 Hello and welcome to this session. This is Professor Farhad in which we would look at accounting error analysis, examining whether the accounting error is counterbalancing or non-counterbalancing. So what did we learn in the prior session about accounting errors? We learned that accounting errors are treated as prior period adjustment and we report them in the current year as an adjustment to beginning retained earning. And this is what we did in the prior session. And remember, if we are showing comparative financial statement, we have to restate, we have to go back and correct the error in that particular year. So comparative financial statement, for example, x5 and x4 are comparable. We have to go back and fix them if we are showing comparative financial statement. Otherwise, we will compute the error and we dump it into beginning retained earning as we see here. Now, if we figure out that there is an error in the current year that's easy, we just simply fix the current year error we make an adjustment. Now, what do we mean by counterbalancing errors? Well, counterbalancing errors are error that correct themselves over two periods. So you made an error in one period, you don't do anything. The error itself will correct itself in period two. Therefore, you don't have to do anything in period two, as long as you did not make any additional errors for that particular year. And we're going to look at a few examples that illustrate the point. But the classic case that we already learned about is inventory. Think about inventory. If one particular year we overstated ending inventory by let's say $5,000. This is in year one. So if we overstated ending inventory by $5,000, what's that going to do to year one? It's going to reduce cost of goods sold because they are inversely related by $5,000. That's fine. Now we made an error in year one. When we go to year two, this ending inventory, the ending inventory, it's going to go to beginning inventory and beginning inventory will be overstated by $5,000. For year two, because beginning inventory is overstated, your cost of goods sold, your cost of goods sold will also be overstated by $5,000. So notice cost of goods sold over two year period, they cancel each other out and basically the error is canceled out. And this is what we mean by counterbalancing error. Now if the books are already closed and the error is already counterbalanced, so you don't have to make any necessary entry. So remember, we talked about year one, year two for this error. So let's assume in year one we made the error for ending inventory, it becomes beginning inventory. Let's assume in year three we figure out that there's an error. We don't have to do anything anymore. Why? Because it's already been counterbalanced. If the error is not counterbalanced yet, then we make the entry, then you can make the entry. That's fine. Now remember, for comparative purposes you always have to restate. I know I repeat myself because it's important to keep reminding you for comparative, you restate. You cannot show two years and in one year there are errors and you know there are errors. You just have to fix the error in that particular year so all years are comparatively correct. If the books are not closed, if the error is already counterbalanced, no entry is necessary. If it fixed itself, and I'm going to show you a few examples, what does it mean it fixed itself. You don't have to do anything. If the error is not yet counterbalanced, you make the necessary journal entry to adjust the present balance of retained earning. You'll fix into retained earning. So those are counterbalancing errors and we're going to look at a few of them. Non-counterbalancing errors, guess what? You already kind of know the definition of it. It doesn't fix itself. So if it doesn't fix itself, what do you have to do? You have to fix it. It doesn't offset in the next accounting period. You must make correcting entries. And we're going to look at a few examples that illustrate those concepts. Now before we look at these examples, most likely you are watching because you are either a student or a CPA candidate. And either or welcome. I'm glad you are here. I'm glad you found me. I'm glad you're watching. Go a step further, farhatlectures.com and subscribe to Farhat Lectures where you have additional resources, lectures, multiple choice, true false. That's going to help you in your accounting courses as well as your CPA exam. I don't replace your CPA review course. I'm going to be a useful addition to your CPA review course. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. Like this recording. If you're watching, it's helping you. Like it. It doesn't cost you anything. Share it with other. Connect with me on Instagram, Facebook, Twitter, and Reddit. So let's take a look at a few examples that illustrate those counterbalancing and non-counterbalancing errors. We have a partial trial balance and let's start with supplies. Supplies on hand on December 31st, total a thousand. So we did a physical count and we say we have a thousand. We look at the trial balance and it shows 2,900. Well, we have a problem. Why? Not a problem. Well, we have to fix something. You want to call this adjusting entries. You want to call this an error. It doesn't matter. It's the same. So supply shows 2,900. In reality, we should have a thousand. So we need to reduce our supplies account. So when we reduce our supplies account, it means we consume the supplies. It has to be consumed into supplies expense. So we need to reduce our supplies 1,900 and remove it from supplies. Now supplies is 1,900 and it's the correct amount. This is assuming we find out about this error before the books are closed. If the books are closed and the entry did not and the error did not counterbalance yet, now we need to prepare a journal entry to fix the error. What happened is this? If we did not. So this is what we are looking for. If we did not book this entry, if we did not fix this error and now it's year 2, year X2, what do we have to do? We have to fix it into retained earnings. For one thing, we have to reduce supplies. So if we reduce supplies, we have to still credit supplies 1,900. Now we're not going to debit supplies expense because we cannot fix supplies expense. Supplies expense was closed because now we are looking at X2, year 2. So what do we do? We debit retained earnings. By debiting retained earnings, we achieve the same thing that we wanted to achieve, record an expense. So those two are the same, except when you're in year 2, when you are in year 2, this is X1, this is X2 entry. In year X2, you can no longer fix that supplies in the prior year. So what you do is you fix the retained earnings. And by fixing the retained earnings, basically you reduce retained earnings by 1,900. It's the same as if you book the expense in year 1 by 1,900 because by increasing the expense, you reduce retained earnings. But you can no longer increase the expense. So you would reduce retained earnings. So I'm just taking a few minutes here to kind of explain why we deal with retained earnings because you're going to see this is the account that we change in year 2 when the books are already closed so we can go back and fix the expenses or the revenues. So you're going to see this repeatedly as I'm going over these examples. Now is this a counterbalancing error? Let's assume we did not even figured out that we made an error. Would this error fix itself? And the answer is yes. Think about it. In X1, we had 2,900 of supplies. That's fine. It should have been 1,000. We missed it. We did not discover the error in the current year. And during year 2, we did not discover it as well even after the books were closed. What do you think is going to happen to those 2,900 of supplies in year 2? Most likely in year 2, those will be expense. So the assumption is what assumption am I making? The assumption is at some point in year 2, eventually we're going to go back and at some point and count the supplies and we're going to see that we no longer have the supplies. So we're going to expense them. So if we did not discover it, supplies would reverse itself assuming that we also did not count the supplies in year 2. But assuming we count the supplies in year 2 and we expense it, basically it's counterbalancing. The expense will be recorded in year 2. It will be recorded in the wrong period. Nevertheless, the supplies expense will be fixed. It will be fixed. But the expense will be in the wrong period. But the effect to retained earning is the same. So it's a counterbalancing error. And I hope you can see this. Because if you did not fix it, we hope that someone counted supplies in year 2 and basically expense the necessary, the proper amount. And by doing so, fixed year 1 as well. Let's take a look at this example. Accrued salaries and wages should be 3,500. If we look at accrued salaries and wages, they are 1,500. And let's assume we discovered the error before the books are closed. Well, what does that mean? It means we need to add 2,000 to our accrued salaries and wages. Well, when we accrued salaries and wages, we're going to debit an expense for that amount and credit accrued salaries and wages. Therefore, we fix this problem. If the books were already closed and we discovered the error, we can no longer fix the expense. What we do is we debit retained earning using the same logic, the same concept that I talked about in the prior session, because you cannot, you can no longer book salaries and wages expense by reducing retained earnings. After the books are closed, you fix the error. Now, let's assume you did not discover the error even in year X2. Would the error fix itself? And the answer is yes. Think about it. If you owe your employees an additional $2,000 and you did not record the expense in the proper period, which it should have been in year one, but you pay them in year two, when you pay them in year two, you are going to expense it. Therefore, it's this is a counterbalancing error. So if you did not discover it and you paid the employee by the end of the year, you would have an additional 2,000 of expenses thus fixing the error, fixing retained earnings, because by including an additional 2,000, you technically reduce your retained earning. However, the 2,000 of expense was recorded in year two. So if you want to show comparative financial statements, you have to go back and put the 2,000 in year one. If you want to show comparative financial statements, let's take a look at this example. A crude interest on investment amounts to 5,000. If we look at our trial balance, interest receivable is 4,000. Well, we have to add 1,000 here. Well, what do we do? We debit interest receivable for 1,000, credit interest revenue for 1,000. Now, if the books are already closed and we discover the error, what we can do is, and the error has not been corrected, we debit interest receivable for 1,000, we can no longer go to revenue. We can no longer increase revenue. What are we going to increase? What do revenue eventually increase retained earnings? Therefore, we credit retained earnings. Is this a counterbalancing error? And the answer is, yes. If you did not do anything, what's going to happen? At some point, you're going to open your bank statement, look at your bond investments, and you're going to see you earned an additional 1,000. So you will debit cash, credit interest revenue. And by crediting interest revenue, what did you do? You either increase revenue and as a result, you increase retained earnings. Basically, it will counterbalance itself. It's another one that counterbalance itself because eventually you're going to get that revenue. Let's take a look at this entry. The inexpired portion of insurance policies total 60,000, the unexpired portion. Well, prepaid insurance shows 90. Well, we should not have 90. We should have 60. What do we have to do? We have to reduce prepaid by 30. Well, we're going to reduce prepaid. We're going to expense it. So we're going to expense insurance expense 30, credit prepaid 30 to reduce it by 30. If the books are already closed and we discovered the error and the error has not been corrected by itself, it's not counterbalancing, we're going to debit retained earnings because we can no longer debit an expense. If the books are closed, we're in the different period and credit prepaid expense. Now, with this, with this entry correct itself, the assumption is most likely, yes, if in year two, whoever taking care of prepaid insurance, they will find out we should reduce it an additional 30,000, they would reduce it, they will expense it and retain retained earning will be proper. However, again, if you're showing competitive financial statements, you have to go back to year one and reduce prepaid insurance and increase increase insurance expense. If you are publishing the financial statements again, this error is counterbalancing. Let's look at this error. 30,000 was received on January 1, X1 for the rent of a building for both X1 and X2. The entire amount was credited to rental income. Well, it's for two years and we credited the whole amount to rental income. What do we have to do? We have to take out half of it from rental income. We have to take half of it from rental income. Why? Because half of it don't belong in X1. Therefore, what we do is if we discover this error before the end of X1, we debit rental income, credit unearned revenue and we fix the error because we have to put 15,000 and unearned revenue, it's not supposed to be an income as of X1 and we fixed it. If the books were closed for X1 and the error did not counterbalance, which you already told you it's a counterbalancing error, what do we have to do? We have to debit retained earnings because we have to reduce income. As a result, we cannot reduce rental income. We have to reduce retained earnings and credit unearned rent revenue, which is the balance sheet account. With this entry, fix itself, is this entry counterbalancing? Absolutely yes. If you did not do anything and by the end of X2, by the end of X2, you would have two years worth of rental revenue of 30,000 and retained earnings will be correct because over a two-year period, you would have earned 30,000, which you did at the beginning, but the problem would be the amount are in the different periods. So the whole amount is an X1 and not an X2. Let's take a look at this entry. Depreciation for the year was erroneously recorded as 10,000 rather than the correct amount of 40,000. Hold on a second. We record the 10, the amount should be 40. What do we have to do? If we find out about the error, well debit depreciation expense, credit accumulated depreciation in that particular year, X1. If the books are closed, what do we have to do? Well, we can no longer debit depreciation expense, but we want the effect of that. We debit retained earnings of 30,000, credit accumulated depreciation by 30,000, thus fixing the error. With this error, fix itself. Most likely not. Why? Because depreciation expense does not counterbalance, there is no effect at the end of the year. If you made an error, you're going to discover it, it's going to reverse itself. So this will be a non, a non counterbalancing example, because you have to go in there and you made an error and you did the computation. It's not going to correct itself, especially if you're, if already, if you already made the error and not aware of the mistake, therefore, you're not going to correct it. Therefore, this doesn't counterbalance. It doesn't counterbalance by itself, because in the prior, in the prior examples, either the cash was involved or the receivable was involved. Therefore, it fix itself. This one is does not counterbalance. Another example of it is bad debt expense. It's, it's a number that you have to compute yourself. Therefore, it doesn't counterbalance. What should you do now? To learn more about this, go to farhatlectures.com to work additional MCQs and true false questions, exercises that can help you solidify your knowledge about this topic. Don't shortchange yourself. Accounting is important. Your professional certification is important. Study hard, good luck, and of course, stay safe.