Accounting errors occur when accounting treatment and/or disclosure of a transactions is not in accordance with the general accepted accounting principles applicable to the financial statements. Accounting standards require companies to restate their historical financial statements when a material accounting error is discovered.
Unlike an accounting estimate which is an approximation made due to non-availability of complete information, an accounting error is definite because it arises from misapplication of accounting policies, estimates or omission of transactions.
Under IFRS, IAS 8 prescribes the accounting treatment for errors. It requires companies to changes it financial statements retrospectively i.e. as if no error ever occurred. US GAAP provides similar basic guidance on accounting errors.
Example of accounting errors include:
- Failing to charge depreciation on a fixed asset
- Understating or overstating closing or opening inventories balance
- Recording revenue when payment is received and not when the risks and rewards are transferred
- Charging a capital expenditure in income statement as revenue expenditure and vice versa
The basic mechanism used to restate historical financial statements in order to rectify accounting errors is similar to adjustments required to account for changes in accounting principles. This is because unlike a change in accounting estimate, which requires prospective adjustment, a change in accounting principle and a rectification of accounting error both require retrospective adjustment.
This broadly involves:
- Restating income statements
- Adjustment to opening retained earnings
- Making relevant tax adjustments
- Restating other affected balance sheet accounts (i.e. in addition to tax and retained earnings accounts)
Example: retrospective application
AE, Inc. understated its inventories balance at the end of financial year 2013 (which is 31 December 2013) by $20 million. Please outline the adjustments needed to rectify this error.
Find out balance as at 1 January 2014 (after rectification) of retained earnings, tax payable and inventories if the unadjusted (incorrect) balances are $26 million, $16 million and $54 million respectively.
Tax rate is 20%.
Understatement of inventories in financial year 2013 would result in an overstatement of cost of good sold, understatement of income tax expense and income tax payable and understatement of net income and eventually opening retained earnings.
Rectification will increase inventories balance as at 1 January 2014 by $20 million. This will result in $20 million decrease in cost of goods sold which in turn will result in $20 million increase in earnings before taxes. $4 million (=$20 million * 0.2) of this $20 million will result in increased tax expense and corresponding tax payable balance as at 1 January 2014. The rest i.e. $14 million will result in increase in net income and equivalent increase in retained earnings balance as at 1 January 2014.
Following rectifying journal entry is needed.
|Taxes payable||$4 million|
|Retained earnings||$16 million|
Rectified balances as at 1 January 2014 will be:
|Account||as at 31 Dec 2013||Adjustment||as at 1 Jan 2014|
|Inventories||$26 million||+ $20 million||$46 million|
|Tax payable||$16 million||+ $4 million||$20 million|
|Retained earnings||$54 million||+ $16 million||$70 million|