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Any Answers Answered: error correction

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2nd Mar 2012
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Over recent weeks, there have been a few threads in Any Answers asking for advice on correcting errors, explains Steve Collings.

The typical scenarios entail firms taking on new clients and discovering errors that have been made in the client’s accounts. Advice normally entails liaising with the previous firm to ascertain the reasons why certain accounting treatments have taken place through to re-creating the prior year’s financial statements and prior-period adjustments.

This article will take a look at the various ways in which errors might occur within a set of financial statements, together with advice on the best ways in which to correct such errors.

Error

The term ‘error’ is taken to mean an unintentional mistake. FRS 3 Reporting Financial Performance also has the concept of ‘fundamental error’. Fundamental errors are defined at paragraph 63 to FRS 3 and are ‘those that are of such significance as to destroy the true and fair view and hence the validity of financial statements.’

What this means is that if the error had been discovered, prior to the financial statements being approved, the error would have been corrected before the financial statements were approved. Similarly, it is also taken to mean that if the error had been discovered after the financial statements had been issued but before the financial statements had been approved, the previous financial statements would have been withdrawn, the error(s) corrected and the revised financial statements issued.

However, sometimes errors are only discovered after the financial statements have been approved and issued. 

Immaterial errors

If an error is deemed to be immaterial, then it can simply be corrected in the current financial year. Such ‘errors’ are likely to occur in amounts such as accruals, prepayments, tax provisions, stock and provisions for debts – in other words figures which are generally estimated by the accountant. 

Consider the following illustration:

Company A Limited has decided to appoint your firm as its new accountants and tax advisers with effect from the 31 January 2012 year-end. You are preparing the financial statements for the client for the year-ended 31 January 2012 and extracts from the prior year’s financial statements are as follows:

                                  31.01.2011

                                         £

Turnover                     4,325,012

Pre-tax profit                 274,201

Net assets                   2,774,231

During the preparation of the 2012 financial statements you discovered that the previous firm had not taken into consideration an electricity bill which was received on 6 January 2011 amounting to £4,000 (excluding VAT) and which related to the period 1 October 2011 to 31 December 2011. The question arises as to how to deal with this omission.

The materiality of the transaction has to be deciphered and such a bill is clearly immaterial to the financial statements as a whole. Certainly at 0.09% of revenue (4,000 / 4,325,012 x 100) and  1.5% of pre-tax profit, the fact that a £4k electricity bill has been overlooked is not going to have a significant impact on the financial statements, hence it can simply be corrected in the current year.

Prior period adjustments

FRS 3 says that when an error is ‘fundamental’ (i.e. the error is of such significance as to destroy the true and fair view and hence the validity of the financial statements), such errors must be corrected by way of a prior period adjustment. That is, they should be adjusted by restating the previous year’s results and adjusting the opening balance of retained profits. When this happens what you will also need to do is to show that the previous year financial statements have been restated by including ‘as restated’ in the headings, illustrated as follows:

XYZ Limited

Profit and Loss Account for the year ended

31 January 2012

                                31.01.12                                    31.01.11

                                                                              (as restated)

                                      £                                                £

Worked example

On 20 January 2012, Accountants & Co Limited were appointed as accountants and tax advisers to New Client Limited. Copies of the financial statements and supporting lead schedules have been obtained from the outgoing firm as well as the financial statements of the new client for the year ended 31 December 2010 and you have produced draft financial statements for the year ended 31 December 2011, both of which are shown below:

New Client Ltd

Profit and Loss Account

For the year ended 31 December 2011

                                                                  2011                       2010

                                                                     £                             £

Turnover                                                  4,000,000               3,500,000

Cost of sales                                             (950,000)                (820,000)

Gross profit                                              3,050,000               2,680,000

Administrative expenses                        (1,200,000)                (800,000)

Profit on ordinary activities before tax     1,850,000               1,880,000

Taxation                                                    (700,000)                (600,000)

Profit after tax                                          1,150,000               1,280,000

New Client Ltd

Balance Sheet

As at 31 December 2011

                                     2011                         2010

                                        £                               £

Tangible fixed assets  5,325,000              4,000,000

Current assets

Stocks                              400,000                                300,000

Debtors                             175,000                               100,000

Cash at bank                     250,000                               200,000

                                          825,000                               600,000

Creditors: amounts falling

due within one year       (750,000)                            (350,000)

Net current assets                  75,000                              250,000

Total assets less current

liabilities                      5,400,000                    4,250,000

Capital and Reserves

Called up share capital                   100,000                        100,000 

Profit and loss account                5,300,000                     4,150,000

                                                  5,400,000               4,250,000  

During the preparation of the financial statements for the year ended 31 December 2011, you noticed that the previous firm had incorrectly posted a large item of plant purchased on 20 December 2010 to repairs and renewals expenditure (shown within administrative expenses) amounting to £325,000. The financial statements above do not contain any amendments to the financial statements in respect of this error, which the partner in charge of the client deems to be ‘fundamental’. He has asked you to correct the previous year’s financial statements by way of a prior period adjustment. 

What is going to happen is that in 2010 the administrative expenses will reduce by £325,000 and the tangible fixed assets will also increase by this amount. However, the depreciation element will also have to be considered, so for the purposes of this illustration assume that the client writes off the value of all its plant and machinery over five years on a straight line basis, hence (£325,000 / 5 years) = £65,000 worth of depreciation (the tax implications have been ignored for the purposes of this illustration).

New Client Ltd

Profit and Loss Account

For the year ended 31 December 2011

                                                                    2011                       2010

                                                                                             (as restated)

                                                                       £                             £

Turnover                                                   4,000,000               3,500,000

Cost of sales                                              (950,000)                (820,000)

Gross profit                                              3,050,000                2,680,000

Administrative expenses                         (1,265,000)                 (540,000)

Profit on ordinary activities before tax      1,785,000                2,140,000

Taxation                                                     (700,000)                (600,000)

Profit after tax                                            1,085,000               1,540,000

New Client Ltd

Balance Sheet

As at 31 December 2011

                                         2011                                 2010

                                                                              (as restated)

                                           £                                         £

Tangible fixed assets    5,520,000                           4,260,000

Current assets

Stocks                               400,000                           300,000

Debtors                             175,000                           100,000

Cash at bank                     250,000                            200,000

                                          825,000                            600,000

Creditors: amounts falling

due within one year                   (750,000)                    (350,000)

Net current assets                        75,000                      250,000

Total assets less current

liabilities                       5,595,000              4,510,000

Capital and Reserves

Called up share capital                100,000                       100,000

Profit and loss account             5,495,000                    4,410,000

                                               5,595,000              4,510,000  

New Client Limited

Statement of Total Recognised Gains and Losses

For the year ended 31 December 2011

                                                   2011                                 2010

                                                                                      (as restated)

                                                     £                                       £

Profit for the financial year    1,085,000                      1,540,000            

Prior year adjustment

(as explained in Note 5)            260,000

Total gains and losses recognised

since the last annual report    1,345,000

Note 4

Profit and Loss Account                        2011

                                                                            £

At beginning of year as previously stated       4,150,000

Prior year adjustment *                                      260,000

At beginning of year as restated                     4,410,000

Profit for the year                                            1,085,000

At the end of the year                                    5,495,000       

*              Cost of asset capitalised                     325,000

                Depreciation (5 years straight line)      (65,000)

                Prior year adjustment                           260,000

Disclosures

The FRSSE (effective April 2008) and FRS 3 Reporting Financial Performance require the effect of prior period adjustments on the results for the preceding period to be disclosed where practicable.  Such a disclosure may be as follows:

The cost of a tangible fixed asset was included within administrative expenses for the year ended 31 December 2010 which was considered to meet the recognition criteria of a tangible fixed asset as contained in FRS 15 ‘Tangible Fixed Assets’.  In the year to 31 December 2011, the cost of the asset together with effects of accumulated depreciation have been corrected by way of a prior period adjustment.  This has had the effect of increasing retained profits in 2010 by £260,000 and a corresponding increase in the net book value of tangible fixed assets for the year then ended.

Conclusion

In many situations, the correction of estimates may not give rise to error because clearly financial statements always contain some degree of estimation. However, in instances when the practitioner determines that an error is ‘fundamental’ (thus destroying the true and fair view), such errors need to be corrected by way of a prior period adjustments and the disclosure of such errors (together with the effect such errors have had on the results for the preceding period) need disclosure.

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘The Interpretation and Application of International Standards on Auditing’ (Wiley March 2011). He is also the author of ‘IFRS For Dummies’ (Wiley April 2012) and ‘The AccountingWEB Guide to IFRS’ (Sift Media May 2011) and was named ‘Accounting Technician of the Year’ at the 2011 British Accountancy Awards.

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By taylorag
02nd Mar 2012 15:40

What about very small companies or charities?

I have a client whose balances were understated by £140* because the previous accountant didn't include cash in hand.  The client wanted me to do the accounts "perfectly" as they had encountered problems with the previous accountant and didn't want to risk upsetting the charities people.  I therefore restated and noted in the Independent Examiner's report that I was restating the opening cash balance.  

The question is: did I go over the top, or did I simply reassure a client?  I think I did the latter, but would be interested in what others think of what I did

 

* against income of between £30 - £40k per annum

 

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collings
By Steven Collings
02nd Mar 2012 22:46

Layouts

The layouts seem to have gone a bit out of sync from the original file.  The £260k and £1.345m figures in the STRGL should be underneath the 2011 current year, whereas the only figure that should be in the 2010 comparative year should, of course, just be the £1.540m figure.

Cheers

steve

 

 

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By JCresswellTax
05th Mar 2012 10:06

It always amazes me.......

The number of accountants that act for "New Client Limited".

Thanks (0)
By Robert Lovell
05th Mar 2012 12:00

Re. Layouts

Hi Steve,

I had a few issues with the formatting when uploading your article, but think it's all fixed now.

Do let me know if it's as it should be now.

Thanks, Rob

 

Thanks (2)
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By Sarfraz Fayyaz
09th Mar 2012 11:27

Corporation tax return

Do we have to resubmit the corporation tax return for 2010 once error has been corrected?

Thanks

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