Error Correction

-identifying the effects of the errors

-correcting the errors

Classifications of Error - Affected Accounts

Balance Sheet Errors - assets, liabilities and equity
Income Statement Errors - revenues and expenses
Combined Balance Sheet and Income Statement Error - most common type

Types of Errors
1. Noncounter-balancing
2. Counter-balancing

Noncounter-Balancing Errors
Without intervention, the errors will not be corrected.
1. Capitalization of PPE without depreciating it.
-non-recording of depreciation will overstate net income and assets
-non-recording of depreciation will overstate retained earnings

2. Outright expense of acquired PPE

Counter-Balancing Errors
Errors that correct themselves
1. Inventory
2. Purchases
3. Accrued income and accrued expenses
4. Deferred income and prepaid expense
Year 1 (current year)
Inventory Errors Correct Net Income
Overstated Ending Inventory Net Sales
Recorded > Correct Amount COGS
Effects for the current year: Beg Inv. 800,000
Overstated Net Income Net Purchases 3,500,000
Understatement of COGS TGAS 4,300,000
Overstated Retained Earnings at the end of current year End Inv. 900,000
Effects for the subsequent year: COGS
Understated Net Income Gross Profit
Overstatement of COGS OPEX
Retained Earnings Correctly Stated, provided no other inventory Net Income

Understated Ending Inventory

Recorded < Correct Amount Year 1 (current year)
Effects for the current year: Correct Net Income
Understated Net Income Net Sales
Overstatement of COGS COGS
Understated Retained Earnings at the end of current year Beg Inv. 800,000
Effects for the subsequent year: Net Purchases 3,500,000
Overstated Net Income TGAS 4,300,000
Understatement of COGS End Inv. 900,000
Retained Earnings Correctly Stated, provided no other inventory COGS
Gross Profit
OPEX
Net Income

Errors on Purchases - Cut-off

Overstated Purchases Year 1 (current year)
Recorded > Correct Amount Correct Net Income
Effects for the current year: Net Sales
Understated Net Income COGS
Overstatement of COGS Beg Inv. 800,000
Understated Retained Earnings at the end of current year Net Purchases 3,500,000
Effects for the subsequent year: TGAS 4,300,000
Overstated Net Income End Inv. 900,000
Understatement of COGS COGS
Retained Earnings Correctly Stated, provided no other inventory Gross Profit
OPEX
Net Income

Understated Purchases
Recorded < Correct Amount Year 1 (current year)
Effects for the current year: Correct Net Income
Overstated Net Income Net Sales
Understatement of COGS COGS
Overstated Retained Earnings at the end of current year Beg Inv. 800,000
Effects for the subsequent year: Net Purchases 3,500,000
Understated Net Income TGAS 4,300,000
Overstatement of COGS End Inv. 900,000
Retained Earnings Correctly Stated, provided no other inventory COGS
Gross Profit
OPEX
Net Income

Accrued Income
No Accruals were made on the current year
Income will be recognized only during the subsequent year when actually received
Effects of Error
Understatement of Net Income - Current Year
Understatement of Retained Earnings - Current Year
Overstatement of Net Income - SUbsequent Year
Retained Earnings Correctly Stated, provided no other errors were made

Correct
Y1
 Receivable
Income

Y2
Cash
Receivable

Accrued Expense
No Accruals were made on the current year
Expense will be recognized only during the subsequent year when actually paid
Effects of Error
Overstatement of Net Income - Current Year
Overstatement of Retained Earnings - Current Year
Understatement of Net Income - SUbsequent Year
Retained Earnings Correctly Stated, provided no other errors were made

Correct
Y1
Expense
Accrued Expense

Y2
Accrued Expense
Cash

Deferred Income
Income method was used
Effect of Error Received 100,000
Overstatement of Net Income - Current Year Earned Y1 70,000
Overstatement of Retained Earnings - Current Earned Y2 30,000
Understatement of Net Income - SUbsequent Y Correct
Retained Earnings Correctly Stated, provided Y1
Cash 100,000
Income 100,000

INcome 30,000
Unearned Income 30,000

Y2
Unearned Income 30,000
Income 30,000

Prepaid Expense
Expense Method was used Paid 200,000
Effect of Error Expired Y1 120,000
Understatement of Net Income - Current Year Expired Y2 80,000
Understatement of Retained Earnings - Current Correct
Overstatement of Net Income - Subsequent Ye Y1
Retained Earnings Correctly Stated, provided Expense 200,000
Cash 200,000

Prepaid Asset 80,000

Expense 80,000

Y2
Expense 80,000
Prepaid Asset 80,000
 Year 1 (current year) Year 2 (subsequent year)
Ending Inv. Overstated by P200,000 Correct Net Income
6,000,000 Net Sales 6,000,000 Net Sales
COGS COGS
Beg Inv. 800,000 Beg Inv. 900,000
Net Purchases 3,500,000 Net Purchases 4,200,000
TGAS 4,300,000 TGAS 5,100,000
End Inv. 1,100,000 End Inv. 650,000
3,400,000 COGS 3,200,000 COGS
2,600,000 Gross Profit 2,800,000 Gross Profit
1,000,000 OPEX 1,000,000 OPEX
1,600,000 Net Income 1,800,000 Net Income

Year 1 (current year) Year 2 (subsequent year)

Ending Inv. Understated by P150,000 Correct Net Income
6,000,000 Net Sales 6,000,000 Net Sales
COGS COGS
Beg Inv. 800,000 Beg Inv. 900,000
 Net Purchases 3,500,000 Net Purchases 4,200,000
TGAS 4,300,000 TGAS 5,100,000
End Inv. 750,000 End Inv. 650,000
3,400,000 COGS 3,550,000 COGS
2,600,000 Gross Profit 2,450,000 Gross Profit
1,000,000 OPEX 1,000,000 OPEX
1,600,000 Net Income 1,450,000 Net Income

Year 1 (current year) Year 2 (subsequent year)

Purchases are overstated by P300,000 Correct Net Income
6,000,000 Net Sales 6,000,000 Net Sales
COGS COGS
Beg Inv. 800,000 Beg Inv. 900,000
Net Purchases 3,800,000 Net Purchases 4,200,000
TGAS 4,600,000 TGAS 5,100,000
End Inv. 900,000 End Inv. 650,000
3,400,000 COGS 3,700,000 COGS
2,600,000 Gross Profit 2,300,000 Gross Profit
1,000,000 OPEX 1,000,000 OPEX
1,600,000 Net Income 1,300,000 Net Income

Year 1 (current year) Year 2 (subsequent year)

Purchases are understated by P400,000 Correct Net Income
6,000,000 Net Sales 6,000,000 Net Sales
COGS COGS
Beg Inv. 800,000 Beg Inv. 900,000
Net Purchases 3,100,000 Net Purchases 4,200,000
TGAS 3,900,000 TGAS 5,100,000
End Inv. 900,000 End Inv. 650,000
3,400,000 COGS 3,000,000 COGS
2,600,000 Gross Profit 3,000,000 Gross Profit
1,000,000 OPEX 1,000,000 OPEX
1,600,000 Net Income 2,000,000 Net Income

Actual
Y1
No entry

Y2
Cash
Income

Actual
Y1
No entry

Y2
Expense
Cash

Actual
Y1
Cash 100,000
Income 100,000

No entry

Y2
No entry

Actual
Y1
Expense 200,000
Cash 200,000

No entry

Y2
No entry
 January 1, 2015
Useful life
Annual depreciation

Actual Dep
2015 0
2016 0
2017 0
2018 0
2019 0
1,000,000

January 1, 2015
Year 2 (subsequent year) Useful life
Effect of Year 1 Error Annual depreciation
7,000,000 Net Sales 7,000,000
COGS Actual Exp
Beg Inv. 1,100,000 2015 1,000,000
Net Purcha 4,200,000 2016 0
TGAS 5,300,000 2017 0
End Inv. 650,000 2018 0
4,450,000 COGS 4,650,000 2019 0
2,550,000 Gross Profit 2,350,000 0
1,300,000 OPEX 1,300,000
1,250,000 Net Income 1,050,000

Year 2 (subsequent year)

Effect of Year 1 Error
7,000,000 Net Sales 7,000,000
COGS
Beg Inv. 750,000
 Net Purcha 4,200,000
TGAS 4,950,000
End Inv. 650,000
4,450,000 COGS 4,300,000
2,550,000 Gross Profit 2,700,000
1,300,000 OPEX 1,300,000
1,250,000 Net Income 1,400,000

Year 2 (subsequent year)

Effect of Year 1 Error
7,000,000 Net Sales 7,000,000 Total Correct Net Inc 2,850,000
COGS Reported Total Net I 2,850,000
Beg Inv. 900,000 0
Net Purcha 3,900,000
TGAS 4,800,000
End Inv. 650,000
4,450,000 COGS 4,150,000
2,550,000 Gross Profit 2,850,000
1,300,000 OPEX 1,300,000
1,250,000 Net Income 1,550,000

Year 2 (subsequent year)

Effect of Year 1 Error
7,000,000 Net Sales 7,000,000 Total Correct Net Inc 2,850,000
COGS Reported Total Net I 2,850,000
Beg Inv. 900,000 0
Net Purcha 4,600,000
TGAS 5,500,000
End Inv. 650,000
4,450,000 COGS 4,850,000
2,550,000 Gross Profit 2,150,000
1,300,000 OPEX 1,300,000
1,250,000 Net Income 850,000
1,000,000
5 years
200000

Should be Reported Net Net incomeCorrect ne Effect in retained earnings

200000 1,200,000 -200000 1,000,000 -200000
200000 900,000 -200000 700,000 -400000
200000 700,000 -200000 500,000 -600000
200000 800,000 -200000 600,000 -800000
200000 1,100,000 -200000 900,000 -1000000
0

1,000,000
5 years
200000

Should be Reported Net Net incomeCorrect ne Effect in retained earnings

200000 1,200,000 800,000 2,000,000 800000
200000 900,000 -200000 700,000 600000
200000 700,000 -200000 500,000 400000
200000 800,000 -200000 600,000 200000
200000 1,100,000 -200000 900,000 0
0
Net Income 2013
Dividends
Add: RE, 1/1/13
RE, unadj 12/31/13
Understated End Inv, 2013

Unadjusted Net Income, 2013

Overstated Commission Expens
Overstated Beg. Inv.
Understated End. Inv.
Adjusted Net Income for 2013

RE, unadj 1/1/13

2012 understated expense
2012 overstated ending invento
RE, adj 1/1/13
Adjusted net income 2013
Dividends
 3,000,000
-1,750,000
12,600,000
13,850,000
150,000
14,000,000

3,000,000
140,000
540,000
150,000
3,830,000

12,600,000
-140,000
-540,000
11,920,000
3,830,000
-1,750,000
14,000,000
Reported Net Income , 2013
Beg inv. Overstatement
End inv. Understatement
Unrecorded Insurance Expense
Overstated sales revenue
2,000,000
300,000
500,000
-50000
-100,000
2,650,000
Unadjusted Net Income, 2013 6,500,000
Understated purchases, 2013 -1,000,000
Understated ending inventory, 2 1,500,000
Understated advertising expense -500,000
Remove the rental income -300,000
Recognize the correct rental inc 100000 -200,000
Remove the insurance expense 200,000
Recognize the correct insurance -100,000
6,400,000