Key Concepts
An exam may ask about an error's effect in two ways — and they point in opposite directions:
- The effect of the error (before correction) — how the books are wrong right now. Answered with overstated (too high) or understated (too low).
- The effect of correcting the error (after correction) — how the figures change once you fix it. Answered with increase or decrease.
Why the split between overstated/understated and increase/decrease? The error itself never changed the real profit — only the reported figure was wrong. Overstated/understated describes that wrong figure as it stands right now, compared with the truth. Increase/decrease describes the action of fixing it — moving the figure from the wrong number to the right one.
Correcting an error simply reverses its effect: if an error understated profit, correcting it increases profit by the same amount.
Which errors change profit? Only errors that touch an income account or an expense account change profit. An error between two assets (or between an asset and a liability) does not affect profit — it only moves figures around the Statement of Financial Position.
The chain of reasoning is short:
- An income recorded too low → profit too low (understated). An income recorded too high → profit too high (overstated).
- An expense recorded too low → profit too high (overstated). An expense recorded too high → profit too low (understated).
Worked example — effect of five errors. These are the same five errors from the previous section. The last column shows the effect before correction.
| Error | Effect on profit (before correction) | Effect on the Statement of Financial Position (before correction) |
|---|---|---|
| 1. Sale $1,200 recorded as $120 | Sales revenue understated by $1,080 → profit understated by $1,080 | Trade receivables (current asset) understated by $1,080 |
| 2. Credit purchase $650 omitted | No effect — no income or expense account is involved | Inventory understated by $650; Trade payables understated by $650 |
| 3. Motor vehicle repairs $800 recorded as Motor vehicles | Motor vehicle repairs (expense) understated by $800 → profit overstated by $800 | Motor vehicles (non-current asset) overstated by $800 |
| 4. Sale $3,000 posted to the wrong customer | No effect — sales revenue was recorded correctly | No effect on total trade receivables — one customer up, another down by the same amount |
| 5. Payment $2,500 recorded on the wrong sides | No effect — no income or expense account is involved | Cash at bank overstated by $5,000; Trade payables overstated by $5,000 |
After correction, each effect simply flips. The same five errors, now showing what happens once each is corrected.
| Error | Effect on profit (after correction) | Effect on the Statement of Financial Position (after correction) |
|---|---|---|
| 1. Sale $1,200 recorded as $120 | Profit increases by $1,080 | Trade receivables increase by $1,080 |
| 2. Credit purchase $650 omitted | No effect — no income or expense account is involved | Inventory increases by $650; Trade payables increase by $650 |
| 3. Motor vehicle repairs $800 recorded as Motor vehicles | Profit decreases by $800 | Motor vehicles decrease by $800 |
| 4. Sale $3,000 posted to the wrong customer | No effect — sales revenue was already recorded correctly | No effect on total trade receivables — the correction just moves the amount to the right customer |
| 5. Payment $2,500 recorded on the wrong sides | No effect — no income or expense account is involved | Cash at bank decreases by $5,000; Trade payables decrease by $5,000 |
Income and expense accounts move profit; assets and liabilities do not. An expense too high or an income too low understates profit (profit too low); an expense too low or an income too high overstates profit (profit too high). Correcting an error reverses whatever it did — an understatement becomes an increase, an overstatement becomes a decrease.
Mixing up the two directions. "Effect of the error" is overstated/understated; "effect of correcting the error" is increase/decrease. Read the question carefully — they are opposites.
Assuming every error changes profit. An error between two asset accounts (like a sale posted to the wrong customer) leaves profit unchanged — only income and expense accounts move profit.
Getting an expense error backwards. An expense recorded too low makes profit overstated (too high), not too low — the missing cost was never taken off.