DJ Stockbridge is currently pursuing a Masters degree in Accounting.
In this lesson, we'll identify and define several accounting errors, and we'll provide some useful tips that you can use to prevent yourself from making these errors in the future.
Imagine you've been working at the same accounting firm for the last ten years. The firm recently hired a new college graduate, Alex. He just completed his first work auditing the financials of a large company. You were asked to be his mentor and to review his work. You noticed he made a few mistakes, which included:
Incorrectly capitalizing $1 million of tools supplies expense when he should have expensed the amount.
Recording sales of $981 million when he should have recorded sales of $918 million.
Rounding cost of goods of $543.6 million down to $543 million.
Forgetting to include salary expense of $15 million.
Recording Total Assets that did not match up with Total Liabilities plus Total Shareholders' Equity.
In this lesson, we'll give each of these accounting errors a name. We'll also give a formal definition of each type of error, along with some helpful tips on how you can prevent these mistakes in the future. It's useful to note that these accounting errors are inadvertent; if they were on purpose, the errors would be considered fraud, and they would carry severe penalties for the wrongdoer.
Error of Principle
When Alex incorrectly capitalized $1 million of tools supplies expense, he made an error of principle. This error occurs when an entry is recorded in the incorrect amount or an inappropriate estimate is used, which violates the accounting standards. In the U.S., the standards are called U.S. Generally Accepted Accounting Principles (U.S. GAAP). Alex's mistake has the effect of over reporting operating income by $1 million because he recognized $0 of tooling supplies expense when he should have recorded $1 million of additional expenses. The best way to prevent this mistake from happening is to make sure you are well versed in the accounting standards. This is why public accountants need to take and pass all four levels of the CPA exam, and it's why they need to take continuing education classes to keep their CPA license.
Transposition and Commission Errors
An error of transposition occurs when two digits are reversed. Alex made this error when he recorded sales of $981 million instead of $918 million. As you can see, he incorrectly switched the 8 and the 1 when recording revenue. The error of transposition is part of a larger subset of errors called errors of commission. These are errors where the calculation was incorrectly inputted or calculated. A way to prevent these errors is to automate as much as possible. These errors occur because of human error such as a lapse of attention or people having fat fingers that hit the wrong key. Even if you're incredibly careful, check your work, and have others that check your work, there are still bound to be errors of commission.
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We were all taught the rounding principles in grade school, but if we haven't gone through the calculations in a while, we may make mistakes. When Alex rounded $543.6 million down to $543 million, he made a rounding error, incorrectly rounding whole numbers up or down. As you may know, if the tenths place digit is greater than or equal to 5, the number is rounded up to the next whole number. If the tenths place digit is less than 5, the number is rounded down to the nearest whole number. In Microsoft Excel, there are specific formulas that automate the rounding process. These are very helpful to prevent a silly mistake.
When Alex forgot to include salary expenses of $15 million, he committed an error of omission, which is when a transaction is not recorded. Only a careful checklist can prevent this type of error. Also, accounting has built-in checks thanks to the double entry bookkeeping system. If you forget one item your balance sheet accounts will not match.
Speaking of balance sheet accounts not matching brings us to counterbalancing errors, which are when financial statement categories fail to match. Alex made this type of error when he presented a balance sheet where Total Assets did not match Total Liabilities plus Total Shareholders' Equity. This is a fundamental concept in accounting: if the statements do not match, then you know something is wrong.
In this lesson you learned that accounting errors are inadvertent errors. If the errors were deliberate, they would be considered fraud. Some accounting errors to be mindful of are:
The error of principle, which is when an entry is recorded in the incorrect amount or an inappropriate estimate is used, violating the accounting standards
The error of transposition, which is when two digits are reversed when the transaction is input
The error of commission, which is when a transaction is improperly recorded
Rounding errors, which are when you incorrectly round whole numbers up or down
The error of omission, which is when a transaction is not recorded
Counterbalancing errors, which are when financial statement categories fail to match
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