Unusual expenses, Effects of error

The income statement summarizes sales, expenses and profits for an accounting period. Expenses include cost of goods sold, operating and non-operating expenses, and unusual expenses. Operating expenses include administration and advertising, while interest and taxes are some of the non-operating expenses. Unusual expenses are extraordinary or one-time in nature. The company does not incur these expenses every period, but they may have a significant effect on profits and cash flow.

Types

Unusual items include discontinued operations, extraordinary items and changes in accounting principles. Discontinued operations refer to the sale or shutdown of a significant operating unit. For example, the costs associated with shutting down overseas manufacturing operations would count as unusual expenses. Extraordinary expenses are infrequent or one-time events, such as damages caused by natural disasters and accidents. Unusual expenses also include changes in accounting principles, such as a change from cash-basis to accrual-basis accounting.

Accounting

Income statements show unusual items in a separate section near the bottom. Items must be both unusual and infrequent to be in this section. For example, gains and losses from disposal of fixed assets or changes in inventory valuations are not part of this section. Companies may show the net income from continuing or regular operations as a separate line item, then list the extraordinary and discontinued items, and finally show the net income. The income statement shows these unusual items net of taxes. For example, if the corporate tax rate is 20 percent and the losses from flood damage are $10,000, the net loss is $8,000 — $10,000 x (1 – 0.20) = $10,000 x 0.80 = $8,000.

Impact

Unusual items affect the net income calculation on the income statement, including resulting in a loss. For example, a fire that destroys a small company’s production facilities could result in a net loss because the company would have to repurchase inventory, repair damages to the building and buy or lease new equipment. For public companies, unusual items also affect earnings per share, which is the net income divided by the number of shares outstanding. Changes in net income also affect operating cash flow.

Considerations

Investors should review the unusual items to determine whether they indicate an underlying problem. For example, if a company discontinues its Latin American operations, investors might want to know why management closed the business or could not find a buyer. Some companies may classify certain items as unusual in every accounting period to make the net income from continuing operations number look better. External stakeholders should assess whether the company management is trying to hide operational weaknesses in unusual items.

Accounting errors

Accounting errors are the mistakes committed in bookkeeping and accounting. The mistake may be one relating to routine or one relating to principle. They may occur in entering the transactions in the journal or subsidiary books or they may creep at the time of posting into the ledger.

Thus, errors may be committed while recording, classifying or summarizing the accounting transactions. The error may be the result of an act of omission or commission.

Classification of Errors:

Depending upon the nature of errors, they may be classified into the following four types:

(1) Errors of Omission

(2) Errors of Commission

(3) Errors of Principles

(4) Compensating Errors

1. Errors of Omission:

When a transaction is not recorded by mistake in the books of accounts, it is called an error of omission. The omission may be partial or complete.

Partial Omission may happen in relation to any subsidiary book. Here the transaction is entered in the subsidiary book but not posted to the ledger.

For example, goods returned by a customer has been entered in the sales returns book but not posted to the credit of customer’s account. Similarly, cash paid to the supplier has been entered in the payment side of the Cash Book but not posted to the debit of supplier’s account.

Complete omission can happen when the transaction is completely omitted from the books of accounts. For example, a bookkeeper failed to enter an invoice from the sales daybook.

2. Error of Commission:

When a transaction is entered in the books of accounts, it might be entered wrongly. It may be entered partially or incorrectly. Such error is called an error of commission. These errors arise often due to the ignorance or negligence or absent-mindedness of the accountant. It may be of different types. Examples of such errors are as follows:

(a) Errors relating to subsidiary books:

These are three types:

(i) Entering wrong amount in a subsidiary book, e.g., a purchase of Rs.430 may be entered in the Purchase Day Book as Rs.340 due to wrong transposition of figures.

(ii) Entering the transaction in a wrong subsidiary book, e.g., a purchase transaction may be entered in sales daybook and a sales transaction may be entered in the purchase daybook.

(iii) Wrong casting or carry forward of a subsidiary book. Casting refers to the process of totaling the daybooks periodically. A mistake in relation to totaling is called ‘error in casting’.

If there is excess totaling, the error is ‘over casting’ and short totaling is ‘under casting’. Sometimes, error may be the result of wrong carry forward of the total from one page of the daybook to another, e.g., the total of a page may be Rs.235 and carried forward to the next page as Rs.325.

(b) Errors relating to ledger:

These errors may be subdivided broadly into two types. They are: errors of posting and errors in balancing.

Error of posting may be further being subdivided as follows:

(i) Posting wrong amount on the right side of an account. Example. Sale of Rs.560 to Mr.Raja is entered as Rs.650 in the debit side of his account from the Sales Day Book.

(ii) Posting the same amount twice to an account. Example. A cash receipt of Rs.1000 from Mr.Ram is credited twice to his account.

(iii) Posting the correct amount to the wrong side of the right account. Example. A purchase of goods from Mr. Raj for Rs.1000 is debited to his account [instead of crediting],

(iv) Posting wrong amount to the wrong side of right account. Example. A purchase of Rs.1000 from Mr.Sam is debited to his account as Rs. 10,000.

(v) Posting the correct amount to the wrong account but on the right side. Example. A sale of goods to S.Anish for Rs.1000 is wrongly debited to G.Anish a/c.

(vi) Posting correct amount to the wrong account and on the wrong side. Example. A sale of Rs.1000 to S.Anish is wrongly credited to G.Anish a/c.

Errors in balancing:

Errors may arise in balancing the account resulting in excess or short balance of the account.

3. Errors of Principle:

These errors occur when entries are made against the principles of accounting. Example. Purchase of computer for office use is wrongly entered in the Purchases Day Book. Capital expenditure should not be treated as revenue expenditure.

These errors may be committed:

(a) Due to the inability to make a distinction between revenue and capital items;

(b) Due to inability to make a difference between business expenses and personal expenses;

(c) Due to inability to make a difference between productive expenses and non-productive expenses, e.g., wages paid for production may be debited to salaries a/c or salaries paid to office employees may be debited to wages a/c.

4. Compensating Errors:

These are the errors, which compensate themselves in the net results, i.e., over debit of one account is neutralized by an over credit in some other account to the same extent. Similarly a wrong credit might have been compensated by some wrong debit in some other account.

For example, if tax paid Rs.2, 500 is debited in Tax a/c as Rs.3, 000 and interest received Rs.3, 500 is credited in the interest a/c as Rs.4, 000, the excess debit of Rs.500 in tax a/c is compensated by an excess credit of Rs.500 in interest a/c.

This type of error may be committed in combination of different errors in different accounts. Normally the presence of this type of errors will not be revealed by the trial balance.

Impact of Errors on Trial Balance:

The agreement of the Trail balance is proof as to the arithmetical accuracy of the books of accounts. But it is a final proof of accuracy of books of accounts; it simply assures that for every debit there is a corresponding and equal credit.

If trial balance does not agree, it is a clear indication that there are certain errors in the books of accounts. Even if the trial balance agrees, there may be errors in the books of accounts.

Hence, the errors may be classified, depending upon the agreement of trial balance, as follows:

(a) Errors that do not affect the agreement of the trial balance.

(b) Errors that affect the agreement of the trial balance.

Errors that are not disclosed by Trial balance or not affect the agreement of the Trial balance are mainly the errors of principle, errors of complete omission, errors of commission and compensation errors.

Certain errors like entering a transaction in two subsidiary books or writing a wrong amount in a subsidiary book or mis-posting to the wrong account but correct side, etc. locating such errors are quite difficult and such errors can always be rectified by means of journal entries.

Errors that are disclosed by trial balance or affect the agreement of the Trial balance are mainly the errors of wrong or omission of posting, wrong totaling of subsidiary books, wrong carry-forward and wrong balancing of ledger accounts, etc.

Wrong posting may be in the forms of posting a wrong amount to a ledger account or posting to the wrong side of an account or double posting.

As these errors affect mostly only one side of ledger accounts, they will be revealed by the trial balance through disagreement of debit and credit totals.