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’.
accountingexplained 
Maaaan. ! Thank you sooo much.!!! Helped me alot. 🙂
It has helpedddd….
Love you, you made my life easy ♥️
Thank you . This has helped me a lot
thank you sir . finally now i understand the concept .
Thank you sir for concept. I now understand the whole show
Please what about returns inwards and returns outwards, how is it treated. Help out please
Hi, in order to understand more about return inward and return outward, do read up my “Trading and Profit and Loss account” blog post.
NET PROFIT = Sales – Return Inward – Opening Stock – Purchases + Return Outward + Closing Stock – Expenses + Gains/Other Income.
Please i have understand it. Thank you very much
Please another question, what about effect of cost of production on profit whether overcast or undercast. Thank you
Please what about effect of cost of production on profit whether overcast or undercast. Thank you
This might be a very late response but I am still responding because this is a good question. In a manufacturing company (please refer!), Production Cost or Cost of Production = Direct Material + Direct Expenses + Factory Overhead + Work in Progress.
If we use the same formula above, we will have
NET PROFIT = Sales – Return Inward – Opening Stock of Finished goods – DM – DE – FO – WIP + Return Outward + Closing Stock of Finished Goods – Expenses + Gains/Other Income.
Same principles as above.
It really helped me! Thankyou so much!!
Its really Helping,love it
Thanks so much, you really make my day.
Hi your question doesn’t have much context. The treatment wouldn’t change, depreciation charge will be posted (debited) to P&L (in this case, under the recommended distribution cost). As for the credit entry, this will be posted (credited) under your Property, Plant and Equipment or your Fixed Assets.
Thanks much sir
On Fri, May 10, 2019, 12:24 AM accountingexplained wrote:
> rebuters commented: “Hi your question doesn’t have much context. The > treatment wouldn’t change, depreciation charge will be posted (debited) to > P&L (in this case, under the recommended distribution cost). As for the > credit entry, this will be posted (credited) under your ” > Respond to this comment by replying above this line > > New comment on *accountingexplained > * > > > > *rebuters* commented > > on The Effect of Errors on Profits > . > > > in response to *stephen prosper dadzie*: > > Please how do we treat “Motor vehicles at 25% on the reducing balance > basis, charged to distribution cost” to the profit and loss account On Mon, > Jun 25, 2018, 11:52
How provision for doubtful debts is shown in financial statements? Please me out with this assignment
On Sun, May 12, 2019, 9:32 PM stephen prosper dadzie wrote:
> Thanks much sir > > > On Fri, May 10, 2019, 12:24 AM accountingexplained comment-reply@wordpress.com> wrote: > >> rebuters commented: “Hi your question doesn’t have much context. The >> treatment wouldn’t change, depreciation charge will be posted (debited) to >> P&L (in this case, under the recommended distribution cost). As for the >> credit entry, this will be posted (credited) under your ” >> Respond to this comment by replying above this line >> >> New comment on *accountingexplained >> * >> >> >> >> *rebuters* commented >> >> on The Effect of Errors on Profits >> . >> >> >> in response to *stephen prosper dadzie*: >> >> Please how do we treat “Motor vehicles at 25% on the reducing balance >> basis, charged to distribution cost” to the profit and loss account On Mon, >> Jun 25, 2018, 11:52
It is treated the same way as how you will treat accumulated depreciation. For Fixed Assets/Property, Plant and Equipment, you showed the Original Cost, less Accumulated Depreciation to get the Net Book Value. You do the same for Debtors/Receivables too.
That’s so good and well elaborated!