Auditing Problems Lecture on Correction of Errors

ABE CAINTA Auditing Problems Accounting for Changes and Correction of Errors Prof. Karlo Joseph C. Pasion, CPA Learning Objectives: 1. 2. 3. 4. 5. 6.

Identify the types of accounting changes. Explain the methods of accounting change. Account for a change in accounting principle using retrospective adjustment method. Account for a change in accounting estimate. Explain the conceptual issues regarding a change in accounting principle and a change in estimate. Account for a correction of an error.

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 considered to be 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.

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  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.

GUIDELINES IN ERROR ANALYSIS 1. What accounts are affected? 2. How were these accounts affected? Was there an understatement or an overstatement? 3. What was the erroneous entry made or what was the entry omitted? 4. What is the correct entry? 5. What is the necessary adjusting or correcting entry? Problems

PROBLEM 1 In your examination of the financial statements of GRISHAM CORP., for the year ended December 31, 2004, 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, 2004 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, 2004 was debited to freight out account.

4.

On December 31, 2003, the physical count was overstated by P5,000.

5.

Improvements on building of P100,000 had been charged to expense on January 01, 2004. 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, 2003. The proceeds were credited to the Capital Stock account.

7.

On January 01, 2004, 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 2004.

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 2003.

10.

On December 31, 2003, goodwill estimated by the Board of Directors at P300,000 was set up by a credit to Retained Earnings.

11.

On December 29, 2004, GRISHAM CORP. issued checks to its creditors amounting to P75,000. These checks were released on January 4, 2005.

12.

A check for P20,000 from a customer to apply to his account was received on December 30, 2004 but was not recorded until January 4, 2005.

13.

A customer's deposit of P60,000 for goods to be delivered in January 2005 was deducted from accounts receivable.

14.

A check was cleared by the bank as P5,200 on December 05, 2003, but was recorded by the bookkeeper as P2,500. This was in payment of an employee cash advance.

15.

On the last day of 2004, the company received a P90,000 prepayment from a tenant for 2005 rent of a building. It was recorded as rent revenue.

PROBLEM 2 In early 2005, while reviewing KEVIN INC.’s 2004 financial records, KEVIN INC.s accountant discovered several errors. For each of the error listed below, indicate the effect on net income for both 2003 and 2004 and the necessary adjusting entries, assuming : a.

books are still open

b.

books are already closed

1. KEVIN INC. frequently borrows from the bank in order to maintain sufficient operating cash. The following loans were at 12% interest rate, with interest payable at maturity. KEVIN INC. repaid each loan on its scheduled maturity date. DATE OF

LOAN AMOUNT

MATURITY DATE

11.01.03

50,000

10.31.04

02.01.04

150,000

07.31.04

05.01.04

80,000

01.31.05

KEVIN INC. records interest expense when the loans are repaid. As a result, interest expense of P15,000 was recorded in 2004 2. Pollution control devices costing P84,000 which is high in relation to the cost of the original equipment, were installed in 2003 and were charged to repairs in 2003. The original equipment referred to has a remaining useful life of 6 years on December 30, 2003 and is being depreciated using the straight line method. Assume tax rate of 32%. 3. KEVIN INC. receives subscription payments for annual (one year) subscriptions to its magazine. Payments are recorded as revenue when received. Amounts received but unearned at the end of each of the last three years are shown below.

Unearned revenues

2002

2003

2004

P240,000

P300,000

P352,000

KEVIN INC. failed to record the unearned revenues in each of the three years. 4. KEVIN INC. has estimated bad debts using the percentage-of-sales method since their business began operations in 2002. Information relating to bad debts and sales is as follows: Estimated Bad Debt Expense

Actual

Year

Sales

(% of Sales)

Bad Debts

2001

P 87,000

P2,610

P1,200

2002

123,000

3,690

2,850

2003

147,000

4,410

3,222

At the beginning of 2004, KEVIN INC. proposes changing their estimation of bad debt expense from 3 percent of sales to 2 percent. Sales for the year totaled P1,630,000 and actual bad debts amounted to P3,720. The company had already made an adjustment based on the old rate. 5.

Beginning merchandise inventory (January 01, 2003) was understated by P8,640.

6. Merchandise costing P24,000 was sold for P40,000 on December 29, 2003 but the sale was recorded in 2004. The merchandise was shipped FOB shipping point and was not included in ending inventory. 7. A one-year note receivable of P96,000 was held by KEVIN INC. beginning October 1, 2003. Payment of the 10 percent note and accrued interest was received upon maturity. No adjusting entry was made on December 31, 2003. 8. Equipment with a ten-year life was purchased on January 1, 2003, for P39,200. No depreciation expense was recorded during 2003 or 2004. Assume that the equipment has no salvage value and that KEVIN INC. uses the straight-line method for recording depreciation.

9. A two-year fire insurance policy was purchased on May 1, 2003, for P57,500. The entire amount was debited to Prepaid Insurance. No adjusting entry was made in 2003 or 2004. 10. Accrued expenses omitted at the end of the year are P43,000 in 2002, P43,000 in 2003 and P92,000 in 2004.