Accounting, Financial, Taxation

We are still in “Accounting Changes” we have talked about: Change in accounting prinsiples, Changes in accounting estimates and reporting entity. In this post we are going talk about journal entry for correction of errors. Some erroneous entries may not need correction journal entries for they have been counterbalanced, but in many case we also find errors that still need correction entries eventhough they were discovered after the closing. Knowing what error needs correction entry and what error doesn’t is critical. So, I am trying to cover those issue through this post.

Mistakes due to errors in arithmetic, poor estimates, or carelessness usually require adjusting, corrective entries. Very often these entries require a debit or credit to the beginning-of-period Retained Earnings. Such entries are called prior period adjustments. (Note: For simplification, we will ignore taxes).

Some errors affect only the balance sheet. For example, a note payable may have been entered as an account payable, or the purchase of a machine was debited to Land instead of to Machine. Such errors require a correcting entry to reclassify these items under their proper account titles. If comparative balance sheets are prepared that include the year in which the error was made, the balance sheet for that year should be restated to reflect the correction.

Example:

In 20X1 a building was purchased for $100,000 and the entry was:

[Debit]. Machine = 100,000
[Credit]. Cash = 100,000

The error was discovered in 20X2. The correction is:

[Debit]. Building = 100,000
[Credit]. Machine = 100,000

As we know: all expense and revenue items flow into Retained Earnings at the end of each period via the closing process. Thus each period begins with a “clean slate” for the expense and revenue accounts.

Accordingly, if an error occurs that affects only income statement accounts, and the error is discovered in the same period, a correction must be made. However, if it is discovered in a future period, no correction is necessary because the original accounts have been closed.

Example:

In 20X1 the payment of a telephone bill was debited to Advertising Expense.

If the error is discovered this year, the correction would be:

[Debit]. Telephone Expense = xx
[Credit]. Advertising Expense = xx

If the error is discovered after this year, no correction would be needed since these accounts have been closed.

Next, Let’s now discuss errors that affect both the balance sheet and the income statement……

Journal Entry For Errors That Effect Both Balance Sheet and Income Statement

These come in two types:

1. Counterbalancing errors are self-correcting over 2 years
2. Non-counterbalancing errors take more than 2 years to self-correct, and sometimes may never self-correct.

Most errors are counterbalancing.

Example:

A company fails to accrue wages on December 31, 20A, but instead records them at the time of payment in January of 20B.

Thus, in 20A the company erred in NOT making the following entry:

[Debit]. Wages Expense = xx
[Credit]. Wages Payable = xx

In 20B the company erred by the following:

[Debit]. Wages Expense = xx
[Credit]. Cash = xx

This is an error because these wages ARE NOT an expense of 20B, they are an expense of 20A. Briefly put, 20B and its income statement DO NOT “deserve” this expense.

Based upon the above analysis, we can conclude as follows:

1. For 20A: (a) “Expenses” were understated, (b) “net income” was thus overstated, (c) “retained earnings” was overstated (because net income flows into retained earnings), and (d) “wages payable” was understated.
2. For 20B: (a) “Expenses” are overstated, (b) “net income” is thus understated, (c) “wages payable” is correct, and (d) “retained earnings” is also correct.

Why is Retained Earnings now correct?

The answer is: Last Year Retained Earnings was overstated because the “net income was overstated. This year net income was understated, causing an understatement in retained earnings. Therefore, the understatement and overstatement offset each other, thus leaving retained earnings correct. This is what we mean by “counter-balancing”.

In light of the above we can now understand what corrective action, if any, need be taken for counterbalancing errors:

1. If the error is discovered in the second period before closing entries have been made, an entry must be made to correct retained earnings. This is because the counterbalancing action (which would self-correct the retained earnings) takes place at closing, and we are still before closing. This correction entry is called a prior period adjustment.
2. If, however, the error is discovered after closing, no corrective entry is needed—retained earnings has self-corrected via the counterbalancing action of closing, the other balance sheet accounts are correct, and the income statement accounts have zero balances due to closing.

Let’s now try with one example………

On December 31, 20A, Company E failed to accrue its telephone expense because it failed to debit Telephone Expense and credit Accounts Payable. In January of 20B, when it received the phone bill, it then made the following entry:

[Debit]. Telephone Expense = 100
[Credit]. Cash = 100

The effect of the error on the 20A statements is as follows:

1. Income statement: Expenses understated, net income overstated.
2. Balance sheet: Liabilities understated, retained earnings overstated (because the net income was overstated).

If the error is discovered in 20B before closing, a correction entry would be made, as follows:

[Debit]. Retained Earnings = 100
[Credit]. Telephone Expense = 100

Notes:

1. Retained Earnings is debited because it was overstated in 20A.
2. Telephone Expense is credited because 20B does not “deserve” the telephone expense belonging to 20A.

If the error is discovered in 20B after closing, no correction entry is needed because the books are now correct.

Retained earnings has been counterbalanced (this year’s overstatement of expense causing an understatement in retained earnings offsets last year’s overstatement), the other balance sheet accounts are correct, and the expense accounts have been closed. The effect on the 20B statements would be the following:

1. Income statement: Expenses overstated, net income understated.
2. Balance sheet: Correct.

For better understanding, let’s take a look at several additional examples involving counterbalancing errors in various cases. (Note: for simplification, we ignore taxes).

Counterbalancing Case-1: (Insurance)

At the beginning of 20A, Company E bought a 2-year insurance policy for $2,000 and debited Insurance Expense and credited Cash for the full $2,000. It should have debited Prepaid Insurance. No adjusting entries were made at the end of 20A to reduce the expense to $1,000 and to recognize the asset prepaid insurance of $1,000.

The effect of this error on the 20A statements would be:

1. Income statement: Expenses overstated, net income understated.
2. Balance sheet: Assets understated, retained earnings understated.

If the error is discovered in 20B before closing, the correction entry is:

[Debit]. Insurance Expense = 1,000
[Credit]. Retained Earnings = 1,000

(Insurance Expense is debited because 20B “deserves” an expense of $1,000.)

If the error is discovered after closing, no correction is needed—retained earnings has been counterbalanced. In this case, the effect on the 20B statements is:

1. Income statement: Expenses understated, net income overstated.
2. Balance sheet: Correct.

Counterbalancing Case-2: (Prepayment/Deposit for Rent)

On the last day of 20A, Company E received a $100,000 prepayment of 20B rent for a building it rented to a tenant.

It debited Cash and credited Rent Revenue for this amount. It should have credited Unearned Rent—a liability. The effect of this error on the 20A statements is:

1. Income statement: Revenue overstated, net income overstated.
2. Balance sheet: Liabilities understated, retained earnings overstated.

If the error is discovered in 20B before closing, the correction is:

[Debit]. Retained Earnings = 100,000
[Credit]. Rent Revenue = 100,000

(Rent Revenue is credited because 20B “deserves” this revenue.)

If the error is discovered after closing, no correction is needed—the error has been counterbalanced. In this case, the effect on the 20B statements is:

1. Income statement: Revenue understated, net income understated.
2. Balance sheet: Correct.

Counterbalancing Case-3: (Interest)

At the end of 20A, Company E failed to accrue interest of $500 on a note receivable via an entry debiting Interest Receivable and crediting Interest Revenue. At the beginning of 20B, when it received the cash, it then debited Cash and credited Interest Revenue. The effect of this error in 20A is:

1. Income statement: Revenue understated, net income understated.
2. Balance sheet: Assets understated, retained earnings understated.

If the error is discovered in 20B before closing, the correction entry is:

[Debit]. Interest Revenue = 500
[Credit]. Retained Earnings = 500
(Note: Interest Revenue is debited because 20B does not “deserve” this interest)

If the error is discovered after closing, no correction is necessary—retained earnings has been counterbalanced, the other balance sheet accounts are correct, and the income statement accounts have all been closed. In this case, the effect on the 20B statements is:

1. Income statement: Revenue overstated, net income overstated.
2. Balance sheet: Correct.

Counterbalancing Case-4: (Inventory)

At the end of 20A, Company E understated its ending inventory by $20,000. This also causes the beginning inventory of 20B to be understated by the same amount. As we know, when the ending inventory is understated, cost of goods sold will be overstated and thus net income will be understated. When the beginning inventory is understated, the opposite effect will occur. Thus the effect of this error on 20A is:

1. Income statement: Ending inventory understated, net income understated.
2. Balance sheet: Assets understated, retained earnings understated.

If the error is discovered in 20B before closing, the correction entry is:

[Debit]. Inventory = 20,000
[Credit]. Retained Earnings = 20,000

If the error is discovered after closing, no correction is needed—the opposite effect that takes place this year (as discussed) counterbalances retained earnings. In this case, the effect on the 20B statements is:

1. Income statement: Beginning inventory understated, net income overstated.
2. Balance sheet: Correct.

Counterbalancing Case-5: (Inventory Purchase)

Near the end of 20A, Company E purchased merchandise FOB destination for the amount of $5,000. The goods did not arrive until 20B and were thus correctly not included in the ending inventory of 20A. However, the company incorrectly recorded the purchase in 20A via the following entry:

[Debit]. Purchases = 5,000
[Credit]. Accounts Payable = 5,000

This is incorrect because the purchase does not belong to 20A; it belongs to 20B. We know that when purchases are overstated, cost of goods sold is also overstated, thus causing net income to be understated (which in turn understates retained earnings).

Accordingly, the effect on the statements for 20A is:

1. Income statement: Purchases overstated, net income understated.
2. Balance sheet: Liabilities overstated, retained earnings understated.

If the error is discovered in 20B before closing, the correction entry is:

[Debit]. Purchases = 5,000
[Credit]. Retained Earnings = 5,000

(Purchases is debited because 20B “deserves” this purchase.)

If the error is discovered after closing, no correction is needed—the error has counterbalanced. In this case, the effect on 20B is:

1. Income statement: Purchases understated, net income overstated.
2. Balance sheet: Correct.

Okay, we have just learnt counterbalancing in various cases.

Let’s now take a look at non-counterbalancing errors. Such errors take longer than two periods to self-correct, and in certain cases, may never self-correct. Thus correction entries are needed in the second period even after closing entries have been made.

Non-counterbalancing case-1: (Capitalization on Repair of Plant Asset)

Company E purchased a machine with an estimated useful life of 5 years on January 1, 20A, for $20,000, thus requiring annual depreciation expense of $4,000. By mistake the entire $20,000 was expensed instead of capitalized, and the entry WAS:

[Debit]. Miscellaneous Expense = 20,000
[Credit]. Cash = 20,000

Accordingly, expenses were overstated by $16,000 (20,000 instead of 4,000). The effect on the 20A statements is:

1. Income statement: Expenses overstated, net income understated.
2. Balance sheet: Assets (machine) understated by $16,000, retained earnings understated by $16,000.

If this error is discovered in 20B before closing, an entry will have to be made to recognize the asset machine, to recognize the related accumulated depreciation, and to correct retained earnings. The entry is:

[Debit]. Machine = 20,000
[Credit]. Accumulated Depreciation = 4,000
[Credit]. Retained Earnings = 16,000

In addition, a second entry must be made to record depreciation expense for 20B, as follows:

[Debit]. Depreciation Expense = 4,000
[Credit]. Accumulated Depreciation = 4,000

If the error is discovered in 20B after closing, a correction entry must still be made because the error has not yet counterbalanced (it will take 4 years for the counterbalancing to occur). The correction entry is:

[Debit]. Machine = 20,000
[Credit]. Accumulated Depreciation = 8,000
[Credit]. Retained Earnings = 12,000

(Note: Accumulated depreciation is now $8,000, representing 2 years of depreciation. Retained earnings needs a correction of only $12,000 because its shortage has been reduced from $20,000 due to 2 years of depreciation on the machine).

Non-counterbalancing Case-2: (Plant Asset Purchase Entered to the wrong account)

Early in 20A, Company E purchased a machine with a 5-year life for $20,000. BY MISTAKE the debit was to Land instead of to Machine, and no depreciation was taken. The effect on the 20A statements is:

1. Income statement: Depreciation expense understated, net income overstated.
2. Balance sheet: Assets overstated, retained earnings overstated.

If the error is discovered in 20B before closing, the following correction entry must be made:

[Debit]. Machine = 20,000
[Debit]. Retained Earnings = 4,000
[Credit]. Accumulated Depreciation = 4,000
[Credit]. Land = 20,000

In addition, an entry must be made for the 20B depreciation:

[Debit]. Depreciation Expense = 4,000
[Credit]. Accumulated Depreciation = 4,000

If the error is discovered after closing, a correction MUST STILL be made—the error has not yet counterbalanced. The correction entry is:

[Debit]. Machine = 20,000
[Debit]. Retained Earnings = 8,000
[Credit]. Land = 20,000
[Credit]. Accumulated Depreciation = 8,000

Since the error was not discovered until after closing and the 20B financial statements have already been issued, they would be incorrect, as follows:

1. Income statement: Expenses (depreciation) understated, net income overstated.
2. Balance sheet: Assets overstated (because no depreciation has been taken), retained earnings overstated.

Mentioned on my previous post (Changes and Correction of Errors Journal Entry), there are three types of accounting changes; change in Accounting principle, estimates and reporting entity. And the ”Change in Accounting Principle” has been posted previously, so now I am coming with: Change in Accounting Estimate and Reporting Entity.

Change In Accounting Estimates

There are a number of situations in accounting that require the use of estimates. Examples include un-collectibility of accounts receivable, liabilities for estimated warranty costs, and the salvage values and lives of plant assets.

If often happens that estimates need to be revised as a result of new information. Such changes in accounting estimates are handled differently from changes in accounting principles. Prior statements are not revised, correction entries are not made, and the cumulative effect of the change is not recorded. Instead, the change affects only the future (and this period if the revision is made before the end of the period). In short, this change is neither retroactive nor current, but “prospective” in nature.

The reason why the accounting profession prescribed this treatment is that such changes occur frequently, and would thus require continual retroactive or catch-up entries. This would make the financial statements difficult to read and interpret.

If a change is made in the estimated useful life or residual value of a plant asset, then for the future, the new depreciation would be calculated based on the following:

No adjustment or correction entries would be made for the depreciation taken so far.

Example:

Royal bali Corp. purchased a machine on January 1, 19X1, for $100,000. At that time it was thought the machine would have a life of 10 years and a residual value of $10,000.

Thus the annual depreciation taken was $9,000 [($100,000? $10,000) / 10].

Early in 19X5 the company realizes that the total life of the machine is only 8 years and the residual value is only $8,000. Since 4 years have already passed (19X1–19X4), there are another 4 years still remaining. The book value at this time is $64,000, as indicated by the following T-accounts:

The annual depreciation for 19X5, 19X6, 19X7, and 19X8 is:

No correction entries are made to correct the depreciation of prior years.

If a change has to be made and it is unclear if it is a change in principle or a change in estimate, it should be considered a change in estimate.

The treatment just discussed for changes in estimates only applies if the original estimate was calculated with proper care. It does not apply if the estimate was determined without proper care or in bad faith. In such cases, the change is considered to be a correction of an error, which requires different treatment. Correction of errors is discussed later in this post.

Changes In Reporting Entity

Some accounting changes result in financial statements that are the statements of a new or different entity. Examples include presenting consolidated statements instead of statements for each individual company, changing the specific subsidiaries that make up a consolidated group, and accounting for a pooling of interests.

The financial statements in the year of the change should describe the nature of the change and the reason for the change, and the statements for all prior periods presented should be restated to reflect this new entity.

The effect of the change on net income and earnings per share should be disclosed for all periods presented.

Up-coming post: Journal Entry for Correction of Errors and counterbalancing

Companies often make changes in their use of accounting principles or accounting estimates. For example: they may decide to change from one method of depreciating their plant and equipment to another. Or they may decide that an original estimate of the life of equipment was incorrect and should be revised. Such changes are referred to in accounting literature as “accounting changes”.

Occasionally, a company discovers that errors were made in a previous accounting period and it now wishes to correct them. These are referred to as “error corrections”. Both accounting changes and error corrections are discussed in this post.

There are three types of accounting changes:

1. Changes in accounting principle
2. Changes in accounting estimates
3. Changes in reporting entity

A change in accounting principle involves changing from one generally accepted accounting principle to another. For example: A change in most inventory costing methods.

If the accounting principle previously followed was not acceptable OR was incorrectly applied, it is not considered a change in principle but rather a “correction of an error“.

A change in accounting estimate arises as a result of new information obtained regarding certain estimations.

For example: A change in the estimated useful life or residual value of a fixed asset would fall under this category.

If the original estimate was made either in bad faith or with poor judgment, the change is not considered to be a change in estimate BUT rather a “correction of an error“.

A change in reporting entity involves organizations whose identity has evolved from one form to another,  example: preparation of consolidated statements instead of individual statements for a parent and its subsidiary.

Error corrections involve the discovery of errors that took place in prior periods, examples: omissions, mathematical mistakes, double counting and improper application of accounting rules and principles.

Now let’s start it with……

Change In Accounting Principle

As stated previously, these changes involve a change from one generally accepted accounting method to another.

Examples:

1. A change in inventory methods (except to LIFO)
2. A change in construction methods
3. A change from the cost method to the equity method or vice versa

There are two approaches for handling these changes:

1. The retrospective approach
2. The prospective approach

The retrospective approach, which corrects and revises the past, requires the following:

1. A journal entry to correct and revise previous years. If the correction involves revenue or expense it is referred to as a “prior period adjustment.” This adjustment would be shown on the current year’s Retained Earnings Statement as a correction of the January 1 balance:
2. A revision of prior year financial statements that are presented alongside the current year’s statements.
3. A footnote in the year of the change describing and justifying the change, and showing its effects.

The prospective approach does not correct or revise the past, it merely applies the new principle to the correct and future periods. Thus no journal entries or revision of prior financial statements are necessary.

Most changes in accounting principles use the retrospective approach. However, there are three exceptions:

1. A change in depreciation methods (since these changes are often rooted in a change in the asset’s estimated future cash flows, they are treated as a change in accounting estimate, which as we will discuss later on, uses the prospective approach).
2. A change for which an authoritative pronouncement requires the prospective approach.
3. A change where the retrospective approach would be impractical, Example: a change to the LIFO method of inventory.

Let’s now take a look at a situation involving the retroactive approach……

Example:

During 19X1 and 19X2, the Royal Bali Corp. used the completed-contract method of accounting for construction contracts. At the beginning of 19X3, it decides to change to the percentage-of-completion method, for both tax and book purposes. The tax rate for all years is 40%, and there are 1,000 shares of common stock outstanding. The following table presents the relevant information for the years 19X1, 19X2, and 19X3:

The entry in 19X3 to record this change is:

[Debit]. Construction in Process = 130,000
[Credit]. Taxes Payable = 52,000
[Credit]. Retained Earnings = 78,000

Retained earnings is increased by $78,000 because the net income after taxes for 19X1 and 19X2 has risen by this amount, and net income increases retained earnings.

The 19X3 comparative income statement would show the following (assuming 19X3 income before tax of $170,000):

The above figures are based upon the new, retroactive, percentage-of-completion figures.

Let’s assume the beginning retained earnings balances for 19X3 and 19X2 were $800,000 and $680,000, respectively, and that no dividends were declared during these years. The comparative retained earnings statements for these years would appear as follows:

Another Example:

Royal Bali Corp. purchases a machine on January 1, 2005 for $11,000. This machine has an estimated life of 10 years and an estimated salvage of $1,000. During 2005 and 2006 Royal Bali Corp. used the sum-of-the years’ digits method of depreciation, resulting in the following t-account balances:

At the beginning of 2007 Royal Bali decides to change to the straight-line method, without changing the estimated life or salvage value.

Royal Bali would make no journal entry to revise the past, nor would it revise its comparative financial statements. The only thing Royal Bali would do is change its depreciation calculation prospectively (for 2007 and onward), as follows:

Up-coming post: Change In Accounting Estimates & Reporting Entity. There are a number of situations that require the use of estimates, such as un-collectability of account receivable, liabilities for estimated warranty costs, and salvage values and lives of plant assets.