Impact of Errors on Profit & Financial Position (Cambridge (CIE) O Level Accounting)
Revision Note
Written by: Dan Finlay
Reviewed by: Lucy Kirkham
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
Accounts which increase gross profit | Accounts which decrease gross profit | Accounts which do not affect gross profit |
|---|---|---|
|
|
|
Examiner Tips and Tricks
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
Examiner Tips and Tricks
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
Balances which increase profit for the year | Balances which decrease profit for the year | Balances which do not affect profit for the year |
|---|---|---|
|
|
|
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.
A credit sale, $360, to Emily, had been debited to the sales account and credited to Emily’s account.
Felipe had taken goods for his own use, $300, but he had not entered this into the ledger accounts.
The sales returns account and the discount received account had both been undercast by $250.
Rent received, $1 200, had been debited to the rent payable account. It was entered correctly into the cash book.
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 |
Gross profit: $12 340 + $720 + $300 - $250 = $13 110
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
Examiner Tips and Tricks
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. | ✓ | ||
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. | ✓ |
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