What is the difference between adjusting entries and correcting entries

Accounting Assignment

Summary of the Accounting Cycle

LEARNING OBJECTIVE 4 State the required steps in the accounting cycle.

Illustration 4-12 summarizes the steps in the accounting cycle. You can see that the cycle begins with the analysis of business transactions and ends with the preparation of a post-closing trial balance. Steps 1–3 may occur daily during the accounting period, as explained in Chapter 2. Companies perform Steps 4–7 on a periodic basis, such as monthly, quarterly, or annually. Steps 8 and 9—closing entries, and a post-closing trial balance—usually take place only at the end of a company's annual accounting period.

Illustration 4-12 Steps in the accounting cycle

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There are also two optional steps in the accounting cycle. As you have seen, companies may use a worksheet in preparing adjusting entries and financial statements. In addition, they may use reversing entries, as explained below.

Reversing Entries—An Optional Step Some accountants prefer to reverse certain adjusting entries by making a reversing entry at the beginning of the next accounting period. A reversing entry is the exact opposite of the adjusting entry made in the previous period. Use of reversing entries is an optional bookkeeping procedure; it is not a required step in the accounting cycle. Accordingly, we have chosen to cover this topic in Appendix 4A at the end of the chapter.

Correcting Entries—An Avoidable Step

LEARNING OBJECTIVE 5 Explain the approaches to preparing correcting entries.

Unfortunately, errors may occur in the recording process. Companies should correct errors, as soon as they discover them, by journalizing and posting correcting entries. If the accounting records are free of errors, no correcting entries are needed.

Ethics Note

When companies find errors in previously released income statements, they restate those numbers. Perhaps because of the increased scrutiny caused by Sarbanes-Oxley, in a recent year companies filed a record 1,195 restatements.

You should recognize several differences between correcting entries and adjusting entries. First, adjusting entries are an integral part of the accounting cycle. Correcting entries, on the other hand, are unnecessary if the records are error-free. Second, companies journalize and post adjustments only at the end of an accounting period. In contrast, companies make correcting entries whenever they discover an error. Finally, adjusting entries always affect at least one balance sheet account and one income statement account. In contrast, correcting entries may involve any combination of accounts in need of correction. Correcting entries must be posted before closing entries. To determine the correcting entry, it is useful to compare the incorrect entry with the correct entry. Doing so helps identify the accounts and amounts that should—and should not—be corrected. After comparison, the accountant makes an entry to correct the accounts. The following two cases for Mercato Co. illustrate this approach.

CASE 1 On May 10, Mercato Co. journalized and posted a $50 cash collection on account from a customer as a debit to Cash $50 and a credit to Service Revenue $50. The company discovered the error on May 20, when the customer paid the remaining balance in full.

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Illustration 4-13 Comparison of entries

Comparison of the incorrect entry with the correct entry reveals that the debit to Cash $50 is correct. However, the $50 credit to Service Revenue should have been credited to Accounts Receivable. As a result, both Service Revenue and Accounts Receivable are overstated in the ledger. Mercato makes the following correcting entry.

Illustration 4-14 Correcting entry

CASE 2 On May 18, Mercato purchased on account equipment costing $450. The transaction was journalized and posted as a debit to Equipment $45 and a credit to Accounts Payable $45. The error was discovered on June 3, when Mercato received the monthly statement for May from the creditor.

Illustration 4-15 Comparison of entries

Comparison of the two entries shows that two accounts are incorrect. Equipment is understated $405, and Accounts Payable is understated $405. Mercato makes the following correcting entry.

Illustration 4-16 Correcting entry

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Instead of preparing a correcting entry, it is possible to reverse the incorrect entry and then prepare the correct entry. This approach will result in more entries and postings than a correcting entry, but it will accomplish the desired result.

ACCOUNTING ACROSS THE ORGANIZATION

Yale Express Loses Some Transportation Bills

Christian Lagereek/iStockphoto.

Yale Express, a short-haul trucking firm, turned over much of its cargo to local truckers to complete deliveries. Yale collected the entire delivery charge; when billed by the local trucker, Yale sent payment for the final phase to the local trucker. Yale used a cutoff period of 20 days into the next accounting period in making its adjusting entries for accrued liabilities. That is, it waited 20 days to receive the local truckers' bills to determine the amount of the unpaid but incurred delivery charges as of the balance sheet date. On the other hand, Republic Carloading, a nationwide, long-distance freight forwarder, frequently did not receive transportation bills from truckers to whom it passed on cargo until months after the year-end. In making its year- end adjusting entries, Republic waited for months in order to include all of these outstanding transportation bills. When Yale Express merged with Republic Carloading, Yale's vice president employed the 20-day cutoff procedure for both firms. As a result, millions of dollars of Republic's accrued transportation bills went unrecorded. When the company detected the error and made correcting entries, these and other errors changed a reported profit of $1.14 million into a loss of $1.88 million!

What might Yale Express's vice president have done to produce more accurate financial statements without waiting months for Republic's outstanding transportation bills? Answer:

Yale's vice president could have engaged his accountants and auditors to prepare an adjusting entry based on an estimate of the outstanding transportation bills. (The estimate could have been made using past experience and the current volume of business.)

Copyright © 2012 John Wiley & Sons, Inc. All rights reserved.

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