MODULE – 2 MISSTATEMENTS IN THE FINANCIAL STATEMENTS

Distinguish Between Errors and Fraud

When you find misstatements as you perform an audit, you’re responsible for making an
assessment. You alone must determine whether the misstatement represents an error or fraud.
Errors aren’t deliberate. Fraud takes place when you find evidence of intent to mislead.

Here are some common errors you’ll come across:

 Inadvertently taking an expense to the wrong account: For example, an advertising
expense shows up as an amortization expense. The two accounts are next to each other
in the chart of accounts, and the data entry clerk made a simple keying error.

 Booking an unreasonable accounting estimate for allowance for bad debt

expense: The person who made this mistake may have simply misinterpreted the facts.
The allowance for bad debt arises because generally accepted accounting principles call
for the matching of revenue and expenses for the same financial reporting period.

 Incorrectly applying accounting principles: Recording assets at their cost rather than

their market value is an example of an accounting principle. Make sure the company
hasn’t inadvertently made an adjustment to increase the value of assets (such as land or
buildings) to their appraised value rather than cost. It’s never appropriate to change the
value of a fixed asset on the balance sheet from its original cost.

FRAUD
Fraud occurs when someone purposefully produces deceptive data. You need to be on the
lookout for two types of fraud:
 Misstatements due to fraudulent financial reporting: In this type of fraud,
management or owners are usually involved, and the fraud is facilitated by overriding
internal controls.

 Misstatements because of the misappropriation of assets: This type of fraud is

usually perpetrated by non-management employees.

Fraud can take the form of the falsification or alteration of accounting records or the financial
statements. Deliberately making a mistake when coding expense checks is fraud. So is
intentionally booking a lower allowance for bad debt than is deemed reasonable by normal
estimation methods.

Fraud also includes intentional omissions of significant information. For example, if a company
knows its largest customer is getting ready to close its doors and doesn’t disclose this fact,
that’s fraud. Not properly disclosing loss contingencies is another example — for instance, if a
company doesn’t disclose that it’s likely going to lose a lawsuit brought against it and the
damages can be reasonably estimated.

Of course, the theft of assets such as cash, inventory, or equipment is also fraud. Paying
personal expenses out of the company checking account is fraud. Another example is taking
company computers home to use personally.
Evaluation of Misstatements
All misstatements should be communicated to management on a timely basis, unless they are
clearly trivial. Management should be asked to correct all misstatements identified during the
audit. Auditors should try and obtain an understanding of management's reasons for refusing to
adjust any of the misstatements. The auditor should determine whether uncorrected
misstatements are material in aggregate or individually, and if material should consider the
potential impact on their audit report.

Materiality
Prior to evaluating the significance of uncorrected misstatements the auditor should
reassess materiality to confirm whether it remains appropriate to the financial statements. Then
the auditor must assess whether uncorrected misstatements are, individually or in aggregate,
material. To do this they should consider the size and nature of the misstatements, both in
relation to the financial statements as a whole and to particular classes of transaction, account
balances and disclosures.

Written representations
Finally, the auditor should obtain a written representation from management and those charged
with governance that they believe the effect of the uncorrected misstatements is immaterial,
individually and in aggregate.

Once these procedures have been completed the auditor should then consider the impact of
uncorrected misstatements on the audit report.

Auditors should be very careful about the detection of errors because manipulation in
accounting may also appear as error or it may be a result of carelessness on part of a
bookkeeper.

Errors may be broadly classified as follows −

 Error of Principle
 Errors of Omission
 Errors of Duplication
 Errors of Commission
 Compensating Errors

Error of Principle
Where the recording of the items of transactions are not done according to the Principle of
Accounting, it is known to be an error of principle. These errors are not traceable from trail
balance; these errors may be committed unintentionally or for the purpose of manipulation of
accounts to inflate or deflate profit.

Following are the examples of such type of errors:

 Providing excessive or inadequate depreciation
 Where the provision for outstanding expenses or prepaid expenses is wrong
 Where revenue expenses may be treated as capital expenditure or vice versa
 Where valuation of Plant & Machinery, Stock, investment and other assets are not done
according to the Principle of Accounting.
 Where income received is credited to personal account of the person who is making the
payment; for example, commission received from Mr. A credited to Mr. A’s account
instead of the commission account, it will increase creditors in the BalanceSheet and
reduce profit in the Profit & Loss account.
  Where the payment of expenses is posted to the personal account of a person who
receives payment; for example, the rent paid to Mr. A wrongly debited to Mr. A’s
account, it will increase profit and also increase debtors in the Balance-sheet.

Errors of Omission
There may be two types of omission of entry while recording the transactions in the books of
accounts;
 Where transaction is totally omitted from the books of accounts, it will not affect the trial
balance and the detection of such error is difficult. Following are the examples of such
errors;
o Omission of purchase or sale from the purchase day book or the sale day book
respectively.
o Omission of outstanding or unpaid expenses.

 Examples of the transactions which are partially omitted from the books of accounts are
o Where total of purchase day book or sale day book omitted to be posted in
purchase or sale account respectively.
o Where payment or receipt transaction omitted to be recorded in ledger account
from cash book.

Errors of Duplication
The detection of error of duplication is very difficult. It might be detected with proper and minute
observation of accounts; for example, purchase may be recorded twice with original and
duplicate copy of purchase invoice, etc. It is also possible to post the total of any ledger
account twice in the trial balance.

Errors of Commission
Error of commission occurs the entry made in the books of the original entry or the ledger
account is wrong. Let us see the following examples
 Purchase of goods for 25,000 wrongly entered as 2,500 in purchase book.
 Credit purchase from AB Company wrongly credited to BA Company’s account.
 Wrong totaling − total of purchase day book is totaled as 112,500 instead of 121,500.
 Purchase from AB Company wrongly debited to AB company account instead of
crediting AB company account and debiting purchase account.

Compensating Errors
When the effect of an error compensates with another error; it is known to be a compensating
error. Such errors do not affect the trial balance; for example, total of a debit account as well as
credit account totaled short by 7,500. This type of error will compensate both.

Prevention of Errors and Fraud

After the completion of audit, the Auditor can suggest his client to make changes in the
accounting systems and also to improve his internal control system as an Auditor cannot do
anything directly to prevent errors and frauds.

Auditors are expected to conduct audit as per professional standards expected from him. He
cannot guarantee that no fraud exists. An Auditor should ensure and follow these standards −
 Internal control system
 While recording the business transaction whether accounting principle are being
followed or not
 Policies of management are being followed or not
  Whether provisions laid in the Companies Act are being followed while preparing books
of accounts
 Whether Balance-sheet and Profit & Loss account show true and fair view of state of
affairs of concern

Following factors decide whether an Auditor is responsible for non-detection of errors

and frauds
 An Auditor should audit as per the principles laid out for auditing.
 He should fulfil his duty as per the prevailing standards of his profession.
 Error should be rectified during his audit and fraud is to be reflected in his audit report.
 Even a simple hint that reflects that there is something wrong should not be overlooked.
 He should believe on substantial accuracy in statement of accounts.

Correction of errors
Errors include misapplication of accounting policies, mathematical mistakes, oversights or
misinterpretation of facts, and fraud.

Financial statements do not comply with PFRSs if they contain either material errors or
immaterial errors made intentionally to achieve a particular presentation of an entity’s financial
position, financial performance or cash flows. (PAS 8.41)

Types of Accounting Errors:

1. A change from an accounting policy that is not generally accepted to an accounting
policy that is acceptable.
2. Mathematical mistakes.
3. Changes in estimates that occur because a company did not prepare the estimates in
good faith.
4. Failure to accrue or defer certain expenses or revenues.
5. Misuse of facts.
6. Incorrect classification of a cost as an expense instead of an asset, and vice versa.

Accounting for Errors

 All material errors must be corrected.
 Record corrections of errors from prior periods as an adjustment to the beginning
balance of retained earnings in the current period.
 Such corrections are called prior period adjustments.
 For comparative statements, a company should restate the prior statements affected, to
correct for the error.

Comparative Statements
Company should
1. make adjustments to correct the amounts for all affected accounts reported in the
statements for all periods reported.
2. restate the data to the correct basis for each year presented.
3. show any catch-up adjustment as a prior period adjustment to retained
earnings for the earliest period it reported.
Companies treat errors as prior-period adjustments and report them in the current year as
adjustments to the beginning balance of Retained Earnings.

Statement of financial position errors affect only the presentation of an asset, liability, or
stockholders’ equity account.
 Current year error - reclassify item to its proper position.
 Prior year error - restate the statement of financial position of the prior year for
comparative purposes.

Improper classification of revenues or expenses.

 Current year error - reclassify item to its proper position.
 Prior year error - restate the income statement of the prior year for comparative
purposes.

Counterbalancing Errors
Will be offset or corrected over two periods.

If company has closed the books:

a. If the error is already counterbalanced, no entry is necessary.
b. If the error is not yet counterbalanced, make entry to adjust the present balance
of retained earnings.

For comparative purposes, restatement is necessary even if a correcting journal entry is not
required.

Counterbalancing Errors
Will be offset or corrected over two periods.

If company has not closed the books:

a. If error already counterbalanced, make entry to correct the error in the current
period and to adjust the beginning balance of Retained Earnings.
b. If error not yet counterbalanced, make entry to adjust the beginning balance of
Retained Earnings.

Non-Counterbalancing Errors
Not offset in the next accounting period.
Companies must make correcting entries, even if they have closed the books.
Summary of Accounting Changes and Errors
 MODULE # 2 Post-test
APPLIED AUDITING
AUDIT OF MISSTATEMENTS IN THE FINANCIAL STATEMENTS

PROF. U.C. VALLADOLID

Multiple Choice
Identify the choice that best completes the statement or answers the question.

1. Moon Corp presented the following information

2019 2020
Ending inventory 130,000 overstated 180,000 understated
Utilities expense 110,000 understated 125,000 overstated
Rent expense 120,000 understated 110,000 overstated

What amount would 2020 net income be overstated or understated if none of the errors were detected or corrected?
a. 360,000 overstated b. 360,000 understated c. 545,000 overstated d. 545,000 understated

2. The following are the errors found in KJD’s accounting records:

2020 2021
Ending Inventory 100,000 (overstated) 150,00 (understated)
Depreciation 50,000 (overstated) 100,000 (understated)

At what amount should the retained earnings be retrospectively adjusted on January 1, 2022?
a. Decrease by 100,000
b. Increase by 100,000
c. Decrease by 150,000
d. Increase by 150,000

3. Jerome Company failed to recognize accruals and prepayments during its first year of operations. The pre-tax profit,
accruals and prepayments at the end of the year were:

Pre-tax profit 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. 4,750,000 b. 4,950,000 c. 5,000,000 d. 5,250,000

4. The JP Company showed pre-tax income of 2,500,000 for the year ended December 31, 2020. On your year-end
verification of the transactions of the company, you discovered the following errors:
 1,000,000 worth of merchandise was purchased in 2020 and included in the ending inventory. However, the
purchase was recorded only in 2021.
 A merchandise shipment at 1,500,000 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, 2020.
  Value added tax for the fourth quarter of 2020, amounting to 500,000, was included to the Sales account.
 Rental of 300,000 on an equipment, applicable for six months, was received on November 1, 2020. The
entire amount was reported as revenue upon receipt.
 Rent paid on building covering the period from July 1, 2020 to July 1, 2021, amounting to 1,200,000, was
paid and recorded as expense on July 1, 2020. The company did not make any adjustment at the end of the
year.
1. The corrected pre-tax profit for 2020 should be
a. 2,400,000 b. 2,900,000 c. 3,000,000 d. 3,400,000

2. What is the net effect of the foregoing errors on the total assets at December 31, 2020?
a. 600,000 understated b. 1,100,000 understated c. 1,500,000 understated d. 2,100,000 understated

3. What is the total understatement of the total liabilities at December 31, 2020?
a. 3,200,000 b. 1,700,000 c. 1,500,000 d. 1,200,000

5. Upon inspection of the records of J0shtin Company, the following facts were discovered for the year ended
December 31, 2020:

 A fire insurance premium of P 40,000 was paid and charged as insurance expense in 2020. The fire
insurance policy covers one year from April 1, 2020.
 Inventory on January 1, 2020 was understated by P 80,000.
 Inventory on December 31, 2020 was understated by P 120,000.
 Expenses of P 55,000 incurred during December were recorded when paid in January 2021
 On December 5, 2020, J0shtin credited to sales a cash advance of P 100,000 received from a customer for
goods delivered in January 2021. The company’s gross profit on sales is 40%
 The profit of J0shtin Company for the year ended December 31, 2020, before any adjustment from the
above information, is P 1,550,000.

What is the adjusted profit of J0shtin Company for the year ended December 31, 2020?
a. 1,365,000 b. 1,425,000 c. 1,445,000 d. 1,505,000

6. Joshtin Inc. submitted to you the following information related to operations for 2020:

Revenue from Sales 7,000,000

Expenses 4,000,000
Income before Income taxes 3,000,000

In reviewing the records, you discovered the following items:

 During 2020, the company discovered an error in Depreciation in 2019. The correction of this error, which
has not been recorded, will result in an increase in depreciation for 2019 of 200,000.
 During 2020, the company sustained a loss of 400,000 because of flood, which destroyed its inventory. The
company charged retained earnings and credited inventory of 400,000.

How much is the correct profit before tax for the year 2020?
a. 2,400,000 b. 2,600,000 c. 3,000,000 d. 3,400,000
7. Mint Co. started operations at the beginning of the current year. The entity failed to recognize accruals and
prepayments at the end of reporting period. The income before tax, accrual and prepayments at the end of the
current year are:
Income before tax 4,100,000
Prepaid insurance 60,000
Accrued wages 75,000
Rent revenue collected in advance 90,000
Interest receivable 150,000
What is the corrected income before tax?
a. 4,145,000 b. 3,995,000 c. 7,895,000 d. 4,025,000

8. Ricoa Company sold imported chocolates for 900,000 to Goya Company on December 31, 2020. The terms of sale
were net 30, FOB shipping point. The chocolates were shipped on December 31, 2020 and arrived at Goya on
January 5, 2021. Due to a clerical error, the sale was not recorded until January 2021 and the merchandise sold at
20% markup on cost was included in inventory on December 31, 2020. What was the effect of the errors on cost of
goods sold for 2020?
a. Understated by 900,000
b. Understated by 750,000
c. Understated by 150,000
d. No correction

9. ZZZ Company is in the process of adjusting the books at the end of 2021. The accounting records revealed the
following information:
Errors in ending inventory for the last three years were discovered to be as follows:
Ø 2019 - 420,000 understated
Ø 2020 - 410,000 overstated
Ø 2021 - 280,000 understated
The entity failed to accrue sales commissions at the end of 2019 and 2020 as follows:
Ø 2019 - 260,000
Ø 2020 – 320,000
In each case, the sales commissions were paid and expensed in January of the following year. The unadjusted
retained earnings balance on January 1, 2021 is 13,500,000 and the unadjusted net income for 2021 was 5,000,000.

1. What is the adjusted net income for 2021?

a. 6,230,000 b. 6,010,000 c. 6,180.000 d. 6,030,000

2. What is the net correction for 2019 and 2020?

a. 160,000 and 890,000
b. 150,000 and 780,000
c. 170,000 and 760,000
d. 170,000 and 850,000

3. What is the adjusted retained earnings on December 2021?

a. 18,780,000 b. 18,790,000 c. 18,800,000 d. 18,810,000
10. On January 1, year 1, Warren Co. purchased a 600,000 machine, with a five-year useful life and no salvage value.
The machine was depreciated by an accelerated method for book and tax purposes. The machine’s carrying amount
was 240,000 on December 31, year 2. On January 1, year 3, Warren changed to the straight-line method for financial
reporting purposes. Warren can justify the change. Warren’s income tax rate is 30%.

1. In its year 3 income statement, what amount should Warren report as the cumulative effect of this change?
a. 120,000 b. 84,000 c. 36,000 d. 0

2. On January 1, year 3, what amount should Warren report as deferred income tax liability as a result of the
change?
a. 120,000 b. 72,000 c. 36,000 d. 0

11. Chen Co. purchased an equipment at the beginning of 2020 for 500,000. At the time of its purchase, the equipment
was estimated to have a useful life of six years and a salvage value of 20,000. The equipment was depreciated
using the straight-line method of depreciation through 2021. At the beginning of 2022, the estimate of useful life was
revised to a total life of nine years and the expected salvage value was changed to 40,000. What is the amount to
be recorded for depreciation for 2022 after reflecting these changes in estimates?
a. 37,777 b. 50,000 c. 51,111 d. 80,000 e. 42,857

12. Chicago Company began operations on January 1, 2019, and uses the FIFO method in costing its raw material
inventory. Management is contemplating a change to the LIFO method and is interested in determining what effect
such a change will have on net income. Accordingly, the following information has been developed:
Final Inventory 2019 2020
FIFO 640,000 712,000
LIFO 560,000 636,000
Net Income (computed under the FIFO method) 980,000 1,080,000

Based on the above information, a change to the LIFO method in 2020 would result in net income for 2020 of
a. 1,120,000 b. 1,080,000 c. 1,004,000 d. 1,000,000

13. Tictac Company reported shareholders' equity of 7,500,000 on December 31, 2021.The company revealed the
following transactions during the year:
 Net income for 2021 – 4,500,000
 Dividend declared, of which 500,000 was paid – 2,300,000
 An adjustment of retained earnings for 2020 under depreciation of 450,000.
 Gain on sale of treasury shares – 300,000
 The share capital balance of 5,000,000 remained unchanged during the year.

What is the balance of retained earnings on January 1, 2021?

a. 400,000 b. 450,000 c. 500,000 d. 550,000

14. In 2020, Oreo Co. discovered that the machinery purchased on January 1, 2018 for 2,000,000 was expensed at that
time. The machinery should have been depreciated over 5 years with no residual value. The tax rate is 30%. What is
the correct entry for retained earnings in 2020?
a. debit 840,000 b. credit 840,000 c. debit 800,000 d. credit 800,000
15. Jongdae Kim’s musical instruments shop began on January 2021. However, the accountant he hired failed to
recognize accruals and prepayments at the end of the year. The following data are gathered regarding the matter:
Income, before tax 2,100,000
Prepaid Insurance 61,000
Advances to Suppliers 99,000
Salaries Payable 14,000
Interest Receivable 4,000
Advances Payments from customers recognized as Sales 112,000
What amounted should be recorded as the correct income after recording the adjustments?
a. 2,039,000 b. 2,062,000 c. 2,130,000 d. 2,138,000