To find the effect on profit, ask of each error: was an income or expense account wrong, and by how much and in which direction? Add back understated profit, take away overstated profit, and ignore corrections that only move amounts within the balance sheet or between expenses.
This lesson follows writing the correcting entry and belongs to suspense and correcting errors.
How do you decide the direction?
Use two rules, in this order.
- Expenses wrongly too high make profit too low. Removing the extra expense raises profit.
- Income wrongly too low makes profit too low. Adding the missing income raises profit.
Reverse the logic for the opposite mistakes: expenses too low, or income too high, mean profit was overstated and the correction lowers it. Where an error touches both an income account and an expense account, add the two effects together.
Worked example
Harbour Bikes reports a net profit of RM 24,500 before checking for errors. The following are then found.
- Equipment costing RM 2,000 was debited to the repairs expense account.
- Commission received of RM 800 was never recorded.
- Wages of RM 450 were debited to the drawings account.
- Rent of RM 600 was debited to the rates account.
- Rent received of RM 120 was debited to the rent received account and credited to bank, instead of the reverse.
Step 1, test each error.
- Error 1: repairs were overstated by RM 2,000 and equipment is a non-current asset, not an expense. Profit was understated, so the correction is +2,000.
- Error 2: income was missing entirely. The correction is +800.
- Error 3: wages are an expense and were left out of the income statement. Profit was overstated, so the correction is −450.
- Error 4: both rent and rates are expenses, so the total of expenses is unchanged. The effect is nil.
- Error 5: income was reduced by 120 when it should have been increased by 120. Profit was understated by 240, so the correction is +240.
Step 2, show the statement.
| Item | RM |
|---|---|
| Net profit before corrections | 24,500 |
| Add: equipment wrongly charged to repairs | 2,000 |
| Add: commission received omitted | 800 |
| Less: wages debited to drawings | (450) |
| Rent and rates, no effect | 0 |
| Add: rent received entered on the wrong sides | 240 |
| Corrected net profit | 27,090 |
Step 3, check by adding the adjustments. The adjustments total 2,000 + 800 − 450 + 240 = 2,590. Then 24,500 + 2,590 = 27,090. The two routes agree.
The mistake to watch for
A common slip is to adjust profit for every correction, including those that do not touch income or expenses.
Mistaken answer: the student adjusts profit by 600 for error 4 as well, writing “rent should go up, so profit up”, giving RM 27,690.
Rent and rates are both expenses, so moving RM 600 from one to the other leaves total expenses unchanged.
Ask of each correction: “does money move between an expense and something that is not an expense, or between income and something that is not income?” If both accounts are in the same group, or both are balance sheet accounts, there is no effect on profit.
Check yourself
Calculate the corrected profit, then open the answer.
1. Net profit is RM 12,000. A computer costing RM 1,500 was debited to office expenses. What is the corrected profit?
Show answer
Expenses were overstated by RM 1,500, so profit was understated. 12,000 + 1,500 = RM 13,500.
2. Net profit is RM 18,600. The owner’s personal phone bill of RM 220 was debited to the telephone expense account. What is the corrected profit?
Show answer
The bill is drawings, not an expense. Expenses were overstated by RM 220, so profit rises. 18,600 + 220 = RM 18,820.
3. Net profit is RM 9,800. Rent of RM 500 was recorded as RM 50 in both the rent account and the bank account. Commission received of RM 130 was omitted. What is the corrected profit?
Show answer
Rent was understated by 500 − 50 = 450, so profit falls by 450: 9,800 − 450 = 9,350. Commission adds 130: 9,350 + 130 = RM 9,480. Check: −450 + 130 = −320, and 9,800 − 320 = 9,480.
Where this leads next
Once each correction’s direction is secure, learn how to reconcile a suspense balance to zero, where the same discipline is applied to the trial balance. The cash versus profit bridge shows in a different setting why profit and cash movements can disagree.
If the arithmetic is fine but the reasoning about direction keeps flipping, our teachers can step through each item with you in online one-to-one Accounting tuition.