Integration Auditing Theory and Practice Frederick Alfred D.

Abao, CPA
BSA – IV Handout 2

Accounting policies - specific principles, bases, conventions, rules and practices adopted by an enterprise in preparing and
presenting the financial statements.

Fundamental errors - are errors discovered in the current period with such significance, that the financial statements of
one or more prior periods can no longer be considered to have been reliable at the date of their issue.

Reasons why Accounting Changes Occur:

1. The accounting profession may mandate that a new accounting principle is to be used.
2. Changing economic conditions
3. Changes in technology and in operations
4. New experience or new information may prompt companies to change its estimate of revenues or expenses.

TYPES OF ACCOUNTING CHANGES

1. Change in Accounting Principles
This is a change from one generally accepted accounting principle to another generally accepted accounting
principle. Adoption of a new principle in recognition of events that have occurred for the 1st time is not a change
in accounting principle. There is no change in accounting principle when the depreciation method adopted for a
newly acquired asset is different from the method or methods used for previously recorded assets of similar class.

A change from a principle that is not generally accepted to one that is generally accepted is considered to be an
error correction than a change in accounting principle.

Accounting Procedure:
Benchmark treatment
A change in accounting policy/principle should be applied retroactively unless the amount of any resulting
adjustment that relates to prior periods is not reasonably determinable. Any resulting adjustment should be
reported as an adjustment to the opening balance of the retained earnings. Comparative information should be
restated unless it is impracticable to do so.

2. Change in Accounting Estimate

This is a change that occur as a result of new information or acquisition of additional experience. Changes in
estimates are viewed as normal recurring corrections and adjustments or the natural result of the accounting
process. Retroactive treatment is prohibited.

Accounting Procedure:
 Report current and future financial statements on the new basis.
 Present prior period financial statements as previously reported.
 Make no adjustment to current period opening balances.

NOTE: Whenever it is impossible to determine whether a change in principle or a change in estimate has occurred, or
if an asset is affected by both a change in principle and a change in estimate during the same period, the change
should be accounted for as a change in estimate rather than a change in principle.

CORRECTION OF ERRORS
No company whether large or small is immune from errors. Errors may be intentional or unintentional. Intentional errors
are significant because of the presence of fraud or intent to deceive. These errors are made for the purpose of concealing
fraud or misappropriation, evading taxes, manipulating or window-dressing the company's financial statements.
Unintentional errors were not deliberately committed. They result from carelessness or ignorance on the part of the
company's personnel or it may result from poor internal control.
The risk of material errors may be minimized through the installation of good internal control and the application of sound
accounting procedures. Prior period adjustments, also called fundamental errors are reported in the current year as
adjustment in the beginning balance of the Retained Earnings account. Prior period statements should be restated to
correct the error when comparative statements are prepared.

Accounting Procedure:
1. If detected in the period the error occurred, correct the accounts through normal accounting cycle adjustments.
2. If detected in subsequent period, adjust errors by making prior period adjustments directly to Retained Earnings or
restate the beginning balance of the Retained Earnings account.
3. Correct all previously presented prior period statements.

Examples of Accounting errors:

 A change from an accounting principle that is not generally accepted to an accounting principle that is generally
accepted.
 Mathematical mistakes
 Mistake in the application of accounting of accounting principle
 Oversight
 Misuse of facts
 Incorrect classification of expense as an asset or vice versa
 Changes in estimates which are not prepared in good faith

TYPES OF ERRORS
1. Balance Sheet Error
This type of error refers to improper classification of real accounts such as assets, liabilities or stockholders' equity
accounts. They have no effect on net income

2. Income Statement Error

This type of error affects only the presentation of nominal accounts in the Income Statement. It involves the
improper classification of revenues and expenses accounts, hence, only the details of the Income Statement are
misstated. A reclassifying entry is necessary only if the error is discovered in the same year it is committed. It has
no effect on the Balance sheet and in the Income Statement. If the error is discovered in a subsequent year, no
classification entry is necessary.

3. Combined Balance Sheet and Income Statement errors

This affects both the balance Sheet and the Income Statement because they result in the misstatement of net
income.

Classifications of Combined Balance Sheet and Income Statement Errors:

1. Counter Balancing Errors
  Errors which if not detected are automatically offset or corrected over two periods. Restatement is
necessary even if a correcting journal entry is not required.

 Effect - Net Income of two successive periods are misstated. The amount of misstatement in one
period is equal to but opposite in effect in the income of the next period.

 Counterbalancing errors include the misstatements of the following accounts:

1. Inventories to include the following
a. Purchases
b. Sales
2. Prepaid expenses
3. Deferred Income
4. Accrued expense
5. Accrued Income

GUIDELINES
 If books are still open
1. If the error is already counterbalanced and the company is in the second year, an entry is
necessary to correct the current period and to adjust the beginning balance of the Retained
earnings.
2. If the error is not yet counterbalanced, an entry is necessary to adjust the beginning balance of
the Retained earnings and correct the current period.
 If books are already closed
1. If the error is already counterbalanced, no entry is necessary.
2. If the error is not yet counterbalanced, an entry is necessary to adjust the present balance of
the Retained earnings.

2. Non-Counter Balancing Errors

 Errors which take longer than two periods to correct themselves. This type of error is carried over to
the subsequent accounting period until corrected or until the balance sheet item involved is removed
from the accounts by sales, retirement or other means of disposal.

REVIEW QUESTIONS

Problem 1
The retained earnings account of MAILENE Corp. is reproduced below:

RETAINED EARNINGS
Date Item Debit Credit
2012
Jan 1 Balance P 81,000
Dec 31 Net income for year 18,000
2013
Jan 10 Dividends paid P 15,000
Mar 6 Stock sold – excess over par 32,000
Dec 31 Net loss for year 11,200
2014
Jan 9 Dividends paid 15,000
Dec 31 Balance 89,800 .
P131,000 P131,000
The audit of the December 31, 2014, financial statements of the company reveals the following:
A. Dividends declared on December 10, 2012 and 2013 had not been recorded in the books until paid.
B. Improvements in buildings and equipment of P9,600 had been charged to expense at the end of April 2011.
Improvements are estimated to have an 8-year life. Mailene computes depreciation to the nearest month and
uses the straight-line depreciation.
C. The physical inventory of merchandise had been understated by P3,000 at the end of 2012, and by P4,300 at the
end of 2013.
D. Merchandise in transit and to which the company had title at December 31, 2013 and 2014 was not included in
the year-end inventories. These shipments of P3,800 and P5,500 were recorded as purchases in January of 2014
and 2015, respectively.
E. The company had failed to record sales commissions payable of P2,100 and P1,700 at the end of 2013 and 2014,
respectively.
F. The company had failed to recognize supplies on hand of P1,200 and P2,500 at the end of 2013 and 2014,
respectively.
G. The company reported a net loss of P12,400 for the year ended December 31, 2014.

REQUIREMENTS:
1. 2012 corrected net income (loss)
2. 2013 corrected net income (loss)
3. 2014 corrected net income (loss)

Problem 2
You have been assigned to audit the financial statements of ABAO Company for the year ended December 31, 2014. You
discover the following situations:

A. Interest income of P42,300 was not accrued at the end of 2013. It was recorded when received in February 2014.

B. A computer costing P12,000 was expensed when purchased on July 1, 2013. It is expected to have a 4-year life
with no residual value. The company typically uses straight line depreciation for all property, plant, and
equipment.

C. Research costs of P99,000 were incurred early in 2013. They were capitalized and were to be amortized over a 3-
year period. Amortization of P33,000 was recorded in 2013 and P33,000 for 2014.

D. On January 4, 2013, ABAO leased a building for 5 years at a monthly rental of P24,000. On that date, the company
paid the following amounts, which were expensed when paid.
Security deposit P 60,000
First month’s rent 24,000
Last month’s rent 24,000
P108,000

E. The company received P108,000 from a customer at the beginning of 2013 for services that it is to perform evenly
over a 3-year period beginning in 2013. None of the amount received was reported as unearned revenue at the
end of 2013.

F. Merchandise inventory costing P54,600 was in the warehouse at December 31, 2013, but was incorrectly omitted
from the physical count at that date. The company uses the periodic inventory method.

Assume all amounts are material and ignore income tax effects.

REQUIRED:
1. 2013 corrected income
 2. 2014 corrected income
3. Corrected retained earnings balance as of December 31, 2104

Problem 3
HIATT TEXTILE CORPORATION is in the process of obtaining a loan at City Bank. The bank has requested audited financial
statements. Hiatt’s financial statements have never been audited before. It has prepared the following comparative
financial statements for the years ended December 31, 2015 and 2014.

HIATT TEXTILE CORPORATION

COMPARATIVE STATEMENTS OF FINANCIAL POSITION
December 31, 2015 and 2014
2015 2014
Assets
Current assets:
Cash and cash equivalents P1,205,000 P 800,000
Accounts receivable 1,960,000 1,480,000
Allowance for bad debts (185,000) (90,000)
Inventory 1,035,000 1,010,000
Total current assets 4,015,000 3,200,000
Noncurrent assets:
Property, plant, and equipment 835,000 847,500
Accumulated depreciation (608,000) (532,000)
Total noncurrent assets 227,000 315,500
Total assets P4,242,000 P3,515,500

Liabilities and Shareholders’ Equity

Liabilities:
Accounts payable P 607,000 P 980,500
Shareholders’ equity:
Ordinary shares, P20 par value;
150,000 shares authorized;
65,000 shares issued and outstanding 1,300,000 1,300,000
Retained earnings 2,335,000 1,235,000
Total shareholders’ equity 3,635,000 2,535,000
Total liabilities and shareholders’ equity P4,242,000 P3,515,500

HIATT TEXTILE CORPORATION

COMPARATIVE INCOME STATEMENTS
For the Years Ended December 31, 2015 and 2014

2015 2014
Sales P5,000,000 P4,500,000
Cost of goods sold 2,150,000 1,975,000
Gross income 2,850,000 2,525,000
Operating expenses:
Selling expenses 1,150,000 1,025,000
Administrative expenses 600,000 525,000
Total operating expenses 1,750,000 1,550,000
Net income P1,100,000 P 975,000

The 2015 audit revealed the following facts:

a. On January 5, 2014, Hiatt Textile Corporation had charged a 5-year insurance premium to expense. The premium
totaled P31,000.

b. The amount of loss due to bad debts has steadily decreased over the last 2 years. Hiatt Textile Corporation has
decided to reduce the amount of bad debt expense from 2% to 1½ % of sales, beginning with 2015. (A charge of 2%
has already been made for 2014.)

c. Hiatt Textile Corporation uses the periodic inventory system. The following are the inventory errors for the last 2
years.
2014 - Ending inventory overstated by P75,500
2015 - Ending inventory overstated by P99,000

d. An equipment costing P150,000 was acquired on January 3, 2014. The purchase was recorded by a charge to
operating expense. The equipment has a useful life of 10 years and a residual value of P25,000. Hiatt Textile
Corporation uses the straight-line method in depreciating its assets.

Assume that the books for 2015 have not yet been closed. Ignore tax implications.

Based on the above information, answer the following:

1. The December 31, 2015 adjusting entry to correct the expensing of insurance premium paid is
A. Prepaid insurance 18,600
Insurance expense 6,200
Retained earnings 24,800
B. Prepaid insurance 18,600
Retained earnings 18,600
C. Insurance expense 18,600
Retained earnings 18,600
D. Insurance expense 6,200
Retained earnings 6,200

2. The December 31, 2015 adjusting entry to correct the expensing of the equipment purchased on January 3, 2014
should include a credit to
A. Accumulated depreciation—P12,500.
B. Retained earnings—P137,500.
C. Equipment—P12,500.
D. Depreciation expense—P12,500.

3. The December 31, 2015 adjusting entry to correct the inventory errors should include a debit to
A. Cost of goods sold—P99,000.
B. Inventory—P23,500.
C. Retained earnings—P75,500.
D. Cost of goods sold—P75,500.

4. What is Hiatt’s corrected net income for the year ended December 31, 2014?
A. P1,012,200 B. P1,212,800 C. P786,800 D. P1,061,800

5. What is Hiatt’s corrected net income for the year ended December 31, 2015?
A. P1,095,200 B. P1,129,800 C. P1,082,800 D. P1,107,800