Error Correction

Error Correction
Introduction
- Errors arise in respect of the recognition, measurement, presentation or disclosure of elements of financial statements.
Potential current period errors discovered in that period are corrected before the financial statements are authorized for
issue.
- However, material errors are sometimes not discovered until a subsequent period, and these prior period errors are
corrected in the comparative information presented in the financial statements for that subsequent period.
Prior Period Errors

- Omissions and misstatements in the entity’s financial statements for one or more periods arising from a failure to use or
misuse of reliable information that:
a. Was available when financial statements for these periods were authorized for issue
b. Could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those
financial statements
- Prior period errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or
misinterpretation of facts, and fraud.
Treatment of Prior Period Errors

- 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 presented in which the error occurred
b. Restating the opening balances of assets, liabilities and equity for the earliest prior period presented if the error
occurred before the earliest period presented
- A prior period error shall be corrected by retrospective restatement, meaning, if comparative statements are presented,
the prior year statements are restated to correct the error.
- The correction of a prior period error is excluded from profit or loss for the period in which the error is discovered but it
is an adjustment of the beginning balance of retained earnings of the earliest period presented.
Type of Errors
a. Statement of financial position errors
b. Income statement errors
c. Combined statement of financial position and income statement errors
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.
Income Statement Errors

- Income statement errors affect the income statement or nominal accounts only, meaning, the improper classification of
revenue and expense accounts. These errors have no effect on the statement of financial position and on net income.
- A reclassifying entry is necessary only if the error is discovered in the same year it is committed. Otherwise, if the error
is discovered in a subsequent year, no reclassifying entry is necessary because the nominal accounts for the current year
are correctly stated.
Combined Statement of Financial Position and Income Statement Errors

- These errors affect both the statement of financial position and income statement because they result in a misstatement
of net income.
- For example, if accrued salaries payable is overlooked, the effects are:
a. Salaries expense is understated (income statement error)
b. Liability is understated (statement of financial position error)
c. Net income is overstated (income statement error)
d. Retained earnings account is overstated (statement of financial position error)
- If depreciation is overstated, the effects are:
a. Depreciation is overstated (income statement error)
b. Property, plant and equipment is understated (statement of financial position error)
- Combined statement of financial position and income statement errors are classified as counterbalancing errors and non-
counterbalancing errors.
Counterbalancing Errors
- Errors which, if not detected, are automatically counterbalanced or corrected in the next accounting period.
- These errors will be offset or corrected over two periods or these errors correct themselves over two periods
Effects of Counterbalancing Errors

1. The income statements for two successive periods are incorrect
2. The statement of financial position at the end of the first period is incorrect
3. The statement of financial position at the end of the second period is correct
- Counterbalancing errors normally include the misstatement of the following:
a. Inventory, including purchases and sales
b. Prepaid expense
c. Accrued expense
d. Deferred income
e. Accrued income
Beginning Inventory xx Direct Relation to Cost of Sales (Increase in BI, Increase in COS)
Net Purchases xx Direct Relation to Cost of Sales (Increase in NP, Increase in COS)
Goods Available for Sale xx
Ending Inventory (xx) Inverse Relation to Cost of Sales (Increase in EI, Decrease in COS)
Cost of Sales xx
Net Sales xx
Cost of Sales (xx)
Gross Profit xx
Operating Expenses (xx)
Net Income xx (BI and NP has inverse relation to NI; while EI has direct relation to NI)
Overstatement of Ending Inventory

For example if on December 31, 2019, the physical count was overstated.
If the books for 2020 have not been closed, the entry on December 31, 2020 is:
Retained Earnings xx
Inventory, January 1, 2020 xx
The retained earnings account is debited because the net income of 2019 was overstated.
Note that if ending inventory is overstated, cost of sales is understated and net income is overstated.
If the books for 2020 have been closed:

No entry is necessary, because the error in 2019 is counterbalanced in 2020.
The ending inventory in 2019 becomes beginning inventory in 2020.

Beginning inventory in 2020 is overstated, cost of sales in 2020 is overstated and net income for 2020 is understated.
Understatement of Ending Inventory

For example if on December 31, 2019, the physical count was understated.
The inventory account is debited and the retained earnings account is credited because the ending inventory in 2019 was
understated and net income was overstated.

Understatement of Purchases
For example if on 2019, the entity failed to record a purchase of merchandise. The same was recorded in 2020. The
physical inventory on December 31, 2019 was correctly stated.
Purchases xx
The retained earnings account is debited because net income of 2019 was overstated. Purchases in 2019 was understated,
cost of sales in 2019 was understated and net income in 2019 was 2019.

The purchases account in 2019 was understated while the purchases account in 2020 was overstated. Thus, they equalize
each other.
Overstatement of Purchases and Ending Inventory

For example if the entity recorded on December 31, 2019 purchases in transit to which the entity had no title. The same
merchandise was included in the inventory of December 31, 2019.
If the books for 2020 have not been closed, the entries on December 31, 2020 are:
Purchases xx
In the first entry, the purchases account is debited because the purchase pertains to 2020 and was erroneously recorded in
2020. The retained earnings account is credited because net income of 2019 was understated by reason of overstated
purchases.
In the second entry, the retained earnings account is debited and the inventory account is credited because the ending
inventory of 2019 was overstated resulting to overstatement of net income.
Actually, the net effect of the error is zero on net income and retained earnings.
If the books for 2020 have been closed, no entry is necessary because the 2019 error is counterbalanced in 2020.
The purchases account in 2019 was overstated and the purchases account in 2020 is understated. Thus, they equalize each
other.
The inventory on December 31, 2019 was overstated resulting to overstatement of net income. The inventory on January
1, 2020 was also overstated and thus overstating cost of sales and understating net income.
Understatement of Sales
For example if the entity failed to record sales in 2019. The same was recorded in 2020. The physical inventory was
correctly stated on December 31, 2019.
Sales xx
The sales account is debited because the same pertains to 2019 and was recorded in 2020 thus overstating 2020 sales.
The retained earnings account is credited because the 2019 net income was understated.

The sales account of 2019 was understated and the sales account of 2020 was overstated. Thus, they equalize each other.
Overstatement of Sales and understatement of Ending Inventory

For example if the entity recorded on December 31, 2019 sales in transit and to which the customer had no title. The cost
of the merchandise was excluded from the December 31, 2019 inventory.
If the books for 2020 have not been closed, the entries on December 31, 2020 are:
Sales xx

In the first entry, the retained earnings account is debited because the 2019 net income was overstated.
The sales account is credited because the sale pertains to 2019 and was erroneously recorded in 2020.
In the second entry, the inventory account is debited and the retained earnings account is credited because the 2019 net
income was understated by reason of understatement of 2019 ending inventory.

The sales account in 2019 was overstated and the sales account in 2020 was understated and thus they counterbalance
each other.
The understated ending inventory on December 31, 2019 becomes the beginning inventory in 2020. Thus, they equalize
the effect on net income.
Failure to Record Prepaid Expense

For example if on January 1, 2019, the entity purchased insurance for two years. The payment was debited to an expense
and no adjustment was made on December 31, 2019 for the prepaid insurance.
Insurance Expense xx
The insurance expense account is debited because the prepaid insurance on December 31, 2019 becomes an expense in
2020. The retained earnings account is credited because the 2019 net income was understated.

The net income of 2019 was understated by reason of overstatement of insurance expense while the net income of 2020
was overstated by reason of understatement of insurance expense.
Failure to Record Accrued Expenses

For example if on December 31, 2019, accrued rent expense was not recorded.
Rent Expense xx
The retained earnings account is debited because the net income of 2019 was overstated.
The rent expense is credited because the accrual of 2019 necessarily was paid in 2020 and the same was debited to
expense, thus overstating the rent expense of 2020.

The net income of 2019 was overstated by reason of understatement of rent expense while the 2020 net income was
understated by reason of overstatement of rent expense.
Failure to Record a Deferred Income

For example if on January 1, 2019, the entity received rent for two years. The same was credited to rent income and no
adjustment was made on December 31, 2019.
Rent Income xx
The retained earnings account is debited because the 2019 net income was overstated.
The rent income is credited because the unearned income on December 31, 2019 becomes an income of 2020.

The 2019 rent income was overstated while the 2020 rent income was understated. Thus, they counterbalance each other.
Failure to Record Accrued Income

For example if on December 31, 2019, accrued interest receivable was not recorded.
Interest Income xx
The interest income is debited because the interest accrual of 2019 necessarily was received in 2020 and the same was
credited to interest income, thus overstating the 2020 interest income.
The retained earnings account is credited because the 2019 income was understated.

The 2019 interest income was understated while the 2020 interest income was overstated. Thus, they equalize each other.
Non-Counterbalancing Errors
- Errors which, if not detected, are not automatically counterbalanced or corrected in the next accounting period
- In other words, if the net income of one year is understated or overstated, the net income of subsequent year is not
affected.
Effects of Non-Counterbalancing Errors

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 and succeeding statement of financial position are incorrect until
the error is corrected.
The best example of a non-counterbalancing error is the misstatement of depreciation.

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Error Correction

Prior Period Errors

Treatment of Prior Period Errors

Statement of Financial Position Errors

Income Statement Errors

Combined Statement of Financial Position and Income Statement Errors

Effects of Counterbalancing Errors

Overstatement of Ending Inventory

If the books for 2020 have been closed:

The ending inventory in 2019 becomes beginning inventory in 2020.

Understatement of Ending Inventory

If the books for 2020 have been closed:

If the books for 2020 have been closed:

Overstatement of Purchases and Ending Inventory

If the books for 2020 have been closed:

Overstatement of Sales and understatement of Ending Inventory

Inventory, January 1, 2020 xx

If the books for 2020 have been closed:

Failure to Record Prepaid Expense

If the books for 2020 have been closed:

Failure to Record Accrued Expenses

If the books for 2020 have been closed:

Failure to Record a Deferred Income

If the books for 2020 have been closed:

Failure to Record Accrued Income

If the books for 2020 have been closed:

Effects of Non-Counterbalancing Errors

The best example of a non-counterbalancing error is the misstatement of depreciation.

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