CORRECTION OF ERRORS

The financial records and reports are used as the basis of significant decisions
related to the operations of the enterprise. As a result, the reliability of the information
reflected in the financial records and reports is very important. However, reliability is not
the same as precision or accuracy of the information. No accounting system has been
devised that would come out with information that is exact, free from errors, and not be
subject to changes. No accountant can claim that his financial records and reports
contain accurate data.

To safeguard against carelessness and dishonesty of certain officers and

employees, a business enterprise must adopt an orderly and integrated system of
procedures and control. Both the internal and external audits are parts of the system that
insures an increase in the efficiency of the operations and the reliability in the recording,
classifying, and summarizing processes within the enterprise. An effective internal control
and exercise of control and the exercise of care can only reduce the number of errors
that would be committed, but they cannot be expected to eradicate completely the
errors in the financial records and reports. Because of this reality, the management, with
the assistance of the accountant and the auditor, should constantly be in the lookout for
weakness in the system that is in place. They should always be ready to take the needed
actions in order to remedy a discovered weakness.

The accountant should be able to distinguish a right from a wrong accounting

treatment or policy. He should attempt to detect the errors committed, whether such
errors are intentional or unintentional. The accountant should be prepared to make the
needed corrections for the errors committed and perpetuated because of the weakness
in the system. Aside from being equipped with a solid knowledge of the generally
accepted accounting principles, the accountant should exercise care and vigilance at
all times.

We must be able to know the following:

 How to analyze an error: What is the effect of the error on the balance
of the assets, liabilities, owners’ equity and on the net income of the
current period? On the balances of the succeeding period?
 How to handle the error: Should correcting entries be prepared? What
correcting entries should be prepared to correct the balances per
records?
 What adjustments/corrections are needed in order to restate the
financial report?

Classifications of Errors

An accounting error may result from:

 A mathematical and clerical mistake, or carelessness in general;
 The misuse or omission of certain financial data;
 The failure to apply the appropriate accounting method, practice,
system, procedure, rule, principle, or concept, and/or;
 The use of accounting method, practice, system, procedure, rule,
principle or concept that is not generally accepted.

Errors may classified, broadly, into the following groups:

1. as to whether the error is intentional or unintentional
2. as to whether the error is material or immaterial
3. as to whether the error may be revealed or not by a trial balance
4. as to whether the error affects only one period or several periods
5. as to whether the error affects only the balance sheet accounts, only the
income statement accounts, or both of them
6. as to whether the error is counterbalancing or non-counterbalancing

Page 1 of 7
 The following do NOT constitute an accounting error:

1. Change in accounting policy. The term accounting policy also known as

accounting principle, includes the accounting methods, practices, systems,
procedures, rules or concepts. The general rule is that an accounting policy
that is chosen for application should be applied consistently from period to
period. However, there are circumstances when it becomes necessary to shift
to generally accepted policy. A change to another generally accepted
accounting policy is allowed if the change is considered justified.

Examples:
a. Change in the method of inventory pricing from the FIFO to
weighted average method;
b. Change in the method of accounting for long-term construction
contract from cost recovery method to percentage of completion
method (note: this will be discussed in Advanced Financial
Accounting);
c. The initial adoption of policy to carry assets at revalued amount is a
change in accounting policy to be dealt with as revaluation in
accordance with PAS 16;
d. Change from cost model to fair value model in measuring
investment property;
e. Change to a new policy resulting from the requirement of a new
PFRS.

2. Change in accounting estimate. The use of estimates is necessary so that the

financial statements can be prepared on time. With the passage of time and
as additional data become available, there may be a need to change an
estimate that was used earlier. Changing an accounting estimate is very
normal and is a necessary consequence of the preparation of the financial
statements and is, therefore, not classified as a correction of error. Instead, the
effects of a change in accounting estimate is accounted for in the period of
the change or in the future periods, and should not have a retroactive effect
on the reporting of the business enterprise.

Examples:
a. The estimate of the doubtful accounts is changed from 2% to 2.5% of
the outstanding accounts receivable.
b. The estimated useful life of the equipment is revised from 10 years to 8
years.
c. The amount provided for the product warranty expense is revised from
5% to 3% of net sales.

A change from an accounting policy that is not generally accepted to

another that is generally accepted is a form of correction of error and is not
classified as falling under a change in accounting policy. For example, Loki
Company deliberately ignored setting up a loss from bad debts. However,
beginning the current year, it decides to provide for estimated bad debts. This
decision in the current year to change from the direct write-off method to the
allowance method falls under correction of error.

Intentional vs. Unintentional Error

An errors intentional if it is the result of a deliberate act on the part of an officer or

an employee of the enterprise. Most of the time, an intentional error is committed for the
purpose of concealing fraud or misappropriation, evading tax, manipulating or window-

Page 2 of 7
dressing the financial statements in order to present a desired financial position or results
of operations.

Generally, intentional errors are significant because of the presence of fraud or

intent to deceive. These errors usually involve one or more of the management personnel,
and are generally material in amount.

Examples:
 In order to report a bigger profit, the payments for expenses in the
current period are debited to asset accounts. The net profit is
intentionally overstated in order to impress the potential creditors, the
loan grantors, or the stockholders of the business enterprise.
 Ending inventory is understated in order to understate the net income
thereby making the taxable income smaller.
 A customer’s account is considered as bad debts in order to cover up
for misappropriated cash collections.

On the other hand, an error is unintentional if its commission is not deliberate on

the part of the officers and/or employees of the enterprise. An unintentional error is
generally the result of carelessness or ignorance about the generally accepted
accounting principles on the part of the officer and/or employee. Unintentional errors
are minimized through the adoption of an effective system of internal control within the
enterprise.

Material vs. Immaterial Error

Any amount, event, information or element is considered material if, in the

surrounding circumstances as they exist at the time, it is of such a nature that its disclosure
or the method of its treatment would likely influence or make a difference in the
judgment and conduct of a reasonable person. An immaterial error is one whose effect
is not significant and which, therefore, is unlikely to affect or influence the judgment of a
user of the financial data.

Fundamental Error

A fundamental error is any error that has significant or material effect on the financial
statements of one or more prior period, so that those financial statements can no longer
be considered reliable at the date of their issue. A fundamental error would significantly
affect the accounting records and reports, and may tend to mislead a data user. Some
examples of this are:
 Big amounts of sales of the prior period is recorded as sales of the current
period;
 Material overstatement or understatement in the depreciation of the
building in a prior period;
 Major repairs incurred treated as expense.

Most of the time, the materiality or immateriality of an error is dependent on the

size of the amount involved. However, a big amount is not always considered material
and a small amount is not always material.

Errors that affect several periods and several financial statements

There are errors that affect the balance sheet accounts only, the income
statement accounts only, or both of them. Some examples of commonly committed
fundamental errors, together with their effects on the current period and on the
succeeding period’s balances are presented in the following table.

Page 3 of 7
 Effects of Selected Errors on the Balances of Two Successive Periods

Effects on the Effects on the

Error Account affected Balances at the end Balances at the end
of Period 1 of Period 2
1. Merchandise Cost of sales overstated understated
inventory at the end
of period 1 was Net income understated overstated
undervalued Retained earnings understated no effect
Merchandise understated no effect
inventory, end
2. Sales on account of Sales understated overstated
period 1 was Net income understated overstated
erroneously recorded Retained earnings understated no effect
in period 2 Accounts receivable understated no effect
3. Purchases on Purchases understated overstated
account of period 1 Cost of sales understated overstated
was recorded in Net income overstated understated
period 2 Retained earnings overstated no effect
Accounts payable understated no effect
4. Collection from Income and expenses no effect no effect
customer in period 1, Net income no effect no effect
to apply on account, Retained earnings no effect no effect
was taken up in Cash understated no effect
period 2
Accounts receivable overstated no effect
5. Payment to creditor Income and expenses no effect no effect
in period 1, to apply Net income no effect no effect
on account was Retained earnings no effect no effect
taken up in period Cash overstated no effect
Accounts payable overstated no effect
6. Depreciation of Depreciation expense understated no effect
period 1 was omitted Net income overstated no effect
Retained earnings overstated overstated
Accumulated understated understated
depreciation
7. Doubtful accounts Allowance for understated overstated
as of the end of doubtful accounts
period 1 was not Net income overstated understated
taken up; account Retained earnings overstated no effect
written off in period 2 Net accounts overstated no effect
receivable
8. Accrued income as Income understated overstated
of the end of period 1 Net income understated overstated
was not recorded Retained earnings understated no effect
Accrued income understated no effect
9. Accrued expenses Expenses understated overstated
as of the end of Net income overstated understated
period 1 was not Retained earnings overstated no effect
recorded Accrued expenses understated no effect
10. Unearned income Income overstated understated
as of the end of Net income overstated understated
period 1 was not Retained earnings overstated no effect
recorded (Income Unearned income understated no effect
method)

Page 4 of 7
11. Earned portion of Income overstated no effect
the unearned income Net income overstated no effect
at the end of period 1 Retained earnings understated understated
was omitted (Liability Unearned income overstated overstated
method)
12. Prepaid expense Expenses overstated no effect
as of the end of Net income understated overstated
period 1 was not Retained earnings understated no effect
recorded (Expense Prepaid expenses understated overstated
method)
13. Expired portion of Expenses understated no effect
the prepaid expense Net income overstated no effect
at the end of period 1 Retained earnings overstated overstated
was omitted (Asset Prepaid expenses overstated overstated
method)

For the other kinds of errors, you may read from the copy of the discussion in
Mercedes B. Kimwell’s Constructive Accounting book.

CORRECTING AN ERROR
Good judgment, maturity and skill are necessary in deciding what course of action
is appropriate to take in case an error or errors are discovered. Some of the factors to
consider in deciding how to handle an error:

1. the period the error is discovered – in the period it was committed or in the
subsequent period
2. the nature and materiality of the error

Errors can be grouped into other classifications, to wit:

A. Errors that affect the balance sheet accounts only
B. Errors that affect the income statements only
o if the nominal accounts affected are still open
o if the nominal accounts affected are already closed

C. Errors that affect both the balance sheet and the income statement
accounts
o Errors related to inventory
o Errors that affect the current period only
o Fundamental errors that affect one or more prior periods

D. Counterbalancing vs. non-counterbalancing errors

EXERCISE. Answer the following exercises.

A. Indicate the effect of the given errors:

On the net income of the current year,
On the total current assets as of the end of the year,
On the total current liabilities as of the end of the year, and
On the balance of retained earnings as of the end of the year.
Write the words overstated, understated, or no effect in each of the space provided.

Net Current Current Retained

Error
income assets liabilities earnings
Ending merchandise inventory was
1.
understated.

Page 5 of 7
 2. Sales on account was understated.
3. Cash purchases was understated.
4. Purchases on account was overlooked.
5. Prepaid taxes was overlooked.
6. Unearned income was understated.
7. Accrued wages was understated.
8. Accrued interest income was understated.
9. Doubtful accounts was not adjusted.
Depreciation of the equipment was
10.
understated.

B. The following errors were discovered before preparing the closing entries of 2011 nominal accounts.
Indicate the effects of each error on the net income of 2009, 2010 and 2011. For your answer, write
the words overstated, understated, no effect, or it depends in each space provided.

Net income
Error
2009 2010 2011
1. Ending inventory of 2010 was overstated.
2. Ending inventory of 2011 was understated.
3. Sales of 2009 was taken up in 2010.
4. Sales of 2010 was taken up in 2011.
5. Sales of 2010 was taken up in 2009.
6. Sales of 2011 was taken up in 2010.
7. Purchases of 2009 was taken up in 2010.
8. Purchases of 2010 was taken up in 2011.
9. Purchases of 2011 was taken up in 2010.
Accrued expenses at the end of 2009 was
10.
overstated.
Accrued expenses at the end of 2010 was
11.
understated.
Accrued expenses at the end of 2011 was
12.
overstated.
Prepaid expenses at the end of 2009 was
13.
understated.
Prepaid expenses at the end of 2010 was
14.
overstated.
Prepaid expenses at the end of 2011 was
15.
overstated.
Accrued income at the end of 2009 was
16.
overstated.
Accrued income at the end of 2010 was
17.
understated.
Accrued income at the end of 2011 was
18.
overstated.
Unearned income at the end of 2011 was
19.
understated.
Unearned income at the end of 2010 was
20.
understated.
Unearned income at the end of 2011 was
21.
understated.
22. Depreciation of 2009 was overstated.
23. Depreciation of 2010 was understated.

Page 6 of 7
 24. Depreciation of 2011 was overstated.
25. Doubtful accounts of 2009 was not taken up.
26. Doubtful accounts of 2010 was not taken up.
27. Doubtful accounts of 2011 was not taken up.

Further reading/computations:

Refer to Intermediate Accounting Volume 3 (Valix), pp. 285-299.

Refer to the excerpts from Constructive Accounting by Mercedes Kimwell (in a
separate PDF)

References:
Kimwell, M. (2007) Constructive Accounting
Valix, C.T., et. al. (2019) Intermediate Accounting Volume 3

END
_____________________________

“If you are working on something exciting that you really care about, you don’t have to be pushed. The vision pulls you.”
– Steve Jobs

“Hard work beats talent when talent does not work hard.”

“For every reason that it’s not possible,

there are hundreds of people who have faced the same circumstances and succeeded.”
– Jack Canfield

“I think goals should never be easy, they should force you to work, even if they uncomfortable at the time.”
– Michael Phelps

Page 7 of 7