We all make mistakes, and accountants are no different. An error of principle is simply accounting entries in an incorrect account. The accountant recorded the right amount but recorded it in the wrong account. 

For example, suppose you want to enter printing expenses, and instead of recording the cost of refilling the printer ink in revenue expenditure, you record it in capital expenditure. Capital expenditures are for fixed assets such as the printer purchase, while revenue expenditures are for day-to-day expenses.

Why is an Error of Principle Such a Big Deal?

The major problem with errors of principle is that, unlike other types of errors, such as the error of original entry, where the incorrect amount is recorded, they are hard to detect. With errors of principle, the account summary may still be balanced with the right amount of expenses and revenue.

However, if your company wants to review its accounting principles these minor accounting mistakes become a problem. They also undermine the integrity of financial statements and lead to significant financial restatements, damaging your company’s reputation with stakeholders.

How Does Errors of Principle Happen?

An error of principle occurs in accounting when a transaction is recorded in violation of a fundamental accounting principle or established company policy. These errors typically involve the correct amount being recorded but in the wrong account. Unlike clerical errors (math mistakes) or errors of omission (missing entries), errors of principle stem from a misunderstanding of accounting concepts or a failure to follow proper procedures.

• Capital Expenditure vs. Revenue Expenditure: Mistakenly recording the purchase of a new machine (capital expenditure) as an expense (revenue expenditure). This distorts the company’s income statement by overstating expenses and understating assets.
• Inventory Valuation: An improper inventory valuation (e.g. FIFO vs LIFO) may result in an incorrect cost of goods sold (COS) and influence profitability calculations.
• Depreciation Method: Applying an improper depreciation method to an asset, thereby misrepresenting its value on the balance sheet and impacting reported earnings.

What Is the Difference Between Errors of Principle and Other Accounting Principles

• Clerical Errors: These are mathematical mistakes in recording or calculating transactions, often involving typos or misplaced decimal points. Unlike principle errors, they affect the trial balance (total debits do not equal total credits), making them easy to identify.
• Errors of Omission: These include missing entries or even transactions. They typically affect the trial balance and are easier to identify than errors of principle.

Consequences of Errors of Principle

Errors of principle affect different aspects of your business, such as finance, law, and trust. Let’s look at them in more detail:

A. Financial Errors

Errors of principle can significantly distort financial statements, leading to:

• Misstated Profits: Recording revenue expenditures as capital expenditures overstates expenses and understates assets, resulting in overstated profitability. If the case is reversed, profits would be understated, significantly affecting company budgeting and plans.
• Incorrect Financial Position: Misvalued assets or liabilities provide an inaccurate picture of a company’s financial health. For example, if a company’s profit is understated, the company could go as far as downsizing, while if it’s overstated, it could try to scale when it doesn’t have enough funds.
• Misleading Information for Investors: Inaccurate financial statements can mislead investors and creditors when making financial decisions.

B. Legal and Regulatory Implications

Depending on the severity and intent, errors of principle can lead to legal and regulatory issues:

• Securities Fraud: If the error is intentional and used to manipulate financial results, it can constitute securities fraud punishable by law.
• Loss of Investor Confidence: Repeated errors of principle can erode investor confidence and damage the company’s reputation.
• Regulatory Scrutiny: Regulatory bodies may investigate companies with significant errors of principle, leading to fines or penalties.

C. Repercussions for Businesses

Errors of principle can hurt your businesses in several ways:

• Financial Losses: Incorrect decision-making based on flawed financial statements can lead to wasted resources and missed opportunities.
• Increased Costs: Correcting significant errors of principle can be expensive and time-consuming.
• Difficulty Obtaining Financing: Lenders may be hesitant to provide financing to companies with a history of errors in financial reporting.

Common Causes of Errors of Principle

Errors happen all the time, but knowing why is how we identify the root cause and prevent them from happening again. Here’s a breakdown of frequent causes:

• Misunderstanding of Accounting Principles: This typically happens with new staff or those unfamiliar with specific accounting treatments. For example, an intern could wrongly classify assets and expenses if they don’t understand the subtle distinction between the two.
• Misinterpretation of Accounting Standards: Accounting standards guide your business and help you measure profitability, but they can also be complicated. If you don’t understand how accounting standards work, you may make mistakes, such as undervaluing inventory or undervaluing assets.
• Poor Internal Controls: Poor internal controls lead to an environment where mistakes can slip through the cracks. For example, if you are short-staffed (e.g. transactions and reconciliation are performed by the same person) or there are no or poor review procedures.

Detecting and Correcting Errors of Principle

While most people don’t intentionally make errors of principle, they can happen. So here are some key methods to help detect and rectify them:

• Internal Audit Processes: Regularly scheduled internal audits by qualified professionals to identify errors in accounting practices. Internal audits provide an independent audit and identify areas where principles may be incorrectly applied.
• Regular Reconciliations: Routinely compare accounts (such as bank statements and inventory records) to identify discrepancies that could indicate errors of principle. For instance, a large discrepancy between a bank statement and a general ledger cash account could indicate an improper accounting for a transaction.
• Using Accounting Software for Accuracy: Accounting software automates a wide range of processes and enforces specific accounting policies, minimizing common accounting errors.

Case Studies: Learning from Errors of Principle

Understanding how errors of principle manifest in real-world scenarios can help prevent them in your practices. Let’s look at some examples:

1. Wages Paid for Office Renovation from the Building Account

In this transaction, wages paid for the office refurbishment are a revenue expenditure and should be debited from the wages account. However, in this case, it is treated as capital expenditure and is debited to the building account, violating the accounting principle.

Implications

Going by the recorded expenses, the company would be led to believe they have more assets than they have. This could lead to incorrect company decisions based on a misconception of financial health.

Always reconcile accounts to ensure there are no accounting errors. This would help guide your company’s decisions, especially for budget allocation.

2. Amount Spent on Machinery Replacement Recorded in Repairs

In this transaction, the amount of replacement is a capital expenditure, not a revenue expenditure. Yes, the new machinery was bought to replace an old one but it was a new asset, it should be debited to the Machinery Account not Repairs.

Implications

Non-recognition of an asset in the form of capital expenditure shows that the company has fewer assets than it does. This can have significant legal consequences, especially if it impacts the company’s tax position. It could result in fines and penalties; you would pay these fines and still have to deal with a damaged reputation.

Preventing Errors of Principle in Accounting Practices

Desiderius Erasmus once said “Prevention is better than cure”, a proverb we incorporate in everyday life including accounting. Instead of wading through compliance and legal hoops and risking your company reputation, here are a few ways to prevent errors of principle from happening in your accounting:

1. Employee Training and Education

• Provide your employees with an in-depth knowledge of GAAP or the applicable accounting framework in your state.
• Offer ongoing training to update employees on any changes or clarifications to accounting standards.

1. Strengthening Internal Controls

• Implement a robust system of internal controls to ensure accurate recording and processing of financial transactions. For example, implementing regular reconciliations, and proper documentation.
• Separate accounting tasks to prevent overburdening staff and common oversights e.g., separating authorization, recording, and custody of assets.

1. Regular Review of Accounting Policies:

• Periodically review your company’s accounting policies to ensure they align with current GAAP or relevant standards. This helps identify potential inconsistencies or areas for improvement and reduces the risk of errors.

How Formplus Can Help Accountants Avoid Errors of Principle

Formplus is your go-to for simple and effective solutions to manage your business accounts more effectively. Here are some ways Formplus helps you manage your accounts more effectively and prevent common accounting errors:

• Transaction records: Formplus’s secure payment integration with Paypal, Stripe, Paystack, and other payment platforms lets you have a clear record of your transactions and helps you spot discrepancies when matching your records.
• Workplace Integration: Rather than opening multiple tabs and applications and losing track of some accounts, you can streamline your workflow and reduce the risk of errors of principle. Formplus also integrates seamlessly with accounting software like Quickbooks and Sage ensuring that financial records are automatically updated.
• Multiple Templates for Expenses: Formplus also has a wide library of templates to record purchases, inventory, and sales. This allows you to track expenses and easily reconcile accounts if you spot errors of principle in your accounting
• Survey: You can also use Formplus to create surveys to guide you in making better financial decision-making. For example, you can create post-reconciliation surveys to gain insights into the defects of your current accounting practices and recommendations to mitigate them.

Conclusion

Errors of principle whether intentional or not have serious implications. You could end up neck-deep in fines, reputation damage, lost opportunities, or debt. So accurate accounting is not just a legal requirement; it enables informed decision-making and maintains your company’s financial health.

We hope this guide helps you spot and prevent errors of principle in your accounting. Don’t forget to check out Formplus accounting forms to help you record your expenses and revenue effortlessly.