How to Correct Accounting Errors
As soon as an error is found, it must be corrected. How you correct the error under GAAP depends on the type of error, the number of financial periods the error affects, how the error affects financial statement presentation, and whether the error is counterbalancing.
To straighten out the messy mistakes and give the users of the financial statements accurate data for ratio analysis, you have to ask yourself these three questions:
What is the type of error? Determine the type of error.
What do you need to do to fix it? Sometimes a simple journal entry is enough. Other times, a direct correction to retained earnings for a prior-period adjustment is on the accounting menu.
Do the financial statements have to be restated? Restatement means previously issued financial statements are revised, to correct the error. If the error is material or prior-period financial statements are shown with the current year, restatement of the financial statements is a must.
How to restate the financial statements
When restating the financial statements, follow these three steps:
Adjust the balances of any assets or liabilities at the beginning of the newest financial period shown in the comparative statements for the cumulative effect of the error.
The other side of the correction goes to retained earnings.
Lastly, you have to correct the error on each of the comparative-year financial statements. Your intermediate accounting textbook may refer to this as period-specific effects.
The notes to the financial statements detail the restatement, giving all necessary info surrounding the event, such as the nature of the error and the effect on net income (both gross and net of income tax).
Walk through error correction
For this example, Robson Corporation discovers the following errors in January 2013 relating to 2012 accounting transactions. The books for the 12 months ending December 31, 2012, are still open. All years prior to January 1, 2012, are closed:
A math mistake was made, and depreciation expense is understated by $35,000.
Robson failed to recognize and accrue salaries payable of $3,000.
The company switches from using the cash method to using the accrual method to book revenue, resulting in understated net sales of $20,000.
Robson further notices that depreciation expense for years prior to January 1, 2012, is understated by an additional $50,000.
The following shows the adjusting journal entries Robson needs to make at December 31, 2012.
Robson Corporation shows two comparative years, 2011 and 2012, on its statement of retained earnings. The following shows how to reflect the adjusting journal entries.
To recap your GAAP guidelines for changes because of errors:
If you to use the restatement approach:
Correct all prior-period financial statements shown on comparative financial statements.
Restate the beginning balance of retained earnings for the first period shown on a comparative statement of retained earnings if the error is prior to the first comparative period.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
