. Exp. under, Prepaid insurance over, WC over 180,000
2) Revunder, unearned rent revenue over, WC under (320,000)
3) Depr under, Accum. Depreciation under, WC unaffected
4) WC in 2014 is unaffected
5) BD exp under, allowance for bad debts under, WC over 11,000
Effect on the Working capital –overstated by (129,000)
Requirement No.2
2014: Insurance Expense 180,000

Rent Revenue 320,000
Depreciation Expense 12, 000

Accumulated Depreciation 12,000
13
Bad Debts Expense 11,000
Allowance for Bad Debts 11,000
2015: Retained Earnings 180,000

Insurance Expense (240,000/12 x 3) 60,000


Rent Revenue 160,000



Depreciation Expense 14,000

2016: Retained Earnings 240,000





14

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AUDITING & ASSURANCE: CONCEPTS AND APPLICATIONS 1

MODULE 1: CORRECTION OF ERRORS

Prior Period Errors

Accounting Treatment of Prior Period Error

Limitations on retrospective restatement

Errors affecting Cost of Sales: Effect in Cost of Sales Relationship

Illustration: Statement of Financial Position Error

Accounts payable 15,000

INCOME STATEMENT ERRORS

Reclassifying entries on:

Illustration: Income Statement Errors

Office supplies expense 25,000

2015: No adjusting entries

Combined Statement of Financial Position and Income Statement Errors

Omission of deferred expense

Omission of deferred income

Nonrecording Of Accrued Expense

Nonrecording of Accrued Revenue

Effect of the error: 2015 2016

Accounts receivable 20,000 Sales 20,000

Error affecting ending inventory (e.g. overstatement)

Effects of the error:

Notes on adjusting entries:

2014 120,000 2015 180,000

Effects on the working capital (WC) Over or (under)

Rent Revenue (24,000/12 x 5) 10,000

Salaries Expense 12, 000

2015: Insurance Expense (18,000/12 x 4) 6,000

Retained Earnings 10,000

Retained Earnings 12,000

2016: No adjusting journal entries

Illustration 2: Combined and Counterbalancing Errors

2014 120,000 2015 180,000

Effects on the working capital (WC)

Cost of Sales 50,000

Salaries Expense 25, 000

2015: Purchases 20,000

Retained Earnings 50,000

Retained Earnings 25,000

2016: No adjusting journal entries

Prepayment under the Asset Method

Precollection under the Liability Method

Errors in Recording Depreciation (e.g. understated)

Improper Capitalization of Expenses

Accumulated Depreciation 2,500 Accumulated Depreciation 5,000

Improper Expensing of Capital Expenditures

Depreciation Expense 12,500 Depreciation Expense 12,500

Errors in recording of proceeds of sale of an asset (e.g.) PPE as of income

Effects of the error:

Illustration: Combined and Non-counterbalancing Errors

2014 6,000,000 2015 8,000,000

Unearned Rent Revenue 320,000

Depreciation Expense 12, 000

2015: Retained Earnings 180,000

Retained Earnings 180,000

Unearned Rent Revenue 160,000

Unearned Rent Revenue 320,000

Retained Earnings 12,000

Accumulated Depreciation 14,000