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.
- Identify which errors cause the trial balance to disagree.
- Prepare journal entries to correct errors, including suspense account entries.
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.
Two separate questions apply to every error: does it make the trial balance disagree, and does it change profit? Errors of omission, commission, principle, and compensating errors (as introduced in the earlier chapter on correcting errors) leave the trial balance in agreement but can still misstate the financial statements. A balanced trial balance is therefore necessary, but not sufficient, for error-free accounts.
Let’s work through some examples.
Illustration: Impact of errors on the statement of profit or loss
The following errors were discovered in the books of Akosua Ltd. Only errors 3 and 4 caused the trial balance to disagree, leaving a suspense balance: in error 3 only the cash side was recorded, and in error 4 the Purchases account was debited with $5,200 while the credit entry was correctly recorded at $2,500. Errors 1, 2 and 5 left the trial balance in agreement (error 1 because nothing was recorded at all, errors 2 and 5 because each debit has its matching credit), even though the figures are wrong. Required: For each error, determine its impact on the statement of profit or loss and the statement of financial position, 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?
Effect on statement of profit or loss: Omitting the sale means sales (revenue) is understated by $4,000; profit will be understated by $4,000.
Effect on statement of financial position: Receivables are understated by $4,000, and retained earnings are understated by $4,000, since the missing profit flows into retained earnings.
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?
Effect on statement of profit or loss: Wages expense is understated by $1,200 because it was posted to an asset account instead of an expense account; profit will be overstated by $1,200.
Effect on statement of financial position: Motor vehicles (non-current assets) are overstated by $1,200, and retained earnings are overstated by $1,200.
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?
Effect on statement of profit or loss: Rent income (revenue) is understated by $800; profit will be understated by $800.
Effect on statement of financial position: Retained earnings are understated by $800, and this entry clears the $800 suspense balance created when only the cash side of the transaction was recorded.
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 (the credit entry was correctly recorded at $2,500).
Do you know the answer?
Effect on statement of profit or loss: Purchases (an expense/part of cost of sales) are overstated by $2,700; profit will be understated by $2,700.
Effect on statement of financial position: Retained earnings are understated by $2,700, and this entry clears the $2,700 suspense balance.
Correcting journal:
Dr. Suspense 2,700
Cr. Purchases 2,700
- Cash of $1,500 received from a customer was credited to the Payables account instead of the Receivables account.
Do you know the answer?
Effect on statement of profit or loss: None. No income or expense account was touched, so profit is unaffected.
Effect on statement of financial position: Receivables are overstated by $1,500, because the customer’s payment was never deducted from them, and payables are overstated by $1,500, because the receipt was credited there instead.
Correcting journal:
Dr. Payables 1,500
Cr. Receivables 1,500
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.
| Statement of adjusted profit or loss | ||
|---|---|---|
| $ | ||
| Profit as originally reported | 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 summarises the net effect of all identified errors on reported profit - here, the errors that understated profit ($7,500) outweighed the error that overstated profit ($1,200), so profit increases by a net $6,300, from $22,000 to $28,300. Error 5 doesn’t appear in the statement because it doesn’t affect profit.