Impact of Errors on Profit & Financial Position (Cambridge International AS Accounting)

Impact of errors on profit

Which accounts affect gross profit?

• It is important to learn whether the balance of an account affects the gross profit

  • An account could cause the gross profit to increase
  • An account could cause the gross profit to decrease
  • An account could have no effect on the gross profit

• Remember the formulae

  • Gross profit = net revenue - cost of sales
  • Net revenue = sales - sales returns
  • Cost of sales = opening inventory + net purchases - closing inventory
  • Net purchases = purchases + carriage inwards - purchases returns - goods for own use

• Anything which increases net revenue will increase gross profit

• Anything which increases the cost of sales will decrease gross profit

• This can be summarised in the following table

Exam Hint Goods taken for the owner’s use are normally recorded in the purchases account. Read the question carefully to see whether this has already been accounted for.

Remember carriage outwards does not affect the gross profit as this is an expense whereas carriage inwards is classed as part of purchases.

How do errors affect the gross profit?

• Some errors cause the gross profit to be overstated or understated

• The gross profit will be overstated if:

  • Either the balance of an account which increases gross profit has been overstated
  • Or the balance of an account which decreases gross profit has been understated

• The gross profit will be understated if:

  • Either the balance of an account which increases gross profit has been understated
  • Or the balance of an account which decreases gross profit has been overstated

• Check the overall effect on the gross profit of all the errors

  • The effects of some errors might cancel each other out

How do corrections of errors affect the gross profit?

• You might be asked to correct errors and find the adjusted gross profit

• Consider which debit and credit entries are needed to correct the errors

• If the account affects gross profit then:

  • Debit entries decrease gross profit
  • Credit entries increase gross profit

• Remember some accounts do not affect the gross profit

Exam Hint Read these questions carefully. Check whether the question is asking you to determine the effect that errors have on the gross profit or whether it is asking you to determine the effect of correcting the errors!

Which accounts affect profit for the year?

• It is important to learn whether the balance of an account affects the profit for the year

  • You can determine the effects using the same methods as for gross profit

• Remember the formula

  • Profit for the year = gross profit + other incomes - other expenses

• Anything which increases gross profit or other incomes will increase the profit for the year

• This can be summarised in the following table

• If the account affects profit for the year then:

  • Debit entries decrease the profit
  • Credit entries increase the profit

Worked Example Felipe is a sole trader. At the end of the accounting period he stated the gross profit as $12 340 and the profit for the year as $5 435. After calculating these values, Felipe identified some errors.

1. A credit sale, $360, to Emily, had been debited to the sales account and credited to Emily’s account.
2. Felipe had taken goods for his own use, $300, but he had not entered this into the ledger accounts.
3. The sales returns account and the discount received account had both been undercast by $250.
4. Rent received, $1 200, had been debited to the rent payable account. It was entered correctly into the cash book.
5. A credit purchase, $900, from Reema, has been credited to Rachel’s account. It was entered correctly into the purchases account.

Calculate the adjusted gross profit and profit for the year after the correction of the errors.

Answer:

Find the corrections that are needed.

If the account affects a type of profit, then debit entries decrease the profit and credit entries increase the profit.

Error	Correction needed	Effect on gross profit	Effect on profit for the year
1	Debit $720 to Emily’s account (asset)	No effect	No effect
Credit $720 to the sales account	Increase by $720	Increase by $720
2	Debit $300 to the drawings account	No effect	No effect
Credit $300 to the purchases account	Increase by $300	Increase by $300
3	Debit $250 to the sales returns account	Decrease by $250	Decrease $250
Credit $250 to the discount received account (income)	No effect	Increase $250
4	Credit $1 200 to the rent payable account (expense)	No effect	Increase by $1 200
Credit $1 200 to the rent receivable account (income)	No effect	Increase by $1 200
5	Debit $900 to Rachel’s account (liability)	No effect	No effect
Credit $900 to Reema’s account (liability)	No effect	No effect

Final answer: Gross profit: $12 340 + $720 + $300 - $250 = $13 110 **

Final answer:** Profit for the year: $5 435 + $720 + $300 - $250 + $250 + $1 200 + $1 200 = $8 855**

Impact of errors on a statement of financial position

How do errors affect the statement of financial position?

• Some errors can affect the stated values for:

  • Assets
  • Liabilities
  • Capital

• The capital account will be overstated if:

  • The profit for the year is overstated
  • The drawings account is understated

• The capital account will be understated if:

  • The profit for the year is understated
  • The drawings account is overstated

• The effects of some errors can cancel each other out and therefore do not affect the statement of financial position

  • Suppose that a payment from a trade receivable of $100 has been omitted from the ledger accounts

    • Trade receivables would be $100 overcast
    • The bank would be $100 undercast

  • The total value of the assets is unaffected by this error

How does the correction of errors affect capital?

• Capital will increase if:

  • The profit for the year increases
  • The balance of the drawings account decreases

• Finding the corrected balance for the capital is very similar to finding the corrected profit for the year

  • Just remember to look out for transactions involving drawings

Exam Hint Always read the question carefully. You might be required to determine whether the capital is understated or overstated due to errors. Or you might be required to calculate the adjusted capital after correcting the errors.

Worked Example Gina is a sole trader. Gina has prepared a draft statement of financial position but later discovers some errors. For each error put a tick (✓) in the correct column to indicate the effect that each error has on Gina’s capital.

Error	Capital is overstated	Capital is understated	No effect on capital
The purchase of a vehicle for business use, $2 000, had been debited to the purchases account.
Goods taken for Gina’s own use, $500, had been omitted from the ledger accounts.
Gina had taken $1 000 from the business bank account for personal use. This had been entered in the cash book but no other entries had been made.

Answer:

• For the first error, the transaction was entered into the purchases account instead of an asset account

  • The purchases account is overstated which means the profit is understated
  • Therefore the capital is understated

• For the second error, the purchases account is understated which means the profit is overstated

  • However, the drawings account is understated which cancels out the effect of the overstated profit when calculating the capital

• For the third error, the drawings account is understated

  • This means the capital is overstated

Error	Capital is overstated	Capital is understated	No effect on capital
The purchase of a vehicle for business use, $2 000, had been debited to the purchases account.		Final answer: ✓
Goods taken for Gina’s own use, $500, had been omitted from the ledger accounts.			Final answer: ✓
Gina had taken $1 000 from the business bank account for personal use. This had been entered in the cash book but no other entries had been made.	Final answer: ✓