2nd Flr, GF Partners Bldg, 139 H.V. dela Costa, Salcedo Village, Makati CityAUDITING PROBLEMSAccounting for Changes and Correction of ErrorsProf.L.O.Aristorenas__Denition of Ter!s Accounting "o#icies $ specifc principles, bases, conventions,rules and practices adopted by an enterprise in preparing and presenting thefnancial statements. %unda!enta# errors $ areerrorsdiscoveredinthecurrent periodwithsuchsignifcance, thatthefnancial statementsof oneormorepriorperiods can no longer be considered to have been reliable at the date of theirissue.Reasons &h' Accounting Changes Occur:. !he accounting profession may mandate that a new accounting principle is tobe used.". #hanging economic conditions$. #hanges in technology and in operations%. &ewe'perienceor newinformationmayprompt companiestochangeitsestimate of revenuesor e'penses.T(PES O% ACCOUNTING C)ANGES*+ Change in Accounting Princi"#es!his is a change from one generally accepted accounting principle to anothergenerally accepted accounting principle.Adoption of a new principle in recognitionof events that haveoccurredfor thest timeis not achangeinaccountingprinciple.!here is no change in accounting principle when the depreciation methodadopted for a newly ac(uired asset is di)erent from the method or methods usedfor previously recorded assets of similar class.Achangefromaprinciplethat is not generallyacceptedtoonethat isgenerally accepted is considered to be an error correction than a change inaccounting principle.Accounting Procedure,Bench!ar- treat!entA change in accounting policy*principle should be applied retroactively unlessthe amount of any resulting ad+ustment that relates to prior periods is notreasonably determinable. Any resultingad+ustment shouldbereportedas anad+ustment to the opening balance of the retained earnings. #omparativeinformation should be restated unless it is impracticable to do so..+Change in Accounting Esti!ate!his is a change that occur as a result of new information or ac(uisition ofadditional e'perience. #hanges in estimates are viewed as normal recurringcorrections and ad+ustments or the natural result of the accounting process.,etroactive treatment is prohibited. Accounting Procedure,a. ,eport current and future fnancial statements on the new basis.1b. Present prior period fnancial statements as previously reported.c. -a.e no ad+ustment to current period opening balances.NOTE, /henever it is impossible to determine whether a change in principleor a change in estimate has occurred, or if an asset is a)ected by both a change inprinciple and a change in estimate during the same period, the change should beaccounted for as a change in estimate rather than a change in principle.CORRECTION O% ERRORS&o company whether large or smallis immune from errors. 0rrors may beintentional or unintentional. 1ntentional errors are signifcant because of thepresence of fraud or intent to deceive. !hese errors are made for the purpose ofconcealing fraud or misappropriation, evading ta'es, manipulating or window2dressing the company3s fnancial statements. 4nintentional errors were notdeliberately committed.!hey result from carelessness or ignorance on the part ofthe company3s personnel or it may result from poor internal control. !he ris. of material errors may be minimi5ed through the installation of goodinternalcontroland the application of sound accounting procedures. Prior periodad+ustments, alsocalledfundamental errorsarereportedinthecurrentyear asad+ustment in the beginning balance of the ,etained 0arnings account.Prior periodstatements should be restated to correct the error when comparative statementsare prepared.Accounting Procedure,. 1f detectedintheperiodtheerror occurred, correct theaccountsthrough normal accounting cycle ad+ustments.". 1f detected in subse(uent period, ad+ust errors by ma.ing prior periodad+ustments directlyto,etained0arningsor restatethebeginningbalance of the ,etained 0arnings account.$. #orrect all previously presented prior period statements.0'amples of Accounting errors:a. A change from an accounting principle that is not generally accepted to anaccounting principle that is generally accepted.b. -athematical mista.esc. -ista.e in the application of accounting of accounting principled. Oversighte. -isuse of factsf. 1ncorrect classifcation of e'pense as an asset or vice versag. #hanges in estimates which are not prepared in good faithT(PES O% ERRORS*+ Ba#ance Sheet Errors !his type of error refers to improper classifcation of real accounts such asassets, liabilitiesor stoc.holders3 e(uityaccounts. !heyhavenoe)ect onnetincome.+ Inco!e State!ent Errors !his type of error a)ects only the presentation of nominal accounts in the1ncome 6tatement.1t involves the improper classifcation of revenues and e'pensesaccounts, hence, onlythedetails of the1ncome6tatement aremisstated. Areclassifying entry is necessary only if the error is discovered in the same year it iscommitted.1t has no e)ect on the 7alance sheet and in the 1ncome 6tatement.1fthe error is discovered in a subse(uent year, no classifcation entry is necessary./+ Co!0ined Ba#ance Sheet and Inco!e State!ent errors !his a)ects both the balance 6heet and the 1ncome 6tatement becausethey result in the misstatement of net income.2C#assications of Co!0ined Ba#ance Sheet and Inco!e State!ent Errors,a. Counter Ba#ancing Errors 0rrors which if not detected are automatically o)set or corrected overtwo periods.Restatement isnecessaryevenif acorrectingjournal entry is not required. E1ect, &et 1ncome of two successive periods are misstated. !heamount of misstatement in one period is e(ual to but opposite in e)ectin the income of the ne't period. #ounterbalancingerrorsincludethemisstatementsof thefollowingaccounts:. 1nventories to include the following a. Purchases b. 6ales". Prepaid e'penses$. 8eferred 1ncome%. Accrued e'pense9. Accrued 1ncomeGUIDELINES 7oo.s are open. 1f the error is already counterbalanced and the company is inthe second year, an entry is necessary to correct the currentperiodandtoad+ust thebeginningbalanceof the,etainedearnings.". 1f the error is not yet counterbalanced, an entry is necessary toad+ust thebeginningbalanceof the,etainedearningsandcorrect the current period. 7oo.s are closed1.1f the error is already counterbalanced, no entry is necessary.2.1f the error is not yet counterbalanced, an entry is necessary toad+ust the present balance of the ,etained earnings.b. Non Counter Ba#ancing Errors 0rrors which ta.e longer than two periods to correct themselves.!histype of error is carried over to the subse(uent accounting period untilcorrected or until the balance sheet item involved is removed from theaccounts by sales, retirement or other means of disposal.GUIDELINES IN ERROR ANAL(SIS. /hat accounts are a)ected:". ;owweretheseaccountsa)ected:/asthereanunderstatementoranoverstatement:$. /hat was the erroneous entry made or what was the entry omitted:%. /hat is the correct entry:9. /hat is the necessary ad+usting or correcting entry:ENDPROBLEM *1n your e'amination of the fnancialstatements of . A P9,=== collection from 6mart #o. was correctly recorded in the generalledger but was erroneouslycreditedtothesubsidiaryledger account of6murf #orp.B. 1nsurancepremiumof P%9,===for threeyearspaidin?anuary"==$wascharged to e'penses in "==$.=. On8ecember $, "==$, goodwill estimatedbythe7oardof 8irectorsatP$==,=== was set up by a credit to ,etained 0arnings.. On 8ecember "B, "==%, ,A9= invoice for oGce supplies was charged topurchases. OGce supplies are e'pensed as purchased.$. 1nventory on 8ecember $, "==% was overstated by P9@,"9=.%. Ane(uipment costingP"9,===andwithanaccumulateddepreciationofPA9,=== was sold for @>,A9= on ?anuary , "==%. 1n addition, depreciationwas recorded for the e(uipment for "==% at the rate of =H.Proceeds fromsale was credited to the 0(uipment account.9. Footings ande'tensionsshowed that the inventory on 8ecember $, "==$was overstatedby P 9B,$A9.@. 8epreciationof e(uipmentcostingP9,===bought on?une$=, "==wascomputedbasedonanestimateduseful lifeof >years. !heengineersestimatedthat theuseful lifeof theasset shouldberevisedto=years!e)ective "==%.!he company still provided for depreciation based on the oldestimate.A. 1nterestofP@,"9= on notes receivable was not recogni5ed on 8ecember $,"==%.>. 6ales on account of P"9,=== in 8ecember "==% were recorded in "==9.B. !a'esof P>,A9=applicableforthefourth(uarterof "==$werepaidandcharged to e'pense on ?anuary "=, "==%. =. A fully depreciated machinery was sold on 8ecember $, "==% but the salewasnotrecordeduntil "==9. !heproceedsfromsalesonthismachinerycosting P%$A,9== wasP$,"9=.. On8ecember"=, "==$, acashadvanceofP$A,9==fromacustomerwasreceivedforgoodstobedeliveredin?anuary"==%. !heamountof cashreceived was credited to sales.!he company3s gross proft is "=H of cost.". 1nsurance premiumfor a three year period amounting to P9,=== wascharged to e'pense on ?anuary , "==$ and no ad+ustment was made on yearend.$. A collection ofP$,"9= from a customer was received on 8ecember $, "==%but not recorded until ?anuary %, "==9.%. Acustomer3schec.of P>,A9=wasreturnedbytheban.on&ovember$,"==%duetolac.of suGcientfunds. Ad+ustmentwasmadethefollowingyear.9. 8epreciationcomputedonthebuildingfor theyears"==$and"==%wasoverstated by P",9== per year.,ecords of -ervyn #ompany reported the following net 1ncome."==$ P 9%@,>A9"==% @"9,===RE4UIREMENTS,. Prepare a wor.sheet showing the corrected income for "==$ and "==%.". Prepare the necessary ad+usting entries on 8ecember $, "==% assuming:a. 7oo.s are still openb. 7oo.s are closedPro0#e! 61nearly"==9, whilereviewing!;O-A6#O,P.3s"==%fnancial records, itsaccountant discovered several errors. For each of the error listed below, indicatethee)ectonnetincomeforboth"==$and"==%assumingnocorrectionwasmade and the company uses the periodic system of inventory.. A9B.Failed to recogni5e gain on sale of landL Land credited forthe proceeds A9,====.Failed to record accrued salaries @,"9= "",9== 2Re8uire!ents, Prepare a schedule to correct the reported net income foreach year and the ad+usting entries to correct the boo.s at the end of "==%.Pro0#e! 9. -I6!0,I6#O! -A&4FA#!4,1&< purchased a machine on ?anuary , "=== forP9=,===.At the time, it was determined that the machine has an estimated usefullife of = years and an estimated residual value of P",===.!he company used thedouble declining balance method of depreciation.On ?anuary , "==%, the companydecided to change its depreciation method fromdouble declining balance tostraight line.!he machine3s remaining useful life was estimated to be 9 years witha residual value of P ,===.". &o allowance had been set up for estimated uncollectible receivables. !hecompany decided to set up such an allowance for the estimated probable losses asof 8ecember $, "==$, for "==$ accounts of P$9= and for "==% accounts of PA9=.1t#was also decided to correct the charge against each year so that it shows the lossesJactual and estimatedK relating to that year3s sales.Accounts have been written o)to bad debts e'penses as follows: In .22/In .223"==$ accounts P "== P ,==="==% accounts>==$. 0(uipment ac(uired by -I6!0,I6#O! -A&4FA#!4,1&< for P$=,=== on ?une$=, "==" was sold for P"@,=== cash on ?uly , "==%.!he proceeds from the samewere credited to the e(uipment account. !he company depreciates e(uipment at=H a year. 8epreciation is ta.en up at year2 end computed on a monthly basis.8epreciation of P,@== was recorded in "==%.%. On-ay=, "==", -I6!0,I6#O!-A&4FA#!4,1&A9&et income as reported $,"9= $,A9=B@,"9=&o dividends were declared during the years and no ad+ustments were madeto retained earnings.,0N41,0-0&!6:/or.ingpaper to compute for thecorrectedincomefor theyears"==","==$and "==%.Prepare a corrected balance sheet for 8ecember$, "==%.MULTIPLE C)OICE PROBLEMS,. 6ean #ompanyEs beginning inventory at ?anuary , "==% was understated byP%9,9==, and its ending inventory was overstated by PB,===. As a result, 6ean#ompanyEs cost of goods sold for "==% was:a. 4nderstated by P%9,9==b. Overstated by P%9,9==c. 4nderstated by P$@,9==d. Overstated by P$@,9==". On ?anuary , "==", 7reton #ompany purchased for P%"=,=== a machine witha useful life of = years and no salvage value.!he machine was depreciated by thedoubledecliningbalancemethodandthecarryingamount of themachinewasP"@>,>==on8ecember$, "==$. 7reton#ompanychangedtothestraightlinemethodon?anuary=, "==%. /hatwouldbethedepreciatione'penseonthismachine for the year ended 8ecember $, "==%:a. P "@,>>=b. P $$,@==c. P %",===d. P 9$,A@=$. 7randy #orp. reports on a calendar2year basis. 1ts "==% and "==9 fnancial statements contained the following errors:"==% "==9Over JunderK statement of ending inventory P=,=== P%,===4nderstatement of depreciation %,=== @,===Failure to accrue salaries at year end >,=== ",===As a result of the above errors, "==9 income would be:11a. overstated by P%,===b. overstated by P"%,===c. overstated by P"",===d. overstated by P@,===%. On ?anuary =, "==, Laden #ompany purchased a patent for P9$9,9==.!hepatent is being amorti5ed over its remaining life of 9 years e'piring ?anuary =,"=@.8uring "==%, Laden #ompany determined that the economic benefts of thepatentwouldnotlast longerthan=yearsfromthedateof ac(uisition. /hatamount should be reported in the 7alance sheet for the patent, net of accumulatedamorti5ation on 8ecember $, "==%:a. P $",$==b. P $@A,"==c. P $A>,===d. P $B",A==9. 0)ective?anuary", "==9, Cincaid#o. adoptedtheaccountingprincipleofe'pensing advertising and promotion costs as they are incurred. Previously,advertisingandpromotioncosts applicabletofutureperiods wererecordedinprepaid e'penses. Cincaid can +ustify the change, which was made for both fnancialstatementandincometa'reportingpurposes. Cincaid3sprepaidadvertisingandpromotion costs totaled P"9=,=== at 8ecember $, "==%. Assume that the incometa'rateis%=percentfor"==%and"==9. !head+ustmentforthee)ectof thechange in accounting principle should result in a net charge against income in theincome statement for "==9 ofa. P =b. P ==,===c. P 9=,===d. P "9=,===@. On ?anuary =, "==, ,odney #ompany purchased a machine for P$B@,===and depreciated it using the straight line method using an estimated useful life of >yearswithnosalvagevalue. On?anuary, "==%, ,odney#ompanydeterminedthat the machine had a useful life of si' years from the date of ac(uisition and willhaveasalvagevalueof P$@,===. Anaccountingchangewasmadein"==toreOect this additional data.!he accumulated depreciation for this machine shouldhave a balance at 8ecember $, "==% of:a. P "B,===b. P "$,===c. P "%=,===d. P "@%,===A. 7art, 1nc. receives subscription payments for annual Jone yearK subscriptions toitsmaga5ine. Payments are recorded as revenue when received. Amounts received butunearnedat the end of each of the last three years are shown below: "==$"==% "==94nearned revenues P"=,=== P9=,=== PA@,===7art failed to record the unearned revenues in each of the three years. As a result ofthe omission, "==9 income was:a. overstated by P%@,===b. understated by P%@,===c. understated by P"@,===d. overstated by P"@,===>. ,A9=,===.;owmuch should be reported in "==% as warranty e'pense.a. P >A,9==b. P 9%,===12c. P A9,===d. P "%,9==B. Aninsurancepremiumof P$,@==wasprepaidin"==%coveringtheyears"==%, "==9, and"==@. !heentireamount waschargedtoe'pensein"==%. 1naddition, on 8ecember $, "==9, fully depreciated machinery was sold for P@,%==cash, but the sale was not recorded until "==@. !here were no other errors during"==%or"==9, andnocorrectionshavebeenmadeforanyoftheerrors. 1gnoreincometa'considerations. /hat is thetotal e)ect of theerrors on"==9netincome:a. &et income is understated by P",>==b. &et income is overstated by P$,@==c. &et income is understated by P,@==d. &et income is overstated by P",%===. Adger#orporationpurchasedamachineforP9=,===on?anuary, "==%.Adger will depreciate the machine using the straight2line method using a fve2yearperiodwithnoresidual value. Asaresult of anerror initspurchasingrecords,7adgerdidnotrecogni5eanydepreciationforthemachineinits"==%fnancialstatements. Adger discoveredtheproblemduring the preparation of its "==9fnancial statements. /hat amount should Adger record for depreciation e'pense onthis machine for "==9:a. P =b. P $=,===c. P $A,9==d. P @=,===. On ?anuary , "==", ,A9=b. P $@$,A9=c. P $@B,A9=d. P $%9,===$. ?erry #ompany reported a net income of P9"9,=== in "==%.Iour audit disclosed the following:"==% "==9Overstatement of ending inventory ",A9="%,A9=Omission of depreciation ,"9= ,"9=4nderstatement of commission receivable @,9==$,9==Purchase of mdse not recorded but included inthe year end inventory %9,===Ad+usted net income for "==% is:a. P 9"9,===b. P 9=A,A9=c. P 9$,===d. P 99",A9=13%. Centuc.y 0nterprises purchased a machine on ?anuary ", "==%, at a cost ofP"=,===. Anadditional P9=,===wasspentforinstallation, butthisamountwascharged erroneously to repairs e'pense. !he machine has a useful life of fve yearsand a salvage value of P"=,===. As a result of the error,a. ,etained earnings at 8ecember $, "==9 was understated by P$=,===and "==9 income was overstated by P@,===.b. ,etained earnings at 8ecember $, "==9 was understated by P$>,===and "==9 income was overstated by P@,===.c. ,etained earnings at 8ecember $, "==9 was understated by P$=,===and "==9 income was overstated by P=,===.d. "==% income was understated by P9=,===.9. On 8ecember $=, "==%, 6augie #orporation sold merchandise for P9@,"9= to6teve#ompany. !hetermsof thesalewerenet$=days, 8O76hippingpoint. !hemerchandise was shipped on 8ecember $, "==% and arrived at 6teve #ompany onQ?anuary =9, "==9. 8ue to clericalerror,the sale was not recorded until?anuary"==9 and the merchandise, s.id at a "9H mar.up on cost was included in 6augieEsinventory at 8ecember $, "==%. As a result, 6augieEs cost of goods sold for theyear ended 8ecember $, "==% was:4nderstated by P9@,"9=4nderstated by P%9,===4nderstated by P,"9=#orrectly stated1tems @ and A are based on the following information:Iou were engaged as an independent auditorof !homas #orporation .1n thecourse of your e'amination of the accounts on 8ecember $, "==%, the end of theaccounting period, you determined that certain prepaid and accrued items were notrecorded in prior years and in the current year as follows:"==" "==$ "==%Accrued e'penses %,9== A,9== @,9==Prepaid e'penses 9,=== ",=== >,===Prepaid revenues ,"== ",A9=,evenues receivable $,=== ",9==,etainedearnings at theendof "=="amountedtoP%%9,===whilenetincome for "==$ was reported at P"@,===.!he income summary account for "==%shows a credit balance of P9=,=== before any audit ad+ustments.Iou have verifedthat no dividends were declared in the two year period.@. #omputeforthecorrected,etainedearningsbalanceasof 8ecember$,"==".a. P %%%,$==b. P %9=,===c. P 9A>,9==d. P %%9,===A. !he corrected net income for the years ended 8ecember $, "==$ and "==%are:"==$ "==%a. P"@,=== P9=,===b. P$%,"== P%$,A9=c. P%@,A== P@>,===d. P"","== P99,A9=>. On ?anuary , "==", #arnival 6hipping bought a machine for P,9==,===. At that time, this machine had an estimated useful life of si' years, with no salvage value. As a result of additional information, #arnival determined on ?anuary , "==9,that the machine had an estimated useful life of eight years from the date it was ac(uired, with no salvage value. Accordingly, the appropriate accounting change was made in "==9. ;ow much depreciation e'pense for this machine should #arnival record for the year ended 8ecember $, "==9 assuming #arnival uses the straight2line method of depreciation:14a. P "9,===b. P 9=,===c. P >A,9==d. P "9=,===B. #ombs, 1nc. isacalendar2year corporationwhosefnancial statementsfor"==% and "==9 included errors as follows:0nding 1nventory 8epreciation 0'pense"==% P$=,=== overstated P"9,=== overstated"==9 P=,=== understated P>,=== understatedAssume that purchases were recorded correctly and that no correcting entries weremade at 8ecember $, "==%, or 8ecember $, "==9. 1gnoring income ta'es, by howmuchshould#oombs3 retainedearningsberetroactivelyad+ustedat ?anuary,"==@:a. P "A,=== increaseb. P "A,=== decreasec. P A,=== decreased. P $,=== decrease"=. Coppell #o. made the following errors in counting its year2end physical inventories:"==$ P @=,=== overstatement"==%=>,=== understatement"==9 B=,=== overstatementAs a result of the above undetected errors, "==9 income wasa. 4nderstated by P>,===b. Overstated by PB>,===c. Overstated by P>,===d. 4nderstated by PB>,===". Coppell #o. made the following errors in counting its year2end physical inventories:"==$ P @=,=== overstatement"==% =>,=== understatement"==9 B=,=== overstatement!he entry to correct the accounts at the end of "==9 isa. ,etained earnings %>,===#ost of sales %",===1nventory B=,===b. ,etained earnings >,===#ost of sales A",===1nventory B=,===c. 1nventory B=,===#ost of sales >,===,etained earnings A",===d. #ost of sales B>,===,etained earnings =>,===1nventory B=,==="". 1nthecourseofyoure'aminationofthefnancial statementsof#orrea#orp., anewclient, fortheyearended8ecember$, "==%, youdiscoveredthefollowing:a. 1nventory at ?anuary =, "==% had been overstatedby P$$,A9=.b. 1nventory at 8ecember $, "==% was understated by P9@,"9=.c. Aninsurancepolicy covering three years had beenpurchased on?anuary =, "==$ for P"",9==.!he whole amount was charged to e'pense in "==$.d. 8uring"==%,thecompanyreceivedaP9,===cashadvancefromacustomer for goods to be manufactured and shipped during "==9.!heamount received was credited to sales.11ncome reported for "==% before reOecting any ad+ustment for the above information is P>A,9==.!he correct income for "==% is:a. P "99,===b. P "","9=c. P @9,===d. P 9=,==="$. !om #ompanyEs beginning inventory at ?anuary =, "==% was understated byP%9,9==anditsendinginventorywasoverstatedbyPB,===. Asaresult, !om#ompanyEs cost of goods sold for "==% was:a. 4nderstated by P%9,9==b. Overstated by P%9,9==c. 4nderstated by P$@,9==d. Overstated by P$@,9=="%. !henet incomefor "==%reportedbytheaccountant of Abbas#ompanyamountedtoP@$%,9==. Iouraudit of theaccountsdisclosedthatthefollowingaccounts were not recorded:"==$ "==%,ent received in advance "",9== $=,===Accrued salaries $,9== >,===Prepaid interest $$,A9= %9,===#ommission receivable 9,A9= %,@"98epreciation e'pense "@,"9="@,"9=0(uipment purchased at year end chargedto e'pense J= year lifeK A9,===#ompute the correct income for the year ended 8ecember $, "==%.a. P 9B>,>A9b. P @$,>A9c. P @99,"9d. P @>,$A9"9. !he frst e'amination of !amerEs fnancial statements was made for the yearended8ecember $, "==%. !heauditor hasfoundthat !amer hadpurchasedanother company in ?anuary "==" and recorded goodwill of PA9,=== in connectionwith this purchase.1t was determined that the goodwill had an estimated useful lifeof only fve years because of obsolescence. &o amorti5ation of goodwill had everbeen recorded.For the 8ecember $, "==% fnancial statements, !amer should debitamorti5ation e'pense of:Amorti5ation e'penses ,etained earningsa. P = PA9,===b. P9,=== P$=,===c. P"9,=== P =d. P%9,=== P =END1!