AUDITING PROBLEMS

Accounting for Changes and Correction of Errors

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 occurs 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.

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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

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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. Financial Position 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 Financial Position 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 Financial Position 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 is 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

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 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?

END

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1. Honey Oh Entertainment Inc. failed to recognize accruals and prepayments during
its first year of operations. Audit of its financial statements revealed the following:

Initial Net Income for the year 2018: P1,200,000

Prepaid Insurance P100,000

Accrued Wages P250,000
Advances from Customers P125,000
Unused Supplies P25,000

What is the correct Profit (Loss) for the year 2018?

2-6. Soar Study Lounge started its operations on Jan. 1, 2o17. It has not properly
established accruals and deferrals since its inception. Audit of its financial statements
for the year 2018 has revealed the following:

Unadjusted profit (loss) 2017 – (75,000)

Unadjusted profit (loss) 2018 – (125,000)

Accruals and Deferrals 2017 2018

Unused Supplies P23,500 P37,100
Advances from Customer P10,250 P21,000
Accrued Interest Income P2,300 P2,300
Accrued Wages P15,700 P12,200

Additional Information: Cash expenditures relating to supplies for 2017 and 2018 are
P45,000 and P43,000 respectively. (Expense Method is used)

2. What is the corrected profit (loss) for 2017?

3. What is the corrected profit (loss) for 2018?
4. How much is the net audit adjustments to January 1,2018 Retained Earnings?
Credit (Debit)
5. Corrected Supplies Expense for 2017?
6. Corrected Supplies Expense for 2018?

7-11. On July 1, 2018 Riverdale Inc. issued a 4 year note payable in 4 equal annual
installments of P250,000 every June 30 starting 2019. The transaction was recorded
by crediting notes payable by the face value of P1,000,000. During the audit for the

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year 2018, it was discovered that the prevailing interest rate on this type of note were
10% on July 1,2018 and 8% on Dec. 31, 2018.

No adjustments have been made relating to the note since issuance.

PV factor 10% = 0.683 PV annuity factor 10% = 3.170

PV factor 8% = 0.735 PV annuity factor 8% = 3.312

7. What is the carrying amount of the Note upon issuance?

8. Discount on Notes Payable on December 31, 2018?
9. Net audit adjustments on January 1,2018 Retained Earnings? Credit (Debit)
10. Pro forma entry to record omitted accrued revenue on 2018, assuming audit year
is 2018?

11. Pro forma entry to adjust an overstatement in the Ending Inventory of 2017,
assume audit year is 2018?

Prepare the audit adjusting entries assuming that these errors were discovered in the
course of your examination of the 2015 financial statements.

12. Failed to accrue wages, P160,000 at the end of 2014.

13. Accrued interest income of P48,000 in 2013 was recorded only when collected in
January 2014.

14. An insurance premium covering three years (2014,2015 and 2016) was paid in
January 2014. All of the P60,000 premium had been charged to insurance expense in
2014. No adjustments were made in 2014 and 2015 related to this transaction.

15. Failed to record P25,000 and P28,000 unused office supplies at December 31,
2014 and 2015, respectively. Cash expenditures of P45,000 and P52,000 were charged
to an office supplies expense account during the year 2014 and 2015, respectively.

16. Research and Development costs of P120,000 were incurred early in 2014. They
were capitalized and were being amortized over a three-year period. Amortization was
recorded in 2014 and 2015. None of the development costs meet the criteria for
depreciation.

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17. At the beginning of 2014, the company received P120,000 cash from a customer
for services the company is to perform evenly over a three year period. Full amount
was recorded as revenue in 2014 and no adjustment was taken up at year-end.

18. Unearned rent of P36,000 was not recorded at the end of 2014.

19. A capital expenditure of 1,500,000 at January 1, 2013 for office equipment (useful
life, 5 years) was erroneously charge to maintenance expense.

20-21. Rabbit Corporation reported profit for the years 2014 and 2015 at P550,000
and P700,000, respectively. Your audit of the company’s accounts disclosed the need
for adjustments as follows:

2014 2015
Overstatement of ending inventories due to error in pricing 29,000 33,000
Omission of depreciation on newly-acquired equipment 15,000 15,000
Understatement of commission receivable 22,000 18,000
A purchase of merchandise was not recorded until the
following year and also was not included in the ending
inventory 60,000

20. The adjusted profit for 2015 was?

21. What is the effect of the foregoing errors on total assets at December 31, 2015?