 Hello, and welcome to this session in which we would look at an accounting error, CPA simulation that deals with an accounting mistake that could appear either on the CPA exam or in your intermediate accounting course. Let's go ahead and take a look at this exercise. On September 1st, 20x4, Aaron purchased a three-year insurance policy paying $720. That's fine. The policy was debited in error to the land account. Well, that's a mistake. In 20x6, the land account was sold at a loss of $400. So what do we need to do now? We need to figure out what entries are needed, assuming the error was discovered before the books are closed, the books are closed were assuming in 20x6, and what entry is needed assuming the books have closed. So we have two entries to make. First assuming we caught the entry at the end of the year in 20x6, and the other entry is we did not caught the entry by 20x6, so the books are closed, what entries do we need? Well, let's go ahead and start this exercise. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. The first thing we need to do is to take a look at the journal entry that initially took place when we sold the land. When we sold the land, here's what happened. We received some cash for the land, we don't know the amount of the cash. We debited a loss on sale of $400 because we are told the land was sold for $400 and we credited land for some amount, we don't know the amount. It doesn't really matter. The point is we recorded a loss of $400. What is the problem with this loss? Well, we did not really incur a loss on the sale. Why? Because the land account was overstated by $720. Why? Because we debited the land account for $720 in error. So what do we have to do? Well, the first thing, if we did not really incur a loss, let's start by reversing the loss. Well, we're going to go ahead and credit this loss because I just told you we really did not have a loss because the land was overstated by $720. Now since the land was overstated and we did not incur a loss, matter of fact, we had a gain of $320 because if we have to eliminate the loss, we also have to reduce the land by an additional $320. It means we have to recognize a gain of $320. So this is to reduce the land account by $720. So we reduce the land account by $720. Well, generally speaking, we would have reduced the land account, but the land account no longer exists. The land account is gone and we have the gain and the loss. Therefore we have to remove the loss and book again. Well that's fine, but is that the only thing that we need to fix? Not at all. Now we have an insurance policy that was treated as an asset. So what do we have to do? Well, we paid $720 for three years. That means every month that goes by, we have to expense $20 for that insurance policy. Well let's think about it. For 20X4, we had September, October, November and December, we have four months in 20X4. In 20X5, 12 months in 20X6, 12 months. So in total, if you notice, we had 28 months of insurance expense already expired. Well, if we take $20 times 28 months, we need to expense in total of this policy $560, of which $240 belongs to this year. $240 belongs into this year. And if we are going to expense $560, so if the policy is $720 original value, we are going to expense $560, it means we still have in prepaid remaining $160. Let's fix this problem. We have to debit insurance expense $240, and this is specifically for 20X6. Now for the prior two years, we have the prior two years, and we have to expense 16 months of this policy times $20. And that's going to give us retained earnings. We have to reduce retained earnings by $320 because retained earnings for the prior two years was overstated because we did not account for this as an expense. Also since we have $160 remaining in prepaid, we have to debit prepaid for $160. So what we did is this. We fixed the $720 error by reducing the loss and creating a gain from the land. On the flip side, we have to incur $240 in insurance expense. We have to book $320 to reduce retained earnings for year X4 and X5 that were incorrect. And we have to put on the books an asset of $160. Simply put, all what's left of this policy is really $160, all in all. Why? Because the $720 is technically gone. Why it's technically gone? Part of it is a loss, reversing the loss, and part of it is creating a gain. And what's left is $160. That's assuming the books have not been closed. In other words, we did not close the books yet. We caught the error. If we caught the error, take out the loss, book the gain, reinstate the prepaid, book the insurance expense for the year, and fix the prior year error. That's what we have to do. And let's assume we already closed the books. If we close the books, let's think about it. If we close the books, it means we did not discover the error. It means now we discover the error after we close the books. So after we close the books, here's what's going to happen. All what's going to be on the books is prepaid insurance. That's all what's left, $160. So this is going to be $160. And we have to, ever since we close the books, we can no longer go back, change the expenses, change the losses, and change the gains. Expenses, losses, and gains. Remember, those are temporary accounts. So what is that going to do? Well, what's that going to do is it's going to net out to whatever's left. We have to net all the expenses. So let's think about it. Losses, crediting the losses would increase retained earnings by $400. Crediting the gain will increase retained earnings by $320. Insurance expense, if we have to fix this error, it's going to reduce retained earnings by how much? $240. And the X4 and X5 will need to reduce retained earnings by how much? $320. So let's go ahead and net out retained earnings. So we're going to have 720 increases of retained earnings, minus $240, minus $320. And what's left of retained earnings? Retained earnings will need to go up by $160. So the net effect of this error all in all is, well, we need to reinstate an asset for year X7. So this asset will be with us for year X7. $160, which is eight months remaining of the policy. And we have to increase our retained earnings because retained earnings was reduced by $160 as a net effect. And that effect of all of this, we have to increase retained earnings. Now at the end of the year, again, this prepaid insurance will go down to zero and retained earnings will go down to zero for this $160. And basically, the prepaid insurance became an expense, becomes an expense, and the expense will reduce retained earnings. And that's the end of this mistake. And hopefully it will not happen again. What should you do now? Go to FARHAT Lectures and look at additional resources, multiple choice, through falls. That's going to help you understand accounting errors. Accounting errors are important because fixing an error means you know how the process work from A to Z because you have to work backward. FARHAT Lectures will help you understand this by going over additional exercises, multiple choice, through falls. Good luck, study hard, invest in yourself, invest in your career. And of course, stay safe.