Accounting (9215) | The effect of errors on profit calculations

Accounting 9215 Study Notes: The Effect of Errors on Profit Calculations

Welcome, future Accounting professionals! This chapter is incredibly important because it moves us from simply recording transactions to ensuring those records are accurate and true. Think of yourself as a financial detective!

We are focusing on the section "Verification of accounting records". Verification helps us find mistakes (errors). Once we find them, we need to know: How did this mistake affect the profit we calculated?

Don't worry if this seems tricky at first. We will break down how simple classification mistakes can dramatically change your final profit figure!

Section 1: The Basics - Understanding Profit Impact

Before we look at errors, let's quickly remember the two main profit figures we calculate:

1. Gross Profit (GP): This is revenue minus the cost of goods sold (COGS).
\( \text{Gross Profit} = \text{Sales Revenue} - \text{Cost of Goods Sold} \)
2. Net Profit (NP): This is Gross Profit minus all other business expenses (like rent, salaries, electricity, etc.).
\( \text{Net Profit} = \text{Gross Profit} - \text{Expenses} \)

How Errors Affect the Calculation

Every account used in the Income Statement (Revenue, COGS, Expenses) either increases or decreases profit. An error occurs when you put an amount in the wrong account or miss recording it entirely.

Think of calculating profit like making a cake recipe. If you accidentally double the sugar (Revenue), the cake will be too sweet (Profit too high). If you forget to add the baking powder (Expense), the cake won’t rise (Profit calculation is wrong).

The Two Outcomes of an Error:

• Profit is Overstated: The calculated profit is too high.
• Profit is Understated: The calculated profit is too low.

Section 2: Analyzing Specific Error Types and Their Impact

We often deal with errors of commission (putting an amount in the wrong account of the correct class) or errors of principle (putting an amount in the wrong class, e.g., treating an expense as an asset). These errors are what most commonly distort profit.

Error Type 1: Misclassification of an Expense as an Asset

This is one of the most common mistakes found during verification.

Example: A company pays \$1,000 for routine vehicle maintenance (a repair expense), but the bookkeeper incorrectly debits the Motor Vehicles (Asset) account instead of the Repairs (Expense) account.

Step-by-Step Analysis:
1. The Intention: Repairs is an Expense. Expenses must be deducted to find Net Profit.
2. The Error: The Expense account (Repairs) has been recorded \$1,000 too low (it should have been debited but wasn't).
3. The Effect on Profit: Because \$1,000 of expenses was missed (not deducted), the calculated Net Profit figure will be \$1,000 too high.

Key Takeaway for Error 1: Treating an Expense as an Asset always causes profit to be Overstated because you failed to deduct a cost from your revenue.

Error Type 2: Misclassification of Revenue as a Liability

Example: A customer pays \$500 cash for services rendered (Sales Revenue), but the amount is incorrectly credited to Deposits Received (Liability) instead of Sales Revenue (Income).

Step-by-Step Analysis:
1. The Intention: Sales Revenue should be credited to increase Net Profit.
2. The Error: The Revenue account (Sales) is recorded \$500 too low (it should have been credited but wasn't).
3. The Effect on Profit: Because \$500 of revenue was missed (not added), the calculated Net Profit figure will be \$500 too low.

Key Takeaway for Error 2: Treating Revenue as a Liability always causes profit to be Understated because you failed to include income.

Error Type 3: Incorrect Inventory Valuation

This error is particularly important as it affects Gross Profit immediately. Remember, inventory valuation relies heavily on estimation and physical counts, making it prone to error.

Did you know? Incorrect inventory valuation is the number one way businesses accidentally (or sometimes deliberately) misstate their profit!

Recall the formula for Cost of Goods Sold (COGS):
\( \text{COGS} = \text{Opening Inventory} + \text{Purchases} - \text{Closing Inventory} \)

Case A: Closing Inventory is Overstated (Recorded too high)

If you record your Closing Inventory figure too high (e.g., you counted items twice), what happens to COGS?
\( \text{COGS} = \text{Opening} + \text{Purchases} - \mathbf{(Too\, High\, Closing\, Inventory)} \)

A higher deduction (closing inventory) means your resulting COGS will be too low.
Since COGS is an expense, if the expense is too low, the Gross Profit (and Net Profit) will be Overstated.

Case B: Closing Inventory is Understated (Recorded too low)

If you record your Closing Inventory figure too low (e.g., you forgot to count a storage room).

A lower deduction (closing inventory) means your resulting COGS will be too high.
Since the expense (COGS) is too high, the Gross Profit (and Net Profit) will be Understated.

Section 3: The Correction Process and True Profit Calculation

Once an error is found, we must correct the accounts using a Journal Entry and then calculate the true profit.

Step-by-Step Example: Correcting Profit

A business calculated a Net Profit of \$15,000 before errors were found.

Error Found: A payment of \$500 for advertising (an Expense) was completely omitted from the books (an Error of Omission).

1. Analyze the Impact:
We missed recording a \$500 Expense. Since the Expense was not deducted, the original profit of \$15,000 is Overstated by \$500.

2. Determine the Adjustment Needed:
We need to reduce the profit by the amount of the missed expense.

3. Calculate the True Net Profit:

\( \text{Calculated Net Profit} = \$15,000 \)
\( \text{Adjustment (Deduct Missed Expense)} = (\$500) \)

---

\( \mathbf{True\, Net\, Profit} = \mathbf{\$14,500} \)

4. (Optional but important: The Journal Entry):
To fix the accounts, you would debit the Advertising Expense account and credit the bank/cash account (or credit the Suspense Account if the trial balance was out). The act of debiting the Expense account formalizes the profit reduction.

Example of a Revenue Correction

A business calculated a Net Profit of \$20,000 before errors were found.

Error Found: \$1,200 of Commission Income was incorrectly debited to the Bank account and credited to the Drawings account. This means Commission Income (Revenue) was completely missed from the Income Statement.

1. Analyze the Impact:
We missed recording \$1,200 Revenue. Since the Revenue was not added, the original profit of \$20,000 is Understated by \$1,200.

2. Determine the Adjustment Needed:
We need to increase the profit by the amount of the missed revenue.

3. Calculate the True Net Profit:

\( \text{Calculated Net Profit} = \$20,000 \)
\( \text{Adjustment (Add Missed Revenue)} = \$1,200 \)

---

\( \mathbf{True\, Net\, Profit} = \mathbf{\$21,200} \)

Summary Table: The Effect on Profit

Use this table for quick recall. (Remember: Assets, Liabilities, and Drawings/Capital accounts do NOT directly feature in the Income Statement, so classifying something incorrectly into these categories is what causes the profit calculation to be wrong!)

Type of Error	Account Affected (Income Statement)	Effect on Calculated Profit
Expense is omitted or recorded as an Asset/Liability.	Expense is too LOW	OVERSTATED (Too High)
Revenue is omitted or recorded as an Asset/Liability.	Revenue is too LOW	UNDERSTATED (Too Low)
Closing Inventory is Overstated.	COGS is too LOW	OVERSTATED (Too High)
An Expense is incorrectly recorded as Revenue.	Expense is too LOW AND Revenue is too HIGH	Severely OVERSTATED