Adjusting for Errors

Learning Outcomes

  • Finding errors and creating adjustments

A pink and blue eraserSometimes things just don’t get recorded correctly. Remember, we have an external expectation of materiality as we saw in the introduction to this section, looking at Ernst & Young, LLP accounting firm’s opinion on the Alphabet, Inc. financial statements. For Alphabet, the numbers on the balance sheet are rounded to the nearest million. A $100,000 error may not be material if it won’t affect the reported numbers. However, there is also a practical aspect to materiality.

The cash account in your company may be off by $100, which may not concern you, except it is possible that someone stole $17,900 and someone else recorded a $13,000 deposit as $31,000 overstatement mistake on a deposit. When we get to the section on accounting for cash, we’ll learn ways to avoid this kind of thing, but for now, let’s just say that if we find an error, or a couple of errors, in our trial balance, we have to do some research, sketch out some T accounts, and make correcting journal entries.

Maybe an asset was recorded as an expense, or someone recorded a journal entry backward. Each of these situations will have to be addressed according to the specific situation. It is good practice to routinely run checks to catch errors and create the necessary journal adjusting entries. Start the process by asking yourself these three questions when dealing with errors: 

  1. What type of error is it?
  2. How should this error be fixed?
  3. How did this error affect the financial statements?

What type of error is it?

Once you have discovered there is an error evaluate what type of accounting error it is. Here are examples of common accounting errors to watch for:

  • Transposition Error. Reversing or transposing digits (e.g. 3874 instead of 3784)
  • Omission Error. A transaction isn’t recorded like a sale or expense is overlooked (example: a cash sale of a TV wasn’t written down in the rush of a black Friday sale).
  • Entry Reversal. An entry is debated instead of credited or vice versa.
  • Subsidiary Entries. A transaction is incorrectly entered, usually not caught until reconciling the bank statement.
  • Rounding Error. When a number is rounded up or down and can have a cascading effect on subsequently
  • Error of Commission. An amount is entered as the correct account and amount, but is actually incorrect. For example, an amount was added instead of subtracted or charged on one invoice when it should have been applied to a different invoice.

How should this error be fixed?

Now that you understand what type of error it is, it’s time to classify it as a deferral (also known as prepayment) or an accrual. Then ask, “Is it part of accrued revenue, accrued expense, deferred (unearned) revenue, or deferred (prepaid) expense?” Once those steps have been discovered, an adjusted journal entry is created to fix it.

In prior readings we’ve gone over the different types and posting adjusting entries, but here is a quick example of an adjusted entry made to the general ledger after a physical count of inventory corrected an inventory discrepancy.

Journal
Date Description Debit Credit
31-Dec Cost of goods sold 600
Inventory 600
Adjustment for inventory shrinkage.

Now, let’s move on to the final step.

How did this error affect the financial statements?

The last step is to understand how an error before it is adjusted, can overstate or understate the Income Statement and Balance Sheet. Errors in the accrued and deferred (unearned or prepaid) revenues and expenses affect the Balance Sheet and Income Statement in the following manner:

Before Adjusting
Adjusting Entry Not Recorded Balance Sheet Income Statement
Assets Liabilities Equity Revenue Expenses Net Income
Accrued Revenues Understated Understated Understated Understated
Accrued Expenses Understated Overstated Understated Overstated
Unearned Revenues Overstated Overstated Understated Understated
Prepaid Expenses Overstated Overstated Understated Overstated

To review the big picture about adjusting entries, watch this video:

You can view the transcript for “Prepayments and Accruals | Adjusting Entries” here (opens in new window).

In this practice section, you’ll have a chance to exercise your investigative and problem-solving skills.

Practice Question