What Is an Error of Principle?
An error of principle is an accounting mistake in which an entry violates a fundamental principle of accounting or a fundamental accounting principle established by a company.
- Errors of principle typically include correct amounts but violations of company accounting principles.
- Common errors of principle can include: mixing up debits and credits, using the wrong liability account for an expense, crediting the wrong type of asset account for a payment, or potentially debiting the wrong client account in an accounts receivable transaction.
- Resolving errors of principle after final financial statement reporting has been released is typically the most costly for a company in both resolution and reputation.
Understanding Error of Principle
There can be several types of accounting errors. Different types of errors in accounting may be classified as: errors of original entry, errors of duplication, errors of omission, errors of commission, errors of entry reversal, compensating errors, and an error of principle.
Companies strive to hire experienced employees and incorporate protocols that help to mitigate accounting errors. However, errors can still happen. If they do occur and are identified, companies and Generally Accepted Accounting Principles (GAAP) provide guidance for correcting them. Many companies, particularly large companies with complex accounting, may also purchase Errors and Omissions Insurance, which provides some monetary protections if substantial errors are found.
Types of Errors of Principle
Errors of principle are often simply accounting entries recorded in the incorrect account. The amounts are often correct, unlike an error of original entry. Oftentimes, the error of principle is a procedural error, meaning that the value recorded is correct but the entries are made in the wrong accounts. These types of errors can be difficult to identify if they occur because they can still lead to appropriate balancing of debits and credits on the balance sheet, as well as appropriate summations carrying over to the income statement and cash flow statement.
Errors of principle can also be a concern when a company changes an established principle already in processing to another, new principle. From time to time, companies may change certain principles within GAAP parameters to better represent their company’s activities or to integrate a new type of dashboard metrics monitoring system that helps them more efficiently manage the performance measures of a business.
Examples of Errors of Principle
At a base level, accounting clerks are responsible for learning and maintaining a working knowledge of the account categories a company uses on its balance sheet. These categories are particularly important because they lead to the analysis of asset and liability balances on the balance sheet. Account categories also flow over into the income statement where expenses are reported as either direct, indirect, or capital expenses.
The complexity of a company’s balance sheet accounts can affect how easily errors of principle can be to initiate. Most companies keep their balance sheet expense accounts fairly simplified as to avoid the potential for errors of principle. Common expensing accounts for current liabilities include: accounts payable, notes payable, wages payable, and taxes payable. The appropriate expensing entries would be to debit the liability account and credit an asset account. Using the wrong liability accounts or crediting the wrong type of asset account would result in an error of principle. Mixing up the credits and debits or potentially debiting the wrong client account in an accounts receivable transaction can also be common errors.
When a company incorporates a new type of reporting or integrates new account categories within its asset and liability reporting, errors of principle can become more likely. This can happen when a company overhauls its reporting to create new business segments. New business segments may be integrated from time to time as a company grows or enters into a new segment. Taking extra care to ensure that errors of principle do not occur in these transitions will be very important for a company’s accounting success.
Resolving Errors of Principle
Discovering an error of principle usually takes some detective work, since looking at a trial balance, which contains the name of the account and its value, only shows whether debits equal credits. How the error is corrected will depend on the type of error.
Many errors of principle will be detected before a company issues its final financial statements at the end of a reporting period. Errors may be found in the final review of reporting or spotted by financial managers working in conjunction with accounting teams on performance reporting. If an error of principle is identified prior to the release of a final financial report, it can be most easily resolved by making appropriate correcting entries to reverse and appropriately categorize the transaction. In most accounting systems this is a fairly straightforward move that results in a fast resolution.
If an error of principle is identified after final financial statements are released, the Financial Accounting Standards Board requires companies follow Accounting Standards Codification 250 under GAAP to make necessary resolutions. Errors found after financial statement releases can be the most harmful both in cost and reputation. These types of errors will typically require some type of restatement or disclosures for shareholders.
If an error is drastic enough, a company may file a claim for coverage under its Errors and Omissions Insurance Policy, if one is in place. Errors and Omissions Insurance can provide monetary remuneration for errors of principle made by employees, negligence, or company policies.