When spending is put in the wrong category, reported profit and non-current assets are both wrong, and they are wrong by linked amounts. To calculate the effect, ask what the expense line should be, compare it with what was charged, and adjust profit by the difference. If depreciation is involved, correct that as the last step.
This lesson builds on classifying repairs and improvements and separating capital receipts from income inside capital and revenue treatment.
What is the rule for the direction of the adjustment?
Think of what happened to the expense total.
- Capital treated as revenue (an asset charged to expenses): expenses are too high, so profit is understated. Add the amount back, then deduct any depreciation the asset should carry.
- Revenue treated as capital (an expense added to an asset): expenses are too low, so profit is overstated. Deduct the amount, then add back any depreciation wrongly charged on it.
Always correct profit and non-current assets together. If your profit goes up by RM 2,100 after all corrections, the net assets must also be RM 2,100 higher. This is a built-in check.
Worked example
Teratai Tailoring first calculated its profit for the year as RM 18,000. The accountant then found two errors.
- Error A: RM 1,500 spent on repairing a sewing machine was debited to the Machinery account.
- Error B: a new sewing machine costing RM 4,000 was debited to Repairs expense.
Assume machinery is depreciated at 10% a year on cost, straight-line, for a full year. No depreciation had been charged on the RM 1,500 from Error A.
Step 1, correct Error A. The repair is an expense, so profit was overstated. Deduct RM 1,500: 18,000 − 1,500 = RM 16,500. No depreciation had been charged on it, so nothing more is needed.
Step 2, correct Error B. The machine is an asset, so profit was understated. Add back RM 4,000: 16,500 + 4,000 = RM 20,500.
Step 3, charge depreciation on the machine. 10% of RM 4,000 = RM 400. Deduct it: 20,500 − 400 = RM 20,100.
| Step | Adjustment | Profit (RM) |
|---|---|---|
| Profit as first calculated | 18,000 | |
| Repair wrongly capitalised | −1,500 | 16,500 |
| Machine wrongly expensed | +4,000 | 20,500 |
| Depreciation on the machine | −400 | 20,100 |
Step 4, check with the assets. Machinery was overstated by RM 1,500 from Error A. It was understated by 4,000 − 400 = RM 3,600 from Error B. Net: −1,500 + 3,600 = +RM 2,100. Profit also moved by 20,100 − 18,000 = +RM 2,100. The two agree.
The mistake to watch for
A common slip is to adjust in the wrong direction for the item that was expensed.
Mistaken answer: “The machine was charged to repairs, so I deduct RM 4,000 from profit: 18,000 − 4,000 = 14,000.”
The student remembered that an error “affects profit” but did not ask whether profit was too high or too low.
Repairs expense was too high by RM 4,000, so profit was too low. The fix is to add RM 4,000 back, not deduct it. A simple test is to say aloud, “Were the expenses too high or too low?” before touching the profit figure.
Check yourself
Try these on paper first.
1. Equipment costing RM 2,000 was charged to Office expenses. Profit was calculated as RM 12,000. Ignoring depreciation, what is the corrected profit?
Show answer
Capital treated as revenue means profit was understated. Add back RM 2,000: 12,000 + 2,000 = RM 14,000.
2. Repairs of RM 900 were added to the cost of the building. Profit was calculated as RM 30,000. No depreciation is charged on buildings. What is the corrected profit?
Show answer
Revenue treated as capital means profit was overstated. Deduct RM 900: 30,000 − 900 = RM 29,100. Buildings are also overstated by RM 900.
3. State the effect on profit and on non-current assets when a purchase of machinery is wrongly treated as an expense.
Show answer
Profit is understated and non-current assets are understated, both by the amount of the purchase before depreciation. Expenses were too high, and the asset was left out of the statement of financial position.
Where this leads next
The depreciation step above is the bridge to the next lesson on explaining depreciation rather than expensing the whole asset. To see how profit and cash can disagree for related reasons, try the cash versus profit bridge, then work on the capital and revenue practice set.
Some students get the right answer when a question shows only one error, then stumble when two corrections pull in opposite directions. Our teachers use that exact situation in online one-to-one Accounting tuition.