 Hello and welcome to this session. This is Professor Farhad in which we will discuss accounting errors, how to handle and how to treat accounting errors. Now what is an accounting error? Simply put an error is a mistake. It's a computational or a mathematical mistake. That's one form of an error. It could be a misapplication or a misuse of facts. Basically you made a mistake. It could be switching from a non-gap method to a gap method. So when you go from a non-gap to a gap method, that's considered an error. You made a mistake because your method should be gap accepted and it was not accepted. It was an error. If you made changes in estimates, hold on a second. I think we discussed changes in estimate, but those changes are not prepared in good faith. In other words, you change your estimate such as bad debt expense, warranty expense, obsolescence of inventory, but you did those in bad faith, not in good faith. A case in point, waste management. We spoke about this company when we discussed change in estimates specifically when they changed their depreciation amount. So that's also considered an error and you will need to fix it. Failure to book a cruel order furloughs and this will affect both expenses and revenues. You fail to do so. It was an oversight. It's an error. Misclassification of expenses, capitalizing expenses or expensing certain assets that need to be treated as an expense. Wartcom, if you're interested, look up this company, Wartcom Fraud and you will see they misclassify approximately, if my memory is right, approximately $3 billion. They capitalize it rather than expense in it. So they spent $3 billion. Those $3 billion should have been expensed. They treated them as an asset. I'm not sure if it's $3 or $2 billion, but it doesn't matter. The amount was large and now they're gone. Let's take a look at a little bit more of specific examples and categories of accounting errors. You could have accounting errors and expense recognition. Simply put, recording expenses for an incorrect amount or in the wrong period. You could have problem with revenue. Usually revenue is a big one. You could be improperly recognizing revenue, recording questionable revenues or any other related item that affect the recording of revenue. You could have misclassification, short-term versus long-term or capitalizing while you should be expensing. You could have problem with your equity account. You could have improper treatment of computing earnings per share, treating restricted stocks, stock options warrant or any other accounting, I'm sorry, equity instrument. You could have problem with allowances and contingencies. Again, estimating or misestimating bad debt, inventory reserve, income tax allowances, loss contingencies, so on and so forth. You could have problem with long-lived asset. Asset impairment, that's basically an estimate. You could have problem with inventory, costing your inventory, counting your inventory, how to compute cost of goods sold. So all of these, they could be errors, then they will need restatement. Now how to handle the accounting error? How to handle it? Well, simply put, you handle it retrospectively. What does that mean? What does retrospective mean? Retrospective means you have to go back and fix the error. Think about it. If you find an error in the prior year financial statement, should you keep the error? No, because those financial statements are misleading. You have to go back and fix it. Especially if you are presenting the financial statement in a comparative format, you have to show the correct numbers, not the wrong numbers. So all material errors must be corrected. And if you're presenting comparative, you will need to restate the prior financial statement affected for each year presented. Let's assume we're in year X5 and we found an error in X4. Well, we need to fix the error. Okay, it's not only we need to fix it. If we're showing X4 and X5, we want to make sure it's fixed. So they are comparative. X4 and X5 are comparative. So let's assume we found an error in X3, X4 and X5. We need to go back and fix those errors as long as we are and restate, fix them and restate the financial statement. Because if we're showing X3, X4 and X5, for comparability to be preserved, we have to show the correct, not the incorrect number. Let's assume we find an error in X1, X2, and now we're presenting X5. But we're only presenting X3, X4 and X5. But the error goes back to X1. What do we have to do? We have to find, compute the error, how much was the error in X1 and X2 and dump the error in X3 beginning retained earnings, because we're showing only X3, X4 and X5. Therefore, the effect of the error is reflected in X3. But we are not showing X1 and X2. We're only showing X3, X4 and X5. X3 will be need to be restated X4 as well as X5. If we're only presenting one year, if we're only presenting one year, it's easy. Then we compute, it doesn't matter. Let's assume the error was an X1. We compute the whole effect of the error or errors. Then we dump the change into X5, because we're only showing X5. And what I mean by dump the change recorded as a prior period adjustment to beginning retained earnings. So you fix beginning retained earnings, and you solve the problem. Now the best way to illustrate this is to actually look at an example. Before we look at the example, most likely the reason you are watching you are either a student or a CPA candidate, and looking for some help about this topic. You have arrived. Thank you very much. Go step further farhatlectures.com where I have resources, additional lectures, multiple choice through false exercises. That's going to help you reinforce those concepts. If you're studying for your CPA exam, I don't replace your CPA review course. I'm a useful addition. I explain the material differently. If you're studying for your accounting courses, I can be that additional resources, that additional investments that's going to help you. Connect with me if you haven't done so on LinkedIn. Like this recording, it doesn't cost you anything. Just click on the like button, share it with others. Connect with me on Instagram, Facebook, Twitter, and Reddit. The concept, let's look at an example. In 20X1, Adam Company discovered an error. What's that error? In 20X0, the company failed to record 10,000 of the appreciation expense on a newly constructed building. So what they find out is they did not book the proper amount for that particular year in 20X0. Well, the company correctly included the depreciation expense and its tax return incorrectly reported income taxes payable. So as far as the taxes are concerned, we recorded the depreciation expense, but for gap, we did not. Now, for the sake of illustration, the tax rate is 20%. So here's what happened. So this is the income statement for the prior year 20X0. And this is with the error with the error, we had income before the depreciation expense of 100,000. We did not book this 10,000 of the appreciation expense before the error income before taxes is 100,000. For 100,000, 20% is 20,000. However, bear in mind that we know that 10,000 of it will be the third, 10,000 of the expense will be the third. So if we are deferring 10,000, 10,000 times 20% is 2000. So what we did is we deferred $2,000 because in other words, we said we're going to take this expense in future year. We failed to record it in 20X0. We'll take it in future years. It created a deferred income tax expense. Now, without the error, what should have happened is 100,000 should have been income before depreciation expense minus 10,000 depreciation expense income before income tax would be 90,000 times 20%. Our income tax expense will be 18. Our net income will be 72. This is without the error. So notice the difference in total income. The difference in income is 8,000. The reason is here we did not take a $10,000. You might be saying why shouldn't be the difference 10,000 not 8? It's because there's an additional $2,000 that you took in tax deduction. So now let's see from a journal entry perspective. This is what entries Adam actually made. Well, what Adam did is debited income tax expense 20,000, write a check to the IRS for 18,000 income taxes payable and deferred $2,000 because we failed to book this 10,000 of depreciation expense. And this is the entry for income tax expense. If no error was made, this is what Adam should have done. They should have debited depreciation expense 10,000. And by debiting depreciation expense, they would have added 10,000 here and credited accumulated depreciation income tax expense, if no error was made, would have been 18,000 income tax expense 18,000 and income taxes payable 18,000, which is there will be no deferral and this will be 18,000 and therefore this will be 72,000. So this is if no error was made. But what we did is we failed to book this entry and for this entry income tax expense was 20, which is you saw it here. Let's summarize the effect on the financial statement as a result of this error. From an income statement perspective, depreciation expense was understated by 10,000 because we did not book this entry. Well, if depreciation expense was underreported, we reported less expenses as a result we paid an additional 2000 in taxes. As a result, our income was overstated by eight, which is, you know, 80 minus 72 the net income between the two companies, but basically 10,000 of depreciation expense minus the 2000 of taxes, it was overstated by two from a balance sheet perspective, our accumulated depreciation was understated by 10. Again, because we did not book this entry, we missed this accumulated depreciation of 10. And the third tax liability, we booked a deferred tax liability that should not have been there, because that that that tax that that additional 2000 should have should not should not have been deferred, it should have been taking that that year x zero. So what do we need to do to fix this problem? Well, let's start with the easy part. We need an additional 10,000 of accumulated depreciation. We credit accumulated depreciation 10,000. I already told you our net income will be should be lower by 8,000 net income is overstated. What do we have to do if what's overstated, we need to reduce it. Now remember, we're dealing with year two, so we cannot go back and change the expenses. What we do is we debit retained earning for 8,000. So that fixed net income. And remember, we had a deferred tax liability of two should not be there, we're going to debit the third tax liability of two. So this is the entry to fix the problem. And we just fix the problem in this journal entry. Now, what do we do? Now, how do we present this information in year x one, assuming we're only showing x one one year? What do we have to do on the statement of retained earning? We have the beginning retained earnings as reported initially 400,000. Then we deduct from it $8,000, which is 10,000. This is the prior period adjustment 10,000 minus two, we have to reduce our retained earning by a therefore the adjusted retained earning 392. Now we're good to go. This year, we made net income of 220. We did not pay any dividend. Our ending retained earning is 612,000. Simply put, the error that was made, because we're only showing this year, was dumped into was showing into the beginning retained earning into the beginning retained earning as a reduction in retained earning happens to be reduction. Sometimes the error could have increased retained earnings. Who knows? What should you do now? Go to farhatlectures.com and work MCQs and true false. Don't shortchange yourself, whether you are a CPA candidate or an accounting student. Invest in your career, invest in yourself. Accounting is important. It will pay you dividend down the road. Good luck. Study hard. And of course, stay safe.