AUDITING PROBLEMS – CORRECTION OF ERRORS

Definition of Terms
 Accounting policies - specific principles, bases, conventions, rules and
practices adopted by an enterprise in preparing and presenting the financial statements.

 Fundamental errors - are errors discovered in the current period with

such significance, that the financial statements of one or more prior periods can no
longer be considered to have been reliable at the date of their issue.

Reasons why Accounting Changes Occur:

1. The accounting profession may mandate that a new accounting principle is to be used.
2. Changing economic conditions
3. Changes in technology and in operations
4. New experience or new information may prompt companies to change its estimate of
revenues or expenses.

TYPES OF ACCOUNTING CHANGES

1. Change in Accounting Principles

This is a change from one generally accepted accounting principle to another generally
accepted accounting principle. Adoption of a new principle in recognition of events that have
occurred for the 1st time is not a change in accounting principle. There is no change in
accounting principle when the depreciation method adopted for a newly acquired asset is
different from the method or methods used for previously recorded assets of similar class.

A change from a principle that is not generally accepted to one that is generally
accepted is an error correction than a change in accounting principle.

Accounting Procedure:

Benchmark treatment
A change in accounting policy/principle should be applied retroactively unless the
amount of any resulting adjustment that relates to prior periods is not reasonably determinable.
Any resulting adjustment should be reported as an adjustment to the opening balance of the
retained earnings. Comparative information should be restated unless it is impracticable to do
so.

2. Change in Accounting Estimate

This is a change that occur as a result of new information or acquisition of additional

experience. Changes in estimates are viewed as normal recurring corrections and adjustments
or the natural result of the accounting process. Retroactive treatment is prohibited.

Accounting Procedure:

a. Report current and future financial statements on the new basis.

b. Present prior period financial statements as previously reported.
c. Make no adjustment to current period opening balances.

NOTE: Whenever it is impossible to determine whether a change in principle or a change in

estimate has occurred, or if an asset is affected by both a change in principle and a change in
estimate during the same period, the change should be accounted for as a change in estimate
rather than a change in principle.

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CORRECTION OF ERRORS

No company whether large or small is immune from errors. Errors may be intentional
or unintentional. Intentional errors are significant because of the presence of fraud or intent to
deceive. These errors are made for the purpose of concealing fraud or misappropriation,
evading taxes, manipulating or window-dressing the company's financial statements.
Unintentional errors were not deliberately committed. They result from carelessness or
ignorance on the part of the company's personnel or it may result from poor internal control.

The risk of material errors may be minimized through the installation of good internal
control and the application of sound accounting procedures. Prior period adjustments, also
called fundamental errors are reported in the current year as adjustment in the beginning
balance of the Retained Earnings account. Prior period statements should be restated to
correct the error when comparative statements are prepared.

Accounting Procedure:
1. If detected in the period the error occurred, correct the accounts through normal
accounting cycle adjustments.
2. If detected in subsequent period, adjust errors by making prior period
adjustments directly to Retained Earnings or restate the beginning balance of the
Retained Earnings account.
3. Correct all previously presented prior period statements.

Examples of Accounting errors:

a. A change from an accounting principle that is not generally accepted to an accounting
principle that is generally accepted.
b. Mathematical mistakes
c. Mistake in the application of accounting of accounting principle
d. Oversight
e. Misuse of facts
f. Incorrect classification of expense as an asset or vice versa
g. Changes in estimates which are not prepared in good faith

TYPES OF ERRORS:

1. Balance Sheet Errors

This type of error refers to improper classification of real accounts such as assets,
liabilities or stockholders' equity accounts. They have no effect on net income

2. Income Statement Errors

This type of error affects only the presentation of nominal accounts in the Income
Statement. It involves the improper classification of revenues and expenses accounts, hence,
only the details of the Income Statement are misstated. A reclassifying entry is necessary only
if the error is discovered in the same year it is committed. It has no effect on the Balance
sheet and in the Income Statement. If the error is discovered in a subsequent year, no
classification entry is necessary.

3. Combined Balance Sheet and Income Statement errors

This affects both the balance Sheet and the Income Statement because they result
in the misstatement of net income.

Classifications of Combined Balance Sheet and Income Statement Errors:

a. Counter Balancing Errors

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  Errors which if not detected are automatically offset or corrected over two
periods. Restatement is necessary even if a correcting journal entry is
not required.

 Effect: Net Income of two successive periods are misstated. The amount of
misstatement in one period is equal to but opposite in effect in the income of the
next period.
 Counterbalancing errors include the misstatements of the following accounts:
1. Inventories to include the following
a. Purchases
b. Sales
2. Prepaid expenses
3. Deferred Income
4. Accrued expense
5. Accrued Income

GUIDELINES

 Books are open

1. If the error is already counterbalanced and the company is in the
second year, an entry is necessary to correct the current period and to
adjust the beginning balance of the Retained earnings.
2. If the error is not yet counterbalanced, an entry is necessary to adjust
the beginning balance of the Retained earnings and correct the current
period.

 Books are closed

1. If the error is already counterbalanced, no entry is necessary.
2. If the error is not yet counterbalanced, an entry is necessary to adjust
the present balance of the Retained earnings.

b. Non Counter Balancing Errors

 Errors which take longer than two periods to correct themselves. This type of
error is carried over to the subsequent accounting period until corrected or until
the balance sheet item involved is removed from the accounts by sales,
retirement or other means of disposal.

PROBLEM 1

In your examination of the financial statements of GRISHAM CORP., for the year ended
December 31, 2019, you discovered the following errors. Prepare the necessary adjusting
entries.
1. Interest collection from a notes receivable amounting to P3,500 which was received on
December 30, 2019 was deposited and recorded on the same day by a credit to sales.
2. A staled check of P12,000 which had been outstanding for more than six months was
included in the list of outstanding checks. This was in payment of Accounts Payable
3. Payment of P4,500 for freight charges on merchandise purchased on December 18,
2019 was debited to freight out account.
4. On December 31, 2018, the physical count was overstated by P5,000.
5. Improvements on building of P100,000 had been charged to expense on January 01,
2019. Improvements have a life of 5 years.
6. GRISHAM CORP. issued 5,000 shares of P 100 par value capital stock for P550,000 on
January 14, 2018. The proceeds were credited to the Capital Stock account.
7. On January 01, 2019, an equipment costing P70,000 was sold for P35,000. At the date
of sale, the equipment has an accumulated depreciation of P43,750. The cash received
was recorded as other income in 2019.

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8. A P15,000 collection from Smart Co. was correctly recorded in the general ledger but
was erroneously credited to the subsidiary ledger account of Smurf Corp.
9. Insurance premium of P45,000 for three years paid in January 2003 was charged to
expenses in 2018.
10. On December 31, 2018, goodwill estimated by the Board of Directors at P300,000 was
set up by a credit to Retained Earnings.
11. On December 29, 2019, GRISHAM CORP. issued checks to its creditors amounting to
P75,000. These checks were released on January 4, 2020.
12. A check for P20,000 from a customer to apply to his account was received on December
30, 2019 but was not recorded until January 4, 2020.
13. A customer's deposit of P60,000 for goods to be delivered in January 2020 was
deducted from accounts receivable.
14. A check was cleared by the bank as P5,200 on December 05, 2018, but was recorded
by the bookkeeper as P2,500. This was in payment of an employee cash advance.
15. On the last day of 2019, the company received a P90,000 prepayment from a tenant for
2020 rent of a building. It was recorded as rent revenue.

PROBLEM 2

You were engaged for the first time to audit the financial statements of ABC Corp. for the year
ended 31 December 2019. The company started its operations in 2017. In reviewing the books,
you discovered that certain transactions/adjustments had either been overlooked or improperly
recorded at the end of the three years. Omissions/failures and errors for each year are
summarized as follows:

December 31
2017 2018 2019
1. Omissions/understatement of the following at the end of
each year:
a. Accounts Receivable 4,000 7,000 1,000
b. Merchandise Inventory 2,000 9,000
c. Accrued Interest Income 6,000 3,000
d. Prepaid Insurance Expense 8,000 5,000
e. Advances to Suppliers (Erroneously debited to Purchases) 6,000 2,000 7,000
TOTALS 20,000 24,000 16,000

2. Overstatement of the following at the end of each year:

a. Accounts Receivable 15,000 10,000
b. Merchandise Inventory 8,000 6,000
c. Accrued Misc. Income 3,000 5,000 7,000
TOTALS 26,000 15,000 13,000

3. Omissions/Understatement of the following at the end of

each year:
a. Accounts Payable 12,000 13,000
b. Accrued Interest Expense 6,000 8,000
c. Unearned Commission Income 1,000 4,000
d. Advances from Customers (Erroneously credited to Sales) 2,000 11,000 14,000
TOTALS 21,000 23,000 27,000

4. Overstatement of the following at the end of each year:

a. Accounts Payable 14,000 13,000 17,000
b. Accrued Salaries Expense 9,000 8,000 7,000
c. Unearned Other Income 4,000 5,000 6,000
TOTALS 27,000 26,000 30,000

The following errors were likewise noted:

5. Major repairs on the company’s equipment for the years 2017 and 2019 in the amount of
P30,000 and P60,000; respectively, were recognized as outright expenses. Depreciation method
is 10% per annum but depreciation in the year of the expenditure is at 5%.

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6. Minor repairs made on furniture and fixtures for the years 2017 and 2018 in the amount of
P3,000 and P8,000; respectively, were erroneously capitalized.

7. A prepaid operating expense covering a period of three years were paid on January 1, 2017
and 2018 amounting to P45,000 and P120,000, respectively. The client charged all of the
amount to expense upon payment.

8. An Unearned Income covering a period of 4 years were paid on July 1, 2018 and 2019
amounting to P8,000 and P20,000 respectively. Income was credited for the entire proceeds
upon collection.

Compute for the net adjustments on the following:

1. 2017 and 2019 Profits
2. 2018 and 2019 Retained Earnings
3. 2017 and 2018 Working Capital
4. 2017 and 2018 Total Assets
5. 2017 and 2019 Total Liabilities

PROBLEM 3

You are auditing the financial statements of Clark, Inc. for the year 2019. The details of the
company’s RETAINED EARNINGS before adjustments are as follows:

RETAINED EARNINGS
Date Descriptions Dr. Cr. Balance
01.01.201 Balance 570,000
7
12.31.201 Net Loss for the year 70,000 500,000
7
01.31.201 Dividends paid 210,000 290,000
8
04.30.201 Share premium 135,000 425,000
8
08.31.201 Gain on retirement of shares 90,000 515,000
8
12.31.201 Net Income for the year 750,000 1,265,000
8
01.31.201 Dividends paid 150,000 1,115,000
9
12.31.201 Net Loss for the year 248,250 866,750
9

Your examination disclosed the following:

a. Omissions at the end of each year:

2019 2018 2017 2016
Accrued income 11,700 9,300 8,400 7,050
Prepayments 11,100 12,750
TOTAL 11,700 20,400 8,400 19,800

Unearned Income 14,400 11,700

Accrued expenses 14,250 13,050 9,300 8,100
TOTAL 28,650 13,050 21,000 8,100

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b. Dividends has been declared in 2017 and in 2018 but were not recorded until they were paid
the following year. Dividends declared in December 2019, but paid and recorded in 2020
amounted to P150,000

c. The company received transportation equipment as donation from a stockholder on October

31, 2017. As of the date of donation, the equipment has a remaining useful life of 3 years and
a fair value of P240,000. The only entry made at the date of the donation was expensing
P15,000, which was the fee paid to effect the transfer of ownership.

d. Merchandise inventories costing P51,000 and P48,000 were in transit from a supplier at the
end of 2017 and 2018, respectively. These were purchased under FOB shipping point and the
goods were excluded from the physical count made at the end of each year. The purchases;
however, were recorded the immediate following year, upon receipt of the complete purchase
invoice documents.

e. Merchandise inventories with sales invoice prices of P70,000 and P140,000 were in transit to
customers at the end of 2017 and 2019, respectively. These goods, sold at 25% gross profit
based on sales under FOB Destination, were recorded as sales in 2017 and 2019, respectively.
Since goods have already been physically delivered as of the count date, these goods were
excluded from the physical count of that particular year.

Compute for the following:

1. Retained earnings as at December 31, 2017 and 2019
2. Profit/(Loss) for the years
3. Net adjustments to working capital on December 31, 2018
4. Net adjustments to total liabilities on December 31, 2017
5. Net adjustments to total assets on December 31, 2019

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