Achievable ACCA Financial Accounting

6. Preparing trial balance

Our ACCA course is currently in development and is a work-in-progress.

Errors and the financial statement

5 min read

Font

Discuss

Feedback

Learning objectives

By the end of this chapter, you should be able to:

Calculate the impact of errors on the statement of profit or loss and other comprehensive income and the statement of financial position.

Impact of errors on the financial statement

If errors aren’t detected before the financial statements are prepared (mainly the statement of profit or loss and the statement of financial position), their effects will be carried into those statements. That’s why preparing a trial balance and carrying out error checks before finalising the accounts matters: it gives you a chance to find and correct mistakes before they distort the entity’s reported performance and position.

When you discover an error, you need to assess its impact on:

the statement of profit or loss and other comprehensive income, and
the statement of financial position,

and then make the adjustments needed to ensure the financial statements reflect a true and fair view.

Not all errors affect profit. Some errors (for example, errors of commission or compensating errors) may leave the trial balance in agreement but still cause misstatements in the financial statements. A balanced trial balance is therefore necessary, but not sufficient, for error-free accounts.

Errors and the statement of profit or loss

In general, any error that affects income or expense general ledger accounts will impact the statement of profit or loss.

Profit decreases when there is an overstatement of expenses or an understatement of income.
Profit increases when there is an understatement of expenses or an overstatement of income.

A useful way to think about this is to focus on what the error has done to profit:

If an expense has been recorded too high (debited more than it should), profit is reduced.
If income hasn’t been fully recorded (the credit side is understated), profit is also reduced.

The reverse applies when expenses are understated or income is overstated. Errors and the statement of financial position

Generally, any error that affects asset, liability, and equity general ledger accounts will impact the statement of financial position.

Errors in income and expense accounts also affect the statement of financial position indirectly through retained earnings, because retained earnings reflect cumulative profits or losses. For example, if revenue is understated by $4,000, profit is also understated by $4,000. Retained earnings (part of equity on the statement of financial position) will also be understated by $4,000. So a single error in an income or expense account can distort both financial statements.

Let’s work through some examples. Illustration: Impact of errors on the profit or loss statement

The following errors were discovered in the books of Akosua Ltd after the trial balance failed to agree. Required: For each error, determine its impact on the statement of profit or loss, clearly stating whether profit will be overstated, understated, or unaffected. Show the journal entry to correct the error.

A credit sale of $4,000 to Kofi was completely omitted from the books.

Do you know the answer?

(spoiler)

Effect on Statement of Profit or Loss: Omitting the sale reduces revenue and thus reduces profit by the full amount of the omitted sale in this simplified treatment. Sales (revenue) is understated by $4,000; thus, profit will be understated by $4,000.

Correcting journal:

Dr. Receivables 4,000

Cr. Sales 4,000

Wages of $1,200 were debited to the Motor Vehicles account.

Do you know the answer?

(spoiler)

Effect on Statement of Profit or Loss: Wages expense is understated by $1,200 (because it was posted to an asset). Profit will be overstated by $1,200. An expense omitted from P&L increases reported profit; correcting it increases the expense and reduces profit.

Correcting journal:

Dr. Wages Expense 1,200

Cr. Motor Vehicles 1,200

Rent income of $800 received in cash was entered only in the Cash Book.

Do you know the answer?

(spoiler)

Effect on Statement of Profit or Loss: Rent income (revenue) is understated by $800; thus, profit will be understated by $800. Revenue omitted reduces profit by the same amount.

Correcting journal:

Dr: Suspense 800

Cr: Rent Income 800

A purchase of goods worth $2,500 was recorded as $5,200 in the Purchases Account.

Do you know the answer?

(spoiler)

Effect on Statement of Profit or Loss: Purchases (an expense/part of COGS) are overstated by $2,700; thus, profit will be understated by $2,700.

Correcting journal:

Dr. Purchases 2,700

Cr. Suspense 2,700

Requirement 2: Assuming profit reported during the period was $22,000, what would have been the effect of these errors on the profit? Let’s prepare a statement adjusting the profit (for the year) to find the corrected profit after correcting all the errors.

Try preparing it yourself before you compare.

(spoiler)

Statement of adjusted profit or loss
		$
Profit before error		22,000
Add: Errors that decreased the profit:
Sales	4,000
Rent Income	800
Purchases	2,700	7,500
Less: Errors that increase the profit:
Wages	(1,200)	(1,200)
Adjusted profit		28,300

Note: The statement of adjusted profit is a useful working document that summarises the net effect of all identified errors on the reported profit figure. In this case, the errors had a net effect of increasing the adjusted profit from $22,000 to $28,300 - an increase of $6,300. This is because the errors that understated profit ($7,500 in total) outweighed the error that overstated profit ($1,200), resulting in a net understatement of $6,300 in the originally reported figure.

Uncorrected errors flow into financial statements, affecting both profit or loss and financial position statements.
Profit decreases when expenses are overstated or income is understated in error.
Profit increases when expenses are understated or income is overstated in error.
Income and expense errors indirectly affect the statement of financial position through retained earnings.
To adjust reported profit: add errors that decreased profit, subtract errors that increased profit.
A balanced trial balance does not guarantee error-free accounts - some errors leave the trial balance in agreement while still distorting the financial statements.
Every error corrected in the profit or loss account has a corresponding effect on equity in the statement of financial position through retained earnings.

Next | 7.1.1 The formats

Errors and the financial statement

Learning objectives

By the end of this chapter, you should be able to:

Calculate the impact of errors on the statement of profit or loss and other comprehensive income and the statement of financial position.

Impact of errors on the financial statement

When you discover an error, you need to assess its impact on:

the statement of profit or loss and other comprehensive income, and
the statement of financial position,

and then make the adjustments needed to ensure the financial statements reflect a true and fair view.

Errors and the statement of profit or loss

In general, any error that affects income or expense general ledger accounts will impact the statement of profit or loss.

Profit decreases when there is an overstatement of expenses or an understatement of income.
Profit increases when there is an understatement of expenses or an overstatement of income.

A useful way to think about this is to focus on what the error has done to profit:

If an expense has been recorded too high (debited more than it should), profit is reduced.
If income hasn’t been fully recorded (the credit side is understated), profit is also reduced.

The reverse applies when expenses are understated or income is overstated. Errors and the statement of financial position

Generally, any error that affects asset, liability, and equity general ledger accounts will impact the statement of financial position.

Let’s work through some examples. Illustration: Impact of errors on the profit or loss statement

A credit sale of $4,000 to Kofi was completely omitted from the books.

Do you know the answer?

(spoiler)

Correcting journal:

Dr. Receivables 4,000

Cr. Sales 4,000

Wages of $1,200 were debited to the Motor Vehicles account.

Do you know the answer?

(spoiler)

Correcting journal:

Dr. Wages Expense 1,200

Cr. Motor Vehicles 1,200

Rent income of $800 received in cash was entered only in the Cash Book.

Do you know the answer?

(spoiler)

Effect on Statement of Profit or Loss: Rent income (revenue) is understated by $800; thus, profit will be understated by $800. Revenue omitted reduces profit by the same amount.

Correcting journal:

Dr: Suspense 800

Cr: Rent Income 800

A purchase of goods worth $2,500 was recorded as $5,200 in the Purchases Account.

Do you know the answer?

(spoiler)

Effect on Statement of Profit or Loss: Purchases (an expense/part of COGS) are overstated by $2,700; thus, profit will be understated by $2,700.

Correcting journal:

Dr. Purchases 2,700

Cr. Suspense 2,700

Try preparing it yourself before you compare.

(spoiler)

Statement of adjusted profit or loss
		$
Profit before error		22,000
Add: Errors that decreased the profit:
Sales	4,000
Rent Income	800
Purchases	2,700	7,500
Less: Errors that increase the profit:
Wages	(1,200)	(1,200)
Adjusted profit		28,300

Note: The statement of adjusted profit is a useful working document that summarises the net effect of all identified errors on the reported profit figure. In this case, the errors had a net effect of increasing the adjusted profit from $22,000 to $28,300 - an increase of $6,300. This is because the errors that understated profit ($7,500 in total) outweighed the error that overstated profit ($1,200), resulting in a net understatement of $6,300 in the originally reported figure.

Key points

Uncorrected errors flow into financial statements, affecting both profit or loss and financial position statements.
Profit decreases when expenses are overstated or income is understated in error.
Profit increases when expenses are understated or income is overstated in error.
Income and expense errors indirectly affect the statement of financial position through retained earnings.
To adjust reported profit: add errors that decreased profit, subtract errors that increased profit.
A balanced trial balance does not guarantee error-free accounts - some errors leave the trial balance in agreement while still distorting the financial statements.
Every error corrected in the profit or loss account has a corresponding effect on equity in the statement of financial position through retained earnings.

Learning objectives

By the end of this chapter, you should be able to:

Calculate the impact of errors on the statement of profit or loss and other comprehensive income and the statement of financial position.

Impact of errors on the financial statement

When you discover an error, you need to assess its impact on:

the statement of profit or loss and other comprehensive income, and
the statement of financial position,

and then make the adjustments needed to ensure the financial statements reflect a true and fair view.

Errors and the statement of profit or loss

In general, any error that affects income or expense general ledger accounts will impact the statement of profit or loss.

Profit decreases when there is an overstatement of expenses or an understatement of income.
Profit increases when there is an understatement of expenses or an overstatement of income.

A useful way to think about this is to focus on what the error has done to profit:

If an expense has been recorded too high (debited more than it should), profit is reduced.
If income hasn’t been fully recorded (the credit side is understated), profit is also reduced.

The reverse applies when expenses are understated or income is overstated. Errors and the statement of financial position

Generally, any error that affects asset, liability, and equity general ledger accounts will impact the statement of financial position.

Let’s work through some examples. Illustration: Impact of errors on the profit or loss statement

A credit sale of $4,000 to Kofi was completely omitted from the books.

Do you know the answer?

(spoiler)

Correcting journal:

Dr. Receivables 4,000

Cr. Sales 4,000

Wages of $1,200 were debited to the Motor Vehicles account.

Do you know the answer?

(spoiler)

Correcting journal:

Dr. Wages Expense 1,200

Cr. Motor Vehicles 1,200

Rent income of $800 received in cash was entered only in the Cash Book.

Do you know the answer?

(spoiler)

Effect on Statement of Profit or Loss: Rent income (revenue) is understated by $800; thus, profit will be understated by $800. Revenue omitted reduces profit by the same amount.

Correcting journal:

Dr: Suspense 800

Cr: Rent Income 800

A purchase of goods worth $2,500 was recorded as $5,200 in the Purchases Account.

Do you know the answer?

(spoiler)

Effect on Statement of Profit or Loss: Purchases (an expense/part of COGS) are overstated by $2,700; thus, profit will be understated by $2,700.

Correcting journal:

Dr. Purchases 2,700

Cr. Suspense 2,700

Try preparing it yourself before you compare.

(spoiler)

Statement of adjusted profit or loss
		$
Profit before error		22,000
Add: Errors that decreased the profit:
Sales	4,000
Rent Income	800
Purchases	2,700	7,500
Less: Errors that increase the profit:
Wages	(1,200)	(1,200)
Adjusted profit		28,300

Note: The statement of adjusted profit is a useful working document that summarises the net effect of all identified errors on the reported profit figure. In this case, the errors had a net effect of increasing the adjusted profit from $22,000 to $28,300 - an increase of $6,300. This is because the errors that understated profit ($7,500 in total) outweighed the error that overstated profit ($1,200), resulting in a net understatement of $6,300 in the originally reported figure.