CHAPTER 22

Accounting Changes and

Error Analysis
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Discuss the types of accounting 3. Describe the accounting for
changes and the accounting for correction of errors.
changes in accounting policies.
4. Analyze the effect of errors.
2. Describe the accounting and
reporting for changes in
estimates.

22-1
 PREVIEW OF CHAPTER 22

Intermediate Accounting
IFRS 3rd Edition
22-2
Kieso ● Weygandt ● Warfield
 LEARNING OBJECTIVE 1
Accounting Changes Discuss the types of accounting
changes and the accounting for
changes in accounting policies.

Background
Accounting Alternatives:
◆ Diminish the comparability of financial information.

◆ Obscure useful historical trend data.

Types of Accounting Changes:

1. Change in Accounting Policy.

2. Changes in Accounting Estimate.

Errors are not considered an accounting change.

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 Changes In Accounting Policy

Change from one accepted accounting policy to another.

Examples include:

◆ Average-cost to LIFO.

◆ Cost-recovery to percentage-of-completion method.

Adoption of a new policy in recognition of events that have

occurred for the first time or that were previously immaterial is
not an accounting change.

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 Changes In Accounting Policy

Three approaches for reporting changes:

1) Currently.

2) Retrospectively.

3) Prospectively (in the future).

IASB requires use of the retrospective approach.

Rationale - Users can then better compare results from one

period to the next.

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 Changes In Accounting Policy

Retrospective Accounting Change Approach

Company reporting the change
1) Adjusts its financial statements for each prior period
presented to the same basis as the new accounting
policy.

2) Adjusts the carrying amounts of assets and liabilities as

of the beginning of the first year presented. Also makes
an offsetting adjustment to the opening balance of
retained earnings or other appropriate component of
equity or net assets as of the beginning of the first year
presented.
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 Changes In Accounting Policy

Retrospective Accounting Change: Long-Term

Contracts
Illustration: Denson SA has accounted for its income from long-
term construction contracts using the cost-recovery (zero-profit)
method. In 2019, the company changed to the percentage-of-
completion method. Management believes this approach provides
a more appropriate measure of the income earned. For tax
purposes, the company uses the cost-recovery method and plans
to continue doing so in the future. (Assume a 40 percent enacted
tax rate.)

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 Changes In Accounting Policy
ILLUSTRATION 22.1
Comparative Income
Statements for Cost-
Recovery versus
Percentage-of-Completion
Methods

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 Changes In Accounting Policy

Data for Retrospective Change Example ILLUSTRATION 22.2

Journal entry Construction in Process 220,000

beginning of Deferred Tax Liability 88,000
2019
Retained Earnings 132,000

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 Changes In Accounting Policy

Reporting a Change in Policy

Major disclosure requirements are as follows.
1. Nature of the change in accounting principle.
2. Reasons why applying the new accounting policy provides reliable
and more relevant information;
3. For the current period and each prior period presented, to the
extent practicable, the amount of the adjustment:
a) For each financial statement line item affected; and
b) Basic and diluted earnings per share.
4. The amount of the adjustment relating to periods before those
presented, to the extent practicable.

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 Changes In Accounting Policy

Retained Earnings Adjustment

Retained earnings balance is €1,360,000 at the beginning of 2017.

ILLUSTRATION 22.4
Before Change

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 Changes In Accounting Policy

Retained Earnings Adjustment

After Change ILLUSTRATION 22.5

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LO 1
 Changes In Accounting Policy

Illustration: Cherokee Construction Company changed from the cost-

recovery to the percentage-of-completion method of accounting for
long-term construction contracts during 2019. For tax purposes, the
company employs the cost-recovery method and will continue this
approach in the future. (Hint: Adjust all tax consequences through the
Deferred Tax Liability account.) The appropriate information related to
this change is as follows.

2018
2019

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 Changes In Accounting Policy

2018
2019

Instructions: (assume a tax rate of 35%)

(a) What entry(ies) are necessary to adjust the accounting records
for the change in accounting principle?
(b) What is the amount of net income and retained earnings that
would be reported in 2019? Assume beginning retained earnings
for 2018 to be $100,000.

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 Changes In Accounting Policy

Pre-Tax Income from Long-Term Contracts

35%
Percentage- Cost- Tax Net of
Date of-Completion Recovery Difference Effect Tax
2018 $ 780,000 $ 610,000 170,000 59,500 $ 110,500
2019 700,000 480,000 220,000 77,000 143,000

Journal entry (recorded in 2019)

Construction in Process 170,000

Deferred Tax Liability 59,500
Retained Earnings 110,500

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 Changes In Accounting Policy

Retrospective Accounting Change: Inventory

Methods
Illustration: Lancer Company has accounted for its inventory
using the average-cost method. In 2019, the company changes to
the FIFO method because management believes this approach
provides a more appropriate measure of its inventory costs.

Additional information for Lancer Company:

1. Lancer Company started its operations on January 1, 2017. At

that time, shareholders invested $100,000 in the business in
exchange for ordinary shares.
ILLUSTRATION 22.6
Lancer Company Information
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 Retrospective Change: Inventory Methods
ILLUSTRATION 22.6
Lancer Company Information
Additional information for Lancer Company:

2. All sales, purchases, and operating expenses for the period

2017–2019 are cash transactions. Lancer’s cash flows over
this period are as follows.

3. Lancer has used the average-cost method for financial reporting

since its inception.
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 Retrospective Change: Inventory Methods
ILLUSTRATION 22.6
Lancer Company Information
Additional information for Lancer Company:

4. Inventory determined under average-cost and FIFO for the

period 2017–2019 is as follows.

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 Retrospective Change: Inventory Methods
ILLUSTRATION 22.6
Lancer Company Information
Additional information for Lancer Company:

5. Cost of goods sold under average-cost and FIFO for the period
2017–2019 is as follows.

6. Earnings per share is not required on the income statement.

7. All tax effects for this illustration should be ignored.

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 ILLUSTRATION 22.7
Given the information about Lancer Company. Lancer Financial Statements
(Average-Cost)

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 ILLUSTRATION 22.7

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 Retrospective Change: Inventory Methods

Illustration 22.8 (to follow) shows Lancer’s income statement,

retained earnings statement, statement of financial position, and
statement of cash flows for 2017–2019 under FIFO.

• The cash flow statement under FIFO is the same as under

average-cost.

• Net incomes are different in each period.

• There is no cash flow effect from these differences in net

income. (If we considered income taxes, a cash flow effect
would result.)

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 ILLUSTRATION 22.8
Lancer Company information using LIFO. Lancer Financial Statements
(FIFO)

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 ILLUSTRATION 22.8

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 Retrospective Change: Inventory Methods

Under retrospective application, the change to FIFO inventory

valuation affects reported inventories, cost of goods sold, net
income, and retained earnings.

To account for the change we make the following entry.

Inventory 5,000
Retained Earnings 5,000
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 Reporting a Change in Policy

Lancer Company

▪ reports net income under the newly adopted FIFO

method for both 2018 and 2019.
▪ retrospectively adjusted the 2018 income statement to
report the information on a FIFO basis.
▪ Notes to the financial statements
• indicate the nature of the change, why the company
made the change, and the years affected.

• provide data on important differences between the

amounts reported under average-cost versus FIFO.

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 Retained Earnings Adjustment

If Lancer presents comparative statements for 2018 and 2019

under FIFO, then it must change the beginning balance of
retained earnings at January 1, 2018. The difference is computed
as follows.

The $2,000 difference is the cumulative effect.

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 Retained Earnings Adjustment

Lancer adjusted the beginning balance of retained earnings on

January 1, 2018, for the excess of FIFO net income over
average-cost net income in 2017.

ILLUSTRATION 22.12
Retained Earnings Statements after Retrospective Application

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 Changes In Accounting Policy

Direct and Indirect Effects of Changes

◆ Direct Effects - IASB takes the position that companies
should retrospectively apply the direct effects of a
change in accounting policy.

◆ Indirect Effect is any change to current or future cash

flows of a company that result from making a change in
accounting principle that is applied retrospectively.

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 Changes In Accounting Policy

Impracticability
Companies should not use retrospective application if one of the
following conditions exists:
1. Company cannot determine the effects of the retrospective
application.

2. Retrospective application requires assumptions about

management’s intent in a prior period.

3. Retrospective application requires significant estimates that

the company cannot develop.

If any of the above conditions exists, the company prospectively applies

the new accounting principle.
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 LEARNING OBJECTIVE 2
Changes in Accounting Describe the accounting and
reporting for changes in
Estimates estimates.

Examples of Estimates
1. Bad debts.
2. Inventory obsolescence.
3. Useful lives and residual values of assets.
4. Periods benefited by deferred costs.
5. Liabilities for warranty costs and income taxes.
6. Recoverable mineral reserves.
7. Change in depreciation estimates.
8. Fair value of financial assets or financial liabilities.
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 Changes in Accounting Estimates

Prospective Reporting
Changes in accounting estimates are reported prospectively.
Account for changes in estimates in

1. the period of change if the change affects that period only,

or

2. the period of change and future periods if the change

affects both.

IASB views changes in estimates as normal recurring

corrections and adjustments and prohibits retrospective
treatment.

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 Changes in Accounting Estimates

Illustration: Arcadia HS purchased equipment for $510,000

which was estimated to have a useful life of 10 years with a
salvage value of $10,000 at the end of that time. Depreciation has
been recorded for 7 years on a straight-line basis. In 2019 (year
8), it is determined that the total estimated life should be 15 years
with a salvage value of $5,000 at the end of that time.
Required:
⚫ What is the journal entry to correct No Entry
prior years’ depreciation expense? Required

⚫ Calculate depreciation expense for 2019.

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 After 7
Changes in Accounting Estimates years

Equipment cost $510,000 First, establish book

Residual value - 10,000 value at date of
Depreciable base 500,000 change in estimate.
Useful life (original) 10 years
Annual depreciation $ 50,000 x 7 years = $350,000

Statement of Financial Position (Dec. 31, 2018)

Property, Plant, and Equipment:
Equipment $510,000
Accumulated depreciation 350,000
Book value (BV) $160,000

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 Changes in Accounting Estimates

Book value $160,000 Second, calculate

Residual value (if any) 5,000 depreciation expense
Depreciable base 155,000 for 2019.
Useful life 8 years
Annual depreciation $ 19,375

Journal entry for 2019

Depreciation expense 19,375

Accumulated depreciation 19,375

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 Changes in Accounting Estimates

Disclosures
A company should disclose the nature and amount of a change in
an accounting estimate that has an effect in the current period or
is expected to have an effect in future periods (unless it is
impracticable to estimate that effect).

Companies need not disclose changes in accounting estimate

made as part of normal operations, such as bad debt allowances
or inventory obsolescence, unless such changes are material.

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 LEARNING OBJECTIVE 3
Accounting Errors Describe the accounting for
correction of errors.

Types of Accounting Errors:

1. A change from an accounting principle that is not generally
accepted to an accounting policy that is acceptable.
2. Mathematical mistakes.
3. Changes in estimates that occur because a company did
not prepare the estimates in good faith.
4. Failure to accrue or defer certain expenses or revenues.
5. Misuse of facts.
6. Incorrect classification of a cost as an expense instead of
an asset, and vice versa.

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 Accounting Errors
ILLUSTRATION 22.16
Accounting-Error Types

Accounting Category Type of Restatement

Expense recognition Recording expenses in the incorrect period or for an
incorrect amount.
Revenue recognition Instances in which revenue was improperly recognized,
questionable revenues were recognized, or any other
number of related errors that led to misreported revenue.
Misclassification Include restatements due to misclassification of current or
non-current accounts or those that impact cash flows from
operations.
Equity—other Improper accounting for EPS, restricted stock, warrants,
and other equity instruments.
Reserves/Contingencies Errors involving accounts receivables’ bad debts, inventory
reserves, income tax allowances, and loss contingencies.
Long-lived assets Asset impairments of property, plant, and equipment;
goodwill; or other related items.

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 Accounting Errors
ILLUSTRATION 22.16
Accounting-Error Types

Accounting Category Type of Restatement

Taxes Errors involving correction of tax provision, improper
treatment of tax liabilities, and other tax-related items.
Equity—other Improper accounting for comprehensive income equity
comprehensive income transactions including foreign currency items, revaluations
of plant assets, unrealized gains and losses on certain
investments in debt, equity securities, and derivatives.

Inventory Inventory costing valuations, quantity issues, and cost of

sales adjustments.
Equity—share options Improper accounting for employee share options.
Other Any restatement not covered by the listed categories,
including those related to improper accounting for
acquisitions or mergers.

Source: T. Baldwin and D. Yoo, “Restatements—Traversing Shaky Ground,” Trend Alert, Glass Lewis & Co.
(June 2, 2005), p. 8.; and “2015 Financial Restatements,” Audit Analytics (March 2015).

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 Accounting Errors

◆ All material errors must be corrected.

◆ Record corrections of errors from prior periods as an

adjustment to the beginning balance of retained earnings in
the current period.

◆ Such corrections are called prior period adjustments.

◆ For comparative statements, a company should restate the

prior statements affected, to correct for the error.

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 Example of Error Correction

Illustration: In 2020 the bookkeeper for Selectro plc discovered

an error. In 2019 the company failed to record £20,000 of
depreciation expense on a newly constructed building. This
building is the only depreciable asset Selectro owns. The
company correctly included the depreciation expense in its tax
return and correctly reported its income taxes payable.

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 Example of Error Correction

Selectro’s income statement for 2019 with and without the error.
ILLUSTRATION 22.17
Error Correction Comparison
ILLUSTRATION 22.17

What are the entries that Selectro should have made and did make
for recording depreciation expense and income taxes?

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 ILLUSTRATION 22.17

ILLUSTRATION 22.18
Error Entries

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LO 3
 Example of Error Correction
ILLUSTRATION 22.18

The £20,000 omission error in 2019 results in the following effects.

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 Example of Error Correction

Prepare the proper correcting entry in 2020, that should be

made by Selectro. ILLUSTRATION 22.18

Correcting Retained Earnings 12,000

Entry in
2020

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 Example of Error Correction

Prepare the proper correcting entry in 2020, that should be

made by Selectro. ILLUSTRATION 22.18

Reversal
Correcting Retained Earnings 12,000
Entry in Deferred Tax Liability 8,000
2020

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 Example of Error Correction

Prepare the proper correcting entry in 2020, that should be

made by Selectro. ILLUSTRATION 22.18

Correcting Retained Earnings 12,000

Entry in Deferred Tax Liability 8,000
2020
Accumulated Depreciation—Buildings 20,000

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 Example of Error Correction

Single-Period Statements
Illustration: Selectro Company has a beginning retained earnings
balance at January 1, 2020, of £350,000. The company reports net
income of £400,000 in 2020.
ILLUSTRATION 22.19
Reporting an Error—
Single-Period Financial
Statement

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 Example of Error Correction

Comparative Statements
Company should

1. make adjustments to correct the amounts for all affected

accounts reported in the statements for all periods
reported.

2. restate the data to the correct basis for each year

presented.

3. show any catch-up adjustment as a prior period

adjustment to retained earnings for the earliest period it
reported.

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 Accounting Errors

Summary of Accounting Changes and

Correction of Errors ILLUSTRATION 22.21

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 Summary of Changes and Errors
ILLUSTRATION 22.21

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 LEARNING OBJECTIVE 4
Error Analysis Analyze the effects of errors.

Companies must answer three questions:

1. What type of error is involved?

2. What entries are needed to correct for the error?

3. After discovery of the error, how are financial statements to

be restated?

Companies treat errors as prior-period adjustments and report

them in the current year as adjustments to the beginning
balance of Retained Earnings.

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 Error Analysis

Statement of Financial Position Errors

Statement of financial position errors affect only the
presentation of an asset, liability, or equity account.

◆ Current year error - reclassify item to its proper position.

◆ Prior year error - restate the statement of financial position

of the prior year for comparative purposes.

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 Error Analysis

Income Statement Errors

Improper classification of revenues or expenses.
◆ Current year error - reclassify item to its proper position.

◆ Prior year error - restate the income statement of the prior

year for comparative purposes.

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 Error Analysis

Statement of Financial Position and Income

Statement Errors
Counterbalanceing errors will be offset or corrected over
two periods.
1. If company has closed the books in the current year:
a. If the error is already counterbalanced, no entry is necessary.

b. If the error is not yet counterbalanced, make entry to adjust

the present balance of retained earnings.

For comparative purposes, restatement is necessary even if a

correcting journal entry is not required.
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 Error Analysis

Statement of Financial Position and Income

Statement Errors
Counterbalanceing errors will be offset or corrected over
two periods.
2. If company has not closed the books in the current year:
a. If error already counterbalanced, make entry to correct the
error in the current period and to adjust the beginning
balance of Retained Earnings.

b. If error not yet counterbalanced, make entry to adjust the

beginning balance of Retained Earnings.

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 Error Analysis

Statement of Financial Position and Income

Statement Errors
Non-Counterbalancing Errors
◆ Not offset in the next accounting period.

◆ Companies must make correcting entries, even if they have

closed the books.

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 Error Analysis
E22-19 (Error Analysis; Correcting Entries): A partial trial balance of
Dickinson Ltd. is as follows on December 31, 2019.

Dr. Cr.
Supplies R 2,500
Salaries and wages payable R 1500
Interest receivable 5,100
Prepaid insurance 90,000
Unearned rent 0
Interest payable 15,000

Instructions: (a) Assuming that the books have not been closed, what
are the adjusting entries necessary at December 31, 2019?

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 Error Analysis
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2019?

1. A physical count of supplies on hand on December 31, 2019, totaled

R1,100.

Supplies Expense (R2,500 – R1,100) 1,400

Supplies on Hand 1,400

2. Accrued salaries and wages on December 31, 2019, amounted to

R4,400.

Salary and Wages Expense 2,900

Accrued Salaries and Wages 2,900

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 Error Analysis
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2019?

3. Accrued interest on investments amounts to R4,350 on December

31, 2019.

Interest Revenue (R5,100 – R4,350) 750

Interest Receivable 750

4. The unexpired portions of the insurance policies totaled R65,000 as

of December 31, 2019.

Insurance Expense 25,000

Prepaid Insurance 25,000

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 Error Analysis
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2019?

5. R24,000 was received on January 1, 2019, for the rent of a building

for both 2019 and 2020. The entire amount was credited to rental
income.

Rental Income (R24,000 ÷ 2) 12,000

Unearned Rent 12,000

6. Depreciation for the year was erroneously recorded as R5,000 rather

than the correct figure of R50,000.

Depreciation Expense 45,000

Accumulated Depreciation 45,000

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 Error Analysis
E22-19 (Error Analysis; Correcting Entries): A partial trial balance of
Dickinson Corporation is as follows on December 31, 2019.

Dr. Cr.
Supplies R 2,500
Salaries and wages payable R 1500
Interest receivable 5,100
Prepaid insurance 90,000
Unearned rent 0
Interest payable 15,000

Instructions: (b) Assuming that the books have been closed, what are
the adjusting entries necessary at December 31, 2019?

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 Error Analysis
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2019?

1. A physical count of supplies on hand on December 31, 2019, totaled

R1,100.

Retained Earnings 1,400

Supplies 1,400

2. Accrued salaries and wages on December 31, 2019, amounted to

R4,400.

Retained Earnings 2,900

Accrued Salaries and Wages 2,900

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 Error Analysis
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2019?

3. Accrued interest on investments amounts to R4,350 on December

31, 2019.

Retained Earnings (R5,100 – R4,350) 750

Interest Receivable 750

4. The unexpired portions of the insurance policies totaled R65,000 as

of December 31, 2019.

Retained Earnings 25,000

Prepaid Insurance 25,000

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 Error Analysis
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2019?

5. R24,000 was received on January 1, 2019 for the rent of a building

for both 2019 and 2020. The entire amount was credited to rental
income.

Retained Earnings 12,000

Unearned Rent 12,000

6. Depreciation for the year was erroneously recorded as R5,000 rather

than the correct figure of R50,000.

Retained Earnings 45,000

Accumulated Depreciation 45,000

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