What Is An Error Of Principle? Examples And How To Correct

In accounting, an error of principle occurs when a transaction is recorded in violation of fundamental accounting principles or established company policies, leading to inaccurate financial reporting. Such errors can distort financial statements, affecting the representation of a company’s financial health and performance.

Accounting principles, such as (GAAP), serve as a set of standardized rules to ensure consistency and reliability in financial reporting. When these principles are misapplied, whether by capitalizing an expense or misclassifying assets, it can result in significant discrepancies. Correcting these errors is essential to maintain the integrity of financial statements.

What Is An Error of Principle In Accounting?

An error of principle in accounting refers to a mistake that occurs when an entry violates a fundamental accounting principle or an established accounting principle by the company. It occurs when a transaction is recorded in a manner that misapplies a principle in a particular situation or uses the wrong accounting principle for a specific transaction, which can lead to inaccurate financial reporting.

What are Accounting Principles?

Accounting principles are the rules and standards that businesses and other entities must follow when reporting financial data. These principles ensure that all financial transactions are documented and reported consistently and properly. The primary purpose is to generate comparable financial statements so that stakeholders may make informed decisions. These principles are usually referred to as Generally Accepted Accounting Principles (GAAP), and accountants use them to ensure the reliability and accuracy of their financial reporting. Businesses that adhere to these criteria can give clear and consistent financial information.

Error of Principle Example

A company purchases a delivery vehicle for $10,000. According to accounting principles, the vehicle should be recorded as a long-term asset and depreciated over its useful life. However, due to an error of principle, the company mistakenly treats the vehicle as an expense.

The correct treatment that follows the accounting principles:

The vehicle should be capitalized and depreciated over its useful life, as it provides future economic benefits.

Debit: Delivery Vehicle (Asset) $10,000
Credit: Cash or Accounts Payable $10,000

The error of principle:

The vehicle is incorrectly treated as an expense in the income statement, which violates the Matching Principle and the Going Concern Principle (assets should be capitalized if they provide future value).

Debit: Vehicle Expense $10,000
Credit: Cash or Accounts Payable $10,000

The company’s expenses are overstated, and assets are understated in the balance sheet. The company’s profit will be understated in the year the purchase is made, and the asset (a vehicle) is not shown on the balance sheet as it should be. This error leads to inaccurate financial statements, distorting the company's financial position and performance.

How To Correct Error of Principle?

To correct an error of principle, the company must adjust the financial records to align with the proper accounting treatment under generally accepted accounting principles (GAAP) or other relevant company accounting principles.

Here are the steps to correct an error of principle:

1- Identify the Error

The first step is to identify the nature of the error. An error of principle occurs when an accounting entry violates a fundamental accounting principle, such as capitalizing an expense or expensing a capital item. The company must review the transaction and determine how the principle was misapplied.

2- Reverse the Incorrect Entry

The next step is to reverse the original incorrect entry in the accounting records. This involves undoing the effect of the initial misapplication of accounting principles. This step is crucial to prevent any distortion of the financial records and to restart with the correct approach.

3- Record the Correct Entry

Once the incorrect entry has been reversed, the company must record the correct accounting entry. This involves applying the proper accounting principle to the transaction under the relevant standards (such as GAAP or IFRS).

4- Adjust Financial Statements

The company must adjust the affected financial statements. This typically includes the balance sheet and the income statement. The balance sheet must be updated to reflect the correct value of assets, liabilities, and equity, while the income statement must be adjusted to ensure that the correct amounts of income and expenses are reported.

How can you Avoid Errors of Principle?

To avoid errors of principle in accounting, it is essential to establish a solid understanding of accounting principles and consistently apply them in the preparation of financial statements. These errors typically arise from misapplying or misunderstanding accounting standards, leading to incorrect classification or treatment of transactions. You can avoid these errors by following several ways such as:

Keep your staff updated and well-trained

One of the most important steps in preventing errors of principle is ensuring that accounting staff, managers, and anyone involved in financial reporting have a clear understanding of the accounting principles. Regular training and updates on accounting standards (such as GAAP or IFRS) will help keep everyone informed about the correct ways to treat different transactions.

Use Clear and Consistent Policies

Develop and implement clear, written accounting policies for your organization. These policies should outline how different transactions should be handled according to accounting principles, including asset capitalization, expense recognition, and revenue recognition.

Regularly Review Financial Transactions

Regular internal audits and reviews of financial statements can help identify any misapplications early. This is especially important for complex or unusual transactions, where the risk of misapplication of accounting principles may be higher.

Leverage Accounting Software

Use reliable accounting software that is developed to comply with accounting principles. Many modern accounting systems are equipped with features that enforce standard accounting treatments, reducing the likelihood of errors. Automated processes, such as built-in checks for asset depreciation or revenue recognition, can help ensure that transactions are recorded according to the correct principles.

Stay Updated with Accounting Standards

Accounting standards are constantly evolving. New rules or amendments to existing standards may change how certain transactions should be recorded. To avoid errors, it is essential for businesses to stay up to date with changes in accounting rules, whether through industry publications, professional organizations, or by consulting with accounting experts.

How Can Enerpize Help You Avoid Error of Principle?

Enerpize, a comprehensive online accounting software, can play a crucial role in helping businesses avoid errors of principle in accounting. By automating and streamlining key accounting processes, Enerpize can ensure that financial transactions are recorded and reported correctly according to established accounting standards.

Enerpize helps avoid errors of principle by automating compliance with accounting standards, real-time financial monitoring, and customizable templates. It simplifies asset management and depreciation ensuring accurate calculations. The software's user-friendly interface guides users through correct accounting treatments, while audit trails provide transparency.

Regular software updates keep the system compliant with evolving standards, and internal controls reduce errors through role segregation. Enerpize also generates regular financial reports and simplifies reconciliations, ensuring financial statements are accurate and principles are correctly applied.

Avoiding error of principle is easy with Enerpize.