The Trial Balance Agrees, but Is the Profit Right?

Correction of Errors

Skill: Evaluate

Stimulus

Question

(a) Evaluate Encik Rizal's claim that net profit is correct because the trial balance balances. Determine the effect of each error on net profit, then compute the corrected net profit.

(b) Based on your computation, decide whether the financial statements need to be corrected and justify your decision.

Thinking steps

1. Understand the limit of a trial balance: agreement only proves debits = credits and does not guarantee a correct profit; errors of principle, omission, commission and compensating errors leave the trial balance balanced yet can distort profit.
2. Error 1 (principle): RM480 repair expense capitalised as an asset. Expense understated → profit overstated by RM480 → correction subtracts RM480.
3. Error 2 (omission): RM900 credit sales omitted. Sales understated → profit understated by RM900 → correction adds RM900.
4. Error 3 (commission): RM60 discount allowed posted to discount received. Expense understated RM60 + income overstated RM60 → profit overstated by RM120 → correction subtracts RM120.
5. Error 4 (compensating): Sales +RM200 (profit +200) and Purchases +RM200 (profit -200) cancel out → net effect on profit = NIL.
6. Sum all effects starting from reported profit: RM18,500 + 900 - 480 - 120 + 0 = RM18,800 (up by RM300).
7. Evaluate and decide: the claim is wrong because profit changes by RM300; therefore the financial statements must be corrected, with the justification backed by figures, not opinion.

Model answer

Encik Rizal's claim is NOT correct. A balanced trial balance only proves total debits equal total credits; it cannot detect errors of principle, omission, commission and compensating errors, all of which can affect net profit.

Effect of each error on net profit:

1. Error of principle: repair cost (revenue expense RM480) wrongly treated as capital expenditure. Expenses understated RM480 → profit overstated RM480 → correcting it REDUCES profit by RM480.

2. Error of omission: credit sales RM900 completely left out → sales understated → profit understated RM900 → correcting it INCREASES profit by RM900.

3. Error of commission: discount allowed (expense) RM60 wrongly recorded in the discount received account (income). Expense understated RM60 and income overstated RM60 → profit overstated RM120 → correcting it REDUCES profit by RM120.

4. Compensating error: Sales +RM200 (profit up 200) and Purchases +RM200 (profit down 200) → net effect on profit = NIL.

Corrected net profit = RM18,500 + RM900 - RM480 - RM120 + RM0 = RM18,800.

(b) Decision: The financial statements MUST be corrected. Although the trial balance balances, the true net profit (RM18,800) differs by RM300 from the reported figure (RM18,500). An inaccurate profit misleads decision makers (tax, profit sharing, performance appraisal), so correction through the general journal and revised financial statements is compulsory.