AUDITING AND ASSURANCE: CONCEPTS AND APPLICATIONS I

CORRECTION OF ERRORS

Prior Period Errors are omissions from, and misstatements in, prior period financial statements resulting
from the failure to use, or the misuse of, reliable information that was available, or could be reasonably
expected to have been obtained, at the time of preparation of those financial statements. (Adapted from
IAS 8)

Errors must be distinguished from changes made to prior period estimates that had been based
on information that best reflected the conditions and circumstances that existed at the reporting date.
Examples of accounting estimates include the following:
 Valuation of land where it is accounted for at revalued cost
 Impairment of non-current assets
 Useful lives of non-current assets
 Pattern of economic benefits expected to be received from non-current assets for calculating
depreciation
 Impairment of receivables (bad debts)
 Pension Benefit obligations
 Provision for slow moving and obsolete inventory

Accounting Estimates involve management’s judgment of expected future benefits and

obligations relating to assets and liabilities (and associated expense and income) based on information
that best reflects the conditions and circumstances that exist at the reporting date. By its nature, estimates
are subjective and may require frequent revisions in future. Revision of estimates must be distinguished
correction of errors which occur because of not using information that was available at the time of
preparation of financial statements.

Correction of Prior Period Accounting Errors

Prior Period Errors must be corrected retrospectively in the financial statements. Retrospective
application means that the correction affects only prior period comparative figures. Current period
amounts are unaffected.

Therefore, comparative amounts of each prior period presented which contain errors are
restated. If however, an error relates to a reporting period that is before the earliest prior period
presented, then the opening balances of assets, liabilities and equity of the earliest prior period presented
must be restated.

Errors Discovered after Reporting Date

Accounting Errors discovered after the reporting date but before the authorization of financial
statements are adjusting events after the reporting date as per IAS 10 and must therefore be corrected in
the current period prior to the issuance of financial statements.

Impracticability in Correction of Prior Period Errors

The retrospective correction of accounting errors may be impracticable. This may be the case
for example where entity has not collected sufficient data to enable it to determine the effect of correction
of an accounting error and it would be unfeasible or impractical to reconstruct such data.
Where impracticability impairs an entity’s ability to correct an accounting error retrospectively from the
earliest prior period presented, the correction must be applied prospectively from the beginning of the
earliest period feasible (which may be the current period).

Disclosure
 The nature of prior period errors corrected during the period
 The amount of restatement made at the start of the earliest prior period presented
 The circumstances that resulted in impracticability to correct an accounting error retrospectively
and how and from when the error has been corrected

Problem 1: (Change in Accounting Estimate)

CAE, Inc. is an airline that owns an XYZ aircraft that it bought in 2006 for ₱ 300 million. At the time of
recognition of the aircraft as a fixed asset, i.e. on 1 January 2006, the company estimated its useful life to

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 be 15 years and expected it to fetch ₱ 50 million at the end of its useful life.

The company uses straight-line depreciation method for the aircraft.

Regulatory changes introduced in November 2013 barred the company from flying this aircraft after the
end of 2015. The company cannot fly it on any alternate route either. The management is forced to sell it
and acquire an upgrade aircraft by end of 2015. It revised the useful life of the aircraft down to 10 years
and increased its salvage value to ₱ 90 million.

Illustrate how the company will account for the developments in financial year ending 31 December 2014.

Solution

From 2006 to 2013, the company must have recorded yearly depreciation expense of ₱ 16.67 million [=
(₱ 300 million - ₱ 50 million) ÷ 15].

By end of 2013, the aircraft served 8 years of its 15-year useful life. Its book value at the end of 2013
comes out to be ₱ 166.6 [=₱ 300 million - ₱ 16.67 million × 8].

The regulatory changes forced the company to reduce useful life down to 10 years. It means the
remaining useful life as at 1 January 2014 was 2 years.

Depreciation expense for 2014 = (₱166.6 million – ₱90 million) ÷ 2 = ₱38.32 million

Please note that the change in estimate is reflected only in periods subsequent to the change. It doesn’t
affect any of the historical depreciation expense or book values.

Prior Period Adjustments

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

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 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?

1. Problem 2: (Correction of Errors)

2. Erich Company manufactures kerosene heaters for home use. The December 31 financial statements
contained the following error:

2020 2021
Ending inventory 200,000 under 300,000 over
Depreciation 50,000 under

An insurance premium of P150,000 was prepaid in 2020 to cover 2020, 2021 and 2022. The entire amount was
charged to expense in 2020. On December 31, 2021, fully depreciated machinery was sold for P250,000 cash
but the sale was not recorded until 2022. There were no other errors during 2020 and 2021 and no corrections
have been made for any of the errors.

Ignoring income tax, what is the net effect of the errors on the retained earnings on December 31,
2021? 50,000 overstated

2020 ending inventory under 200,000 (200,000)

2021 ending inventory over (300,000)
2020 depreciation under ( 50,000) ---
Insurance premium 100,000 ( 50,000)
Gain on sale of machinery --- _ 250,000_
Net correction to income 250,000 (300,000)

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 Net correction to 2020 net income 250,000
Net correction to 2021 net income (300,000)
Net correction to retained earnings ( 50,000)

3. Problem 3: (Correction of Errors)

4. Bayle Company is in the process of adjusting its books at the end of 2021. Bayle’s records revealed the
following information:

 Bayle failed to accrue sales commissions at the end of 2019 and 2020 as follows:
2019 220,000
2020 140,000

In each case, the sales commissions were paid and expensed in January of the following year.

 Errors in ending inventory for the last three years were discovered to be as follows:
2019 400,000 understated
2020 540,000 overstated
2021 150,000 understated

The unadjusted retained earnings balance on January 1, 2021 is P12,600,000 and the unadjusted net income
for 2021 was P3,000,000. Dividends of P1,750,000 were declared during 2021.

What is the adjusted net income for 2021? 3,830,000

2019 2020 2021

Unrecorded commissions:
2019 (220,000) 220,000
2020 (140,000) 140,000
Ending inventory:
2019 under 400,000 (400,000)
2020 over (540,000) 540,000
2021 under _______ ________ 150,000
Net correction to income 180,000 (860,000) 830,000

Net income per book for 2021 3,000,000

Net correction to income of 2021 830,000
Adjusted net income of 2021 3,830,000

5. What is the adjusted balance of retained earnings on December 31, 2021? 14,000,000

Net correction to income of 2019 180,000

Net correction to income of 2020 ( 860,000)
Net correction to income of prior years ( 680,000)

Retained earnings – January 1, 2021 12,600,000

Prior period errors ( 680,000)
Corrected beginning balance 11,920,000
Net income for 2021 3,830,000
Dividends declared in 2021 ( 1,750,000)
Retained earnings – December 31, 2011 14,000,000

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