Chapter 6 Errors and Corrections ACC PDF

# Chapter 6: Errors and Corrections to Accounting Records and Financial Statements ## Introduction ### Learning Outcomes - Prepare a trial balance from accounting records and identify the uses of a trial balance. - Identify omissions and errors in accounting records and financial statements and d...

# Chapter 6: Errors and Corrections to Accounting Records and Financial Statements ## Introduction ### Learning Outcomes - Prepare a trial balance from accounting records and identify the uses of a trial balance. - Identify omissions and errors in accounting records and financial statements and demonstrate how the required adjustments will affect profits or losses. - Correct omissions and errors in accounting records and financial statements. - Prepare journals for nominal ledger entry and correct errors in draft financial statements. ### Syllabus Links The accuracy of financial statements is the bedrock on which the rest of your studies for this exam, and for *Professional Level Financial Accounting and Reporting*, are built ### Examination Context Questions on the topics in this chapter will be set as multiple choice, multi-part multiple choice or multiple-response questions, some of which may involve calculations. Very often double entry questions are phrased in terms of preparing a journal. In the exam you may be required to: * Identify distinctions between different types of error. * Identify a journal to correct errors. * Identify the correct journal to clear a suspense account. * Identify the effects of correcting errors on draft gross or net profit. * Use the techniques of bank reconciliations to identify the correct cash at bank balance in the financial statements. * Use reconciliation techniques to identify the correct payables balances in the financial statements. ## 1. Reconciling to External Documents ### Section Overview In a computerized accounting system, at any point in time the total of the personal accounts of each credit customer in the receivables ledger, and of each credit supplier in the payables ledger, will be equal to the total trade receivables and total trade payables balances respectively. Companies may verify the accuracy of their accounting records using external documents. Reconciliation of the ledger balances to external documents can help identify errors in accounting records. The external documents most commonly used for this purpose are bank statements and supplier statements. ### Definitions **Trade Receivables Account**: In the nominal ledger, the trade receivables account is used to record transactions relating to credit customers in total. **Receivables Ledger**: The receivables ledger is a listing of all transactions with each individual credit customer. The receivables ledger is divided into individual (personal) accounts, one for each credit customer, and shows the total balance due from that customer at any point in time. The receivables ledger is separate to the nominal ledger and does not form part of the double entry system. It is used for record-keeping purposes only and is therefore often referred to as a memorandum ledger. **Trade Payables Account**: In the nominal ledger, the trade payables account is used to record transactions involving credit suppliers in total, and the balance on this account at any time will be the total amount owed by the business to all its credit suppliers. **The Payables Ledger**: The payables ledger is a listing of all transactions with each individual credit supplier. Consistent with the receivables ledger described above, the payables ledger includes a personal account for each credit supplier which shows the total amount owed to that supplier at any point in time. Consistent with the receivables ledger, the payables ledger is separate to the nominal ledger, does not form part of the double-entry system and is maintained for record-keeping purposes only. In a manual system of accounting, the personal accounts in the receivables ledger are updated independently of the trade receivables account in the nominal ledger. This means that differences between the two could arise. Reconciling the trade receivables account to the receivables ledger is therefore an important part of ensuring the accounting records are accurate. The same also applies to the payables ledger and the trade payables account.  In a computerized system, transactions entered into the personal account of a credit customer in the receivables ledger are automatically posted to the trade receivables account in the nominal ledger. Therefore, whilst a reconciliation is still a useful control mechanism, there is unlikely to be differences between the trade receivables account and the receivables ledger. The same also applies to the payables ledger and the trade payables account in a computerized system.  However, it is still useful for a business that uses a computerized accounting system to verify that the records it keeps are complete and accurate by reconciling certain information to external documents. You should be aware of the following reconciliations and how they are used by businesses: - **Bank reconciliations** – as discussed in Chapter 3, electronic banking now means that businesses are able to access their bank information and download transaction reports at any point in time. The terms bank transaction report and bank statement will be used throughout the *Workbook* to refer to the transactions and balances recorded by the bank. The bank statements are used (1) as a source document for entries into the accounting system; and (2) as an external record against which the accounting records of a business can be checked. The lines have blurred between using the bank statement for recording transactions and for checking the accuracy of the accounting records. - **Supplier statement reconciliations** – supplier statements are prepared by credit suppliers and sent to their customers on a regular basis, usually at the end of each month or each quarter, and list all transactions (invoices, returns, discounts and payments) that have occurred since the date of the previous supplier statement. A business receiving a supplier statement will reconcile the transactions and closing balance on the statement to the payables ledger and any omissions or errors identified in the accounting records can then be corrected. ## 2. Bank Reconciliations ### Section Overview The cash at bank account and the bank statement both reflect transactions through the business’s bank account. The cash at bank account needs to be regularly reconciled to the bank statement to identify any differences. Information relating to deposits and withdrawals shown on the bank transaction report will be matched to transactions undertaken by the business and recorded in the cash at bank account. ### 2.1 Cash at Bank Account and the Bank Statement The cash at bank account is one of a business’s nominal ledger accounts. The balance on the cash at bank account will be reported as a current asset or, in the case of an overdraft, a current liability in the statement of financial position. ### Definition: **Bank statement:** A record of transactions on the business’s bank account maintained by the bank in its own accounting records. The bank statement is the mirror image of the business’s cash at bank account. - Cash at bank is an asset (a debit balance) in the business’s ledger accounts. From the perspective of the bank, the amounts deposited by a business represent money that the bank owes to that business. Thus, every item recorded as a debit in the business’s books – a positive bank balance, and any receipts of cash – will be shown as a credit on the bank statement. - When there is a bank overdraft, which is a liability (a credit balance) in the business’s ledger accounts, as for as the bank is concerned it is owed money from the business. Thus, every credit entry in the business’s cash at bank account – a negative bank balance (an overdraft), and any payments of cash – will be shown as a debit on the bank statement. ### 2.2 The Bank Reconciliation ### Definition **Bank reconciliation:** A comparison of a bank statement (usually daily but perhaps weekly or monthly for a smaller business) with the cash at bank account. Differences between the balance on the bank statement and the cash at bank account should be identified and satisfactorily reconciled. The cash at bank account should be updated accordingly, usually by posting a journal entry. The reconciliation of the bank statement to the cash at bank account may identify the following errors and omissions: (a) Errors in recording transactions in the cash at bank account, such as transposition errors (eg, a payment received for CU360 is manually recorded in the cash at bank account as CU630) or payments made by cheque have been omitted from the cash at bank account. Any errors or omissions from the cash at bank account must be corrected using a journal entry.   (b) Corrections and adjustments to the cash at bank account (1) Deposits into or with drawals from the bank account by way of debit card, digital wallet payment, standing order, direct debit or online transfer which have not yet been entered in the cash at bank account. Most of these will be matched automatically by the computerised accounting system, but there may be unusual or unexpected deposits or withdrawals that cannot be matched. (2) Bank interest and bank charges not yet entered in the cash at bank account. (3) Dishonoured cheques not yet entered in the cash at bank account. (c) Errors in the bank statement, such as transposition errors, payments or receipts recorded twice or interest and fees deducted incorrectly. The correct amount appears in the cash at bank account and the balance per the bank statement must be corrected by notifying the bank of theerror. There is no need to record anything in the accounting records in respect of bank errors. (d) Items reconciling the correct cash at bank account balance to the bank statement (timing differences) (1) Payments made by the business which have been credited to the cash at bank account but which have not yet cleared the bank statement. Some electronic payments do not instantly clear the bank statement and there may be some occasions when cheques are paid out by the business and credited in the cash at bank account which do not yet appear on the bank statement. These are known as *uncleared payments* or *unpresented cheques*. (2) Payments received by the business and debited to the cash at bank account, but which have not yet been ‘cleared’ by the bank and so do not yet appear on the bank statement. These are known as *uncleared lodgements*. ## 3. Types of Error in Accounting ### Section Overview Errors can be classified as: *transposition errors*, *errors of omission*, *errors of principle*, *errors of commission* and *compensating errors.*  As accounting software packages become increasingly sophisticated, the risk and occurrence of errors is decreased. It remains important however for an accountant to be able to identify and correct errors in the accounting system. There are five broad types of error as follows: - *Transposition errors* - *Errors of omission* - *Errors of principle* - *Errors of commission* - *Compensating errors* Once an error has been detected, it needs to be put right via a journal entry. ### 3.1 Transposition Errors ### Definition **Transposition errors:** When two digits in an amount are accidentally recorded the wrong way round. - A sale is credited in the sales account and trade receivables as CU6,843, but the amount should have been CU6,483. The debits and credits will still be equal but will be stated at the wrong amount. ### 3.2 Errors of Omission ### Definition **Error of omission:** Failing to record a transaction at all. - A business receives an invoice from a supplier for CU250, and the transaction is omitted from the accounting records. As a result, both total debits and credits will be wrong by CU250. ### 3.3 Errors of Principle ### Definition **Error of principle:** Posting a double entry in the belief that the transaction is being entered in the correct accounts, but subsequently finding out that the accounting entry breaks the ‘rules’ of an accounting principle or concept. A typical example of such an error is to treat revenue expenditure incorrectly as capital expenditure. - Machine repairs costing CU150 (which should be treated as revenue expenditure) are debited to the cost of a non-current asset (capital expenditure). Although total debits still equal total credits, the repairs account is understated by CU150 and the cost of the non-current asset is overstated byCU150. - A business owner takes CU280 cash out of the till for his personal use. The bookkeeper incorrectly debits sales by CU280, when they should have debited drawings. This is an error of principle, so that drawings and sales are both understated by CU280. ### 3.4 Errors of Commission ### Definition **Error of commission:** A mistake is made in recording transactions in the ledger accounts by recording a debit entry or a credit entry in the wrong account. - Telephone expenses of CU540 are debited to the electricity expense account, an error of commission. Although total debits and credits balance, telephone expenses are understated by CU540 and electricity expense is overstated by the same amount. ### 3.5 Compensating Errors ### Definition **Compensating errors:** Errors which are, coincidentally, equal and opposite to one another. - Compensating errors hide trial balance errors. - Administrative expenses of CU2,800 are entered as CU2,200 in the administrative expenses ledger account. At the same time, distribution costs have been entered as CU4,700 but should have been CU4, 100. Administrative expenses are understated by CU600 and distribution costs are overstated by CU600, but the two amounts cancel each other out. ## 4. Correcting Errors ### Section Overview Errors are corrected using a journal entry.  - A suspense account may be used when a bookkeeper does not know where to post one side of an entry or when the computerised accounting system cannot match a transaction on a bank transaction report to the relevant nominal ledger account. - Suspense accounts are always temporary and should never appear in financial statements. - Financial statements should not be prepared until the errors have been corrected and the suspense account has been cleared.  - Some corrections of errors will result in adjustments to a draft profit calculated while there were still errors in the accounts. In a computerised accounting system, the total of the debit entries will always be equal to the total of the credit entries as the system will not allow a one-sided entry or an imbalanced entry to be recorded. That does not mean, however, that the accounting records are complete and free from error. If an error is identified, it must be corrected via a journal entry. ### Context Example: Correcting Errors A bookkeeper accidentally posts an invoice for CU40 to the local property taxes account instead of tothe electricity account. A journal entry is required to correct the misposting error as follows. **DEBIT**: Electricity account CU40 **CREDIT**: Local property taxes account CU40 To correct a misposting of CU40 from the local property taxes account to electricity account One approach to the correction of errors is to: - Identify the original incorrect entry (what did the business do?) - Identify what the entry should have been (what should the business have done?) - Create a correcting journal entry (what does the business need to do now?) ### 4.1 Suspense Accounts ### Definition **Suspense account:** A temporary account used when the computerised accounting system or the bookkeeper is unsure of how to record one side of a transaction. A suspense account is a temporary account which allows a transaction to be recorded in the accounting system, even though the ledger account for one side of the transaction is not yet confirmed. A suspense account can be opened by the computerised accounting system (when it cannot match a transaction detailed on the bank transaction report) or by the bookkeeper (when they are unsure of which ledger account to use). Once the issue has been resolved, ie, the transaction has been matched or the correct account has been identified, the suspense account should be cleared using a journal entry. ### Context Example: Suspense Account Windfall Garments received a bank transfer of CU620. The accounting system has not been able to match the transaction and so the amount has been credited to the suspense account and listed on anexception report. - **DEBIT**: Cash at bank account CU620 - **CREDIT**: Suspense account CU620 After investigation, it is discovered that the amount received is part payment from a credit customer. The suspense account can now be cleared, as follows: - **DEBIT**: Suspense account CU620 - **CREDIT**: Trade receivables CU620 ### 4.2 Suspense Accounts Might Contain Several Items As all unmatched and unidentified transactions in a reporting period are accounted for in a single suspense account, the balance on the suspense account may contain several different items. All of the items should be investigated and correcting entries made. Several journal entries may be required to clear the suspense account. An exam question might give you a suspense account balance, together with information to make corrections which will leave a nil balance on the suspense account and correct balances on the nominal ledger accounts. ### 4.3 Suspense Accounts are Temporary It must be stressed that a suspense account should only be temporary. There should be no suspense account when it comes to preparing the statement of profit or loss and statement of financial position. The suspense account should be cleared and all correcting entries made before the final financial statements are drawn up. ### 4.4 Adjustment of Profits for Errors - Correcting errors can affect either the statement of financial position or the statement of profit or loss, or sometimes both. An error of omission corrected by debiting sales and crediting trade receivables with CU90 meant that sales decreased, so gross profit was reduced by CU90 as a result of the error being corrected.  - If errors are discovered after the final trial balance and draft statement of profit or loss and statementof financial position have been prepared, then corrections will alter those draft financial statements. - You may need to demonstrate how draft financial statements are affected by error corrections by calculating: - how much gross or net profit is increased or reduced as a result of error correction; and - the final gross or net profit after the error correction. ## 5. Adjusting the Initial Trial Balance for Errors ### Section Overview The initial trial balance can be adjusted for errors (and period end adjustments) that come to light after the initial trial balance has been extracted. In Chapter 5, we saw how an initial trial balance is produced at the year-end date and is then adjusted to reflect information that comes to light after the year end. One way to process the adjustments is by creating debit and credit adjustments columns against the initial trial balance. This is a useful approach when recording correcting journals made at the final stages of preparing financial statements, after the initial trial balance has been prepared. ### Context Example: Error Correction and the Trial Balance Handle extracted its initial trial balance, which included a suspense account of CU6,400 CR, as follows: | Ledger Account | Initial Trial Balance | Adjustments | Final Trial Balance | |---|---|---|---| | Debit | Credit | Debit | Credit | Debit | Credit | | CU | CU | CU | CU | CU | CU | | Cash at bank | 5,415 | | | 5,415 | | | Opening capital | | 10,000 | | | 10,000 | | Loan | | 5,000 | | | 5,000 | | Non-current assets | 30,000| | | 30,000 | | | Trade payables | | 18,689 | 5,400 | | 24,089 | | Expenses | 6,781 | | | 6,781 | | | Purchases | 21,569 | | | 21,569 | | | Sales | | 38,974 | | | 38,974 | | Trade receivables | 9,445 | | 1,000 | 8,445 | | | Suspense account | | 6,400 | 6,400 | | | | Drawings | 5,853 | | | 5,853 | | | Net profit | | 79,063 | | | 78,063 | **Handle has now discovered the following matters:** (a) An amount of CU1,000 was credited on the bank statement in the year and automatically entered in the cash at bank account by the computerised accounting system, but it could not match the amount to a known transaction and a credit entry was made to the suspense account. The bookkeeper subsequently discovered that the amount was a part-payment from a credit customer. (b) A non-current asset was purchased on credit just before the year end for CU5,400. This was correctly entered in the non-current asset account but as the bookkeeper was unsure how to categorise the amount payable, the credit entry was posted to the suspense account. **To correct these errors Handle uses the following journals:** 1. - **DEBIT:** Suspense 1,000 - **CREDIT:** Trade receivables 1,000 2. - **DEBIT:** Suspense 5,400 - **CREDIT**: Trade payables 5,400 These journals are entered in the adjustments columns, and then each row is added across to produce Handle's final trial balance. | Ledger Account | Initial Trial Balance | Adjustments | Final Trial Balance | |---|---|---|---| | Debit | Credit | Debit | Credit | Debit | Credit | | CU | CU | CU | CU | CU | CU | | Cash at bank | 5,415 | | | 5,415 | | | Opening capital | | 10,000 | | | 10,000 | | Loan | | 5,000 | | | 5,000 | | Non-current assets | 30,000| | | 30,000 | | | Trade payables | | 18,689 | 5,400 | | 24,089 | | Expenses | 6,781 | | | 6,781 | | | Purchases | 21,569 | | | 21,569 | | | Sales | | 38,974 | | | 38,974 | | Trade receivables | 9,445 | | 1,000 | 8,445 | | | Suspense | | 6,400 | 6,400 | | | | Drawings | 5,853 | | | 5,853 | | | | 79,063 | | | 78,063 | 78,063 | **No balance remains on the suspense account.**