Auditing Problems
Accounting for Changes and Correction of Errors
Prof. Karlo Joseph C. Pasion, CPA
Learning Objectives:

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
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.
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.

Correct all previously presented prior period statements. correct the accounts through normal accounting cycle adjustments. . 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. If detected in subsequent period. Changes in estimates which are not prepared in good faith TYPES OF ERRORS 1. Prior period statements should be restated to correct the error when comparative statements are prepared. also called fundamental errors are reported in the current year as adjustment in the beginning balance of the Retained Earnings account. A change from an accounting principle that is not generally accepted to an accounting principle that is generally accepted. A reclassifying entry is necessary only if the error is discovered in the same year it is committed. If detected in the period the error occurred. hence. Prior period adjustments. They result from carelessness or ignorance on the part of the company's personnel or it may result from poor internal control. These errors are made for the purpose of concealing fraud or misappropriation. no classification entry is necessary. liabilities or stockholders' equity accounts. evading taxes. manipulating or window-dressing the company's financial statements. Incorrect classification of expense as an asset or vice versa g. Misuse of facts f. 3. The risk of material errors may be minimized through the installation of good internal control and the application of sound accounting procedures. If the error is discovered in a subsequent year. b. Balance Sheet Errors This type of error refers to improper classification of real accounts such as assets. Errors may be intentional or unintentional. Accounting Procedure: 1. 2. Income Statement Errors This type of error affects only the presentation of nominal accounts in the Income Statement. Unintentional errors were not deliberately committed. It involves the improper classification of revenues and expenses accounts. Mistake in the application of accounting of accounting principle d. only the details of the Income Statement are misstated. It has no effect on the Balance sheet and in the Income Statement. Intentional errors are significant because of the presence of fraud or intent to deceive.CORRECTION OF ERRORS No company whether large or small is immune from errors. Oversight e. adjust errors by making prior period adjustments directly to Retained Earnings or restate the beginning balance of the Retained Earnings account. Examples of Accounting errors: a. They have no effect on net income 2. 3. Mathematical mistakes c.

an entry is necessary to adjust the present balance of the Retained earnings. If the error is already counterbalanced. Restatement is necessary even if a correcting journal entry is not required. What is the correct entry? 5. If the error is already counterbalanced and the company is in the second year.  Counterbalancing errors include the misstatements of the following accounts: 1.Classifications of Combined Balance Sheet and Income Statement Errors: a. 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. How were these accounts affected? Was there an understatement or an overstatement? 3. Purchases b. Non Counter Balancing Errors  Errors which take longer than two periods to correct themselves. no entry is necessary. Inventories to include the following a. If the error is not yet counterbalanced. Sales 2. an entry is necessary to correct the current period and to adjust the beginning balance of the Retained earnings. Deferred Income 4. What accounts are affected? 2.  Effect: Net Income of two successive periods are misstated. 2. an entry is necessary to adjust the beginning balance of the Retained earnings and correct the current period. 2. GUIDELINES IN ERROR ANALYSIS 1. Counter Balancing Errors  Errors which if not detected are automatically offset or corrected over two periods. Prepaid expenses 3. Accrued Income GUIDELINES  Books are open 1. Accrued expense 5. retirement or other means of disposal. If the error is not yet counterbalanced. The amount of misstatement in one period is equal to but opposite in effect in the income of the next period. What was the erroneous entry made or what was the entry omitted? 4. b. What is the necessary adjusting or correcting entry? Problems .  Books are closed 1.

000 shares of P 100 par value capital stock for P550. GRISHAM CORP. Interest collection from a notes receivable amounting to P3.000 which had been outstanding for more than six months was included in the list of outstanding checks. 2004. 6.000 collection from Smart Co.000 from a customer to apply to his account was received on December 30. you discovered the following errors. On the last day of 2004. issued checks to its creditors amounting to P75. books are still open b. 14. 2003.000 for three years paid in January 2003 was charged to expenses in 2003. but was recorded by the bookkeeper as P2. 2004 was deposited and recorded on the same day by a credit to sales. goodwill estimated by the Board of Directors at P300. 12. an equipment costing P70. 2003.000. 7. Improvements on building of P100. 13.PROBLEM 1 In your examination of the financial statements of GRISHAM CORP. This was in payment of an employee cash advance. A check for P20. 2003.750. A staled check of P12. 8. 4.000. On January 01.500 which was received on December 30. 1. assuming : a.000 was set up by a credit to Retained Earnings. 11. 2004. On December 29. Improvements have a life of 5 years. 2003. books are already closed . indicate the effect on net income for both 2003 and 2004 and the necessary adjusting entries. issued 5. A P15. On December 31. the company received a P90. GRISHAM CORP.500.000 prepayment from a tenant for 2005 rent of a building. 2005. was correctly recorded in the general ledger but was erroneously credited to the subsidiary ledger account of Smurf Corp. 2004.000 on January 14.500 for freight charges on merchandise purchased on December 18. 2004 was debited to freight out account. On December 31. KEVIN INC. the equipment has an accumulated depreciation of P43. Payment of P4.000 for goods to be delivered in January 2005 was deducted from accounts receivable. Prepare the necessary adjusting entries. 2004.s accountant discovered several errors. PROBLEM 2 In early 2005. while reviewing KEVIN INC. At the date of sale. 9. These checks were released on January 4. for the year ended December 31. 10. A customer's deposit of P60. Insurance premium of P45.. For each of the error listed below.000 was sold for P35.000 had been charged to expense on January 01. A check was cleared by the bank as P5.200 on December 05. It was recorded as rent revenue. 2004 but was not recorded until January 4. The proceeds were credited to the Capital Stock account. 15. 2. 2005.000.’s 2004 financial records. the physical count was overstated by P5. This was in payment of Accounts Payable 3. 5. The cash received was recorded as other income in 2004.

04 05.000 10. Information relating to bad debts and sales is as follows: Estimated Bad Debt Expense Actual Year Sales (% of Sales) Bad Debts 2001 P 87. Pollution control devices costing P84. KEVIN INC.01.000 was recorded in 2004 2.04 02.04 80.000 3.850 2003 147. 6. 8. The merchandise was shipped FOB shipping point and was not included in ending inventory.000 KEVIN INC. proposes changing their estimation of bad debt expense from 3 percent of sales to 2 percent. 2003.222 At the beginning of 2004. 7. Assume tax rate of 32%. KEVIN INC.610 P1. Sales for the year totaled P1. No depreciation expense was recorded during 2003 or 2004. 5. beginning October 1. DATE OF LOAN AMOUNT MATURITY DATE 11. Unearned revenues 2002 2003 2004 P240.000 P2.720. The original equipment referred to has a remaining useful life of 6 years on December 30.000 on December 29. 4. KEVIN INC.000 was sold for P40. The company had already made an adjustment based on the old rate. The following loans were at 12% interest rate. failed to record the unearned revenues in each of the three years. .01.000 was held by KEVIN INC. receives subscription payments for annual (one year) subscriptions to its magazine.200 2002 123. were installed in 2003 and were charged to repairs in 2003.630.31. uses the straight-line method for recording depreciation. repaid each loan on its scheduled maturity date.01.000 P352.000 07. KEVIN INC. No adjusting entry was made on December 31. A one-year note receivable of P96.000 4. with interest payable at maturity. has estimated bad debts using the percentage-of-sales method since their business began operations in 2002. 2003 and is being depreciated using the straight line method. Merchandise costing P24.03 50.690 2.04 150. Payment of the 10 percent note and accrued interest was received upon maturity. 2003. Beginning merchandise inventory (January 01.31. 3. interest expense of P15.1. 2003 but the sale was recorded in 2004.05 KEVIN INC. records interest expense when the loans are repaid. Amounts received but unearned at the end of each of the last three years are shown below. Equipment with a ten-year life was purchased on January 1. 2003. Payments are recorded as revenue when received. frequently borrows from the bank in order to maintain sufficient operating cash. for P39. KEVIN INC.31. Assume that the equipment has no salvage value and that KEVIN INC.640. As a result.000 01.000 and actual bad debts amounted to P3.200.000 P300. 2003) was understated by P8.000 which is high in relation to the cost of the original equipment.410 3.

2003.000 in 2004. The entire amount was debited to Prepaid Insurance.500. P43. 10.000 in 2003 and P92. A two-year fire insurance policy was purchased on May 1. for P57.000 in 2002. Accrued expenses omitted at the end of the year are P43. .9. No adjusting entry was made in 2003 or 2004.