May 2013 – accountingexplained

This topic is related to Suspense Account. If you realized that some errors will/will not have an effect on the result of your net profit, you will be required to make adjustments in order to correct the errors and recalculate the new net profit. This is a hard topic, not as easy as you think it is. People should identify whether the errors will cause an increase or decrease in net profit through logical reasoning and most people cannot do that quickly and correctly.

In order to ace this, you should categorize errors as:

1) errors that do affect the net profit and

2) errors that do not affect the net profit.

Now that’s done but how does one identify whether or not the errors affect the profit or not?

Pretty simple. If you guys remember income statement, picture the whole diagram and denote everything into an equation approach, you will arrive at:

Sales – (Cost of Goods Sold) = Gross Profit where

Cost of Goods Sold = Opening Inventory + Purchases – Closing Inventory (in the Trading Account) and that

Net Profit = Gross Profit – Expenses + Income (in the Profit and Loss Account).

SO, reorganizing the Net Profit as the subject of the FORMULA, you get

NET PROFIT = Sales – (Opening Inventory + Purchases – Closing Inventory) – Expenses + Income

!!! Please note to expand the bracket by multiplying with -1 (Do not just throw the bracket! Expand them like a mathematician!)

Finally we have NET PROFIT =

Sales – Opening Inventory – Purchases + Closing Inventory – Expenses + Income

So the conclusion, anything that deals with changing the sales, opening inventory, purchases, closing inventory, expenses and income values will cause a change in net profit. And anything outside these six variables will not change the value of net profit.

So now, how do we determine whether the errors will increase or decrease the net profit?

For illustration purposes, assume

Sales = $ 10,000, Opening Inventory = $ 2,000, Purchases = $ 5,000, Closing Inventory = #3,000, Expenses = 2,500 and no Income.

Net Profit = 10,000 – 2,000 -5,000 + 3,000 -2,500 = $3,500

If you have two errors, sales are undercast (under-reported) by $1,000 and rent are overcast (over-reported) by $ 500.

To correct the error for sales, Sales will be increased by $1,000 to $ 11,000.

Then you new Net Profit (ignoring rental error) = $ 11,000 – 2,000 – 5,000 + 3,000 – 2,500 = $ 4,500

You see that there is an increase in net profit of $ 1,000.

Now, for the rental error, this affect the expenses, expenses will be reduced by $ 500 to $ 2,000.

The new Net Profit (ignoring sales error) = $ 10,000 – 2,000 – 5,000 + 3,000 – 2,000 = $4,000

You see that there is an increase in net profit of $ 500.

So what will be the adjusted net profit? Adjusted net profit will be the old net profit $3,500 plus all the adjustments, the $1,000 and $500.

So $3,500 + $1000 +$500 = $ 5,000 or alternatively you could amend all the values using the equation approach,

Adjusted net profit (combined errors) = $ 11,000 – 2,000 – 5,000 +3,000 -2,000 = $5,000

Let’s say you dislike going through all this calculation, can we derive something from the equation approach? Yes, you can and here goes!

Increase in sales = Increase in net profit (so addition to existing net profit)

Increase in opening stock = Decrease in net profit (so subtraction to existing net profit)

Increase in purchases = Decrease in net profit (so subtraction to existing net profit)

Increase in closing stock = Increase in net profit (so addition to existing net profit)

Increase in expenses = Decrease in net profit (so subtraction to existing net profit)

Increase in gains = Increase in net profit (so addition to existing net profit)

For the reverse, everything is reversed too. Headache? Look at the equation below again.

NET PROFIT =

Sales – Opening Inventory – Purchases + Closing Inventory – Expenses + Income

There are three (+) positive sign, the sales, closing inventory and income. Increase in these three values increase the net profit and likewise.

There are three (-) negative sign, the opening inventory, purchases and expenses. Increase in these three values decreases the net profit and likewise.

Easy? Super easy man!

You can try to experiment on your own with

Sales = $ 10,000, Opening Inventory= $ 2,000, Purchases = $ 5,000, Closing Inventory = $ 3,000, Expenses = $ 2,500 and no Income. Increasing and decreasing the values as you wish. Try treating Income = $ 0.

Updated on 14/11/2017

Edited grammatical errors.
Changed ‘stock’ to ‘inventory’.
Changed ‘gains’ to ‘income’ or ‘other income’.

Suspense account is a little bit trickier than previous topic on Correction of Errors not affected by Trial Balance. There are more or less the same thing, involving correction of errors too. But obviously, it will get you from thinking, what will be the circumstances to use Suspense and what are the time to use Correction of Errors not affected by Trial Balance?

To make it a little bit clear, I throw out two circumstances,

1) You made a mistake of overlooking a transaction. (*overlooked means ignored or neglected) and

2) You made a mistake of entering a debit side of $100 and a credit side of $1,000 in the credit side.

The first instance will not affect the Trial Balance since both sides are ignored at the same time, thus giving you the same equal balances on debit and credit sides.

As for the second instance, you realized that there is a difference, a $900 differences in the debit side and the credit side. You can draw a conclusion that errors that do affect the Trial Balance will result in the need for suspense account. Suspense account is therefore any differences used to re-balance the trial balance. For the error in second instance, you will need to have a suspense account in the debit side of $900 in order to bring debit side to $1,000 (to equate them as the credit balance.)

Mistakes are commons in accounting. So real accountants will indeed be forced to use suspense account to re-balance their trial balance. However, suspense account consists of errors (multiple of them, you won’t be tested by correcting only one error, that will be too easy!) that must be corrected. –> the MAIN FOCUS of EXAM (I am not saying that Correction of Errors not Affecting Trial Balance is not important, they are equally important.)

Whatever the reasons of errors, you must realized that the combined correction of errors should be reduced back to zero. And one thing to bear in mind is that you only made one correction instead of two in Correction of Errors not Affecting Trial Balance. Essentially, one entry has been made correctly but not the subsequent entry –> which resulted in a difference in Trial Balance.

A comprehensive question involving suspense account could include testing on Trial Balance, Correction of Errors, Suspense Account, recalculation of adjusted profit and maybe reproducing a Profit and Loss or Balance Sheet statement.

Note that Profit and Loss is also called Income Statement and Balance Sheet is also called Statement of Financial Position (you must start to know them as most revised textbooks have started to use those names and you will probably see extinction in using Profit and Loss and Balance Sheet names in few years time.)

This post is still ongoing. 15th May 2013

Month: May 2013

The Effect of Errors on Profits

Suspense Account