An Error of Principle in Accounting occurs when an accounting transaction is recorded in a way that goes against the fundamental accounting principles. We will try to understand the concept using some examples in the start and later I will tell you the possible types of Error of Principle in Accounting and how to correct them using the journal entries. Its pretty easy concept, lets have a look at it;
An Example of Error of Principle in Accounting
Here’s an example to illustrate this type of error:
Let’s say a company purchases a piece of land for $100,000 that will be used for future expansion. However, instead of recording the transaction as a long-term asset in the Land account, an employee mistakenly records it as an expense in the Utilities account.
In this case, the error of principle occurs because the transaction is not recorded in accordance with the matching principle, which requires the recognition of expenses in the period they are incurred to generate revenue. The purchase of land does not represent a utility expense but rather a long-term investment. As a result, the financial statements will be misstated since the land purchase expense is not properly classified as a long-term asset.
How to correct this error?
To correct the error of principle, the transaction should be reversed in the Utilities account and recorded accurately in the Land account as a long-term asset.
Another Example of Error of Principle in Accounting
Let’s say a company receives a loan of $50,000 from a bank to finance the purchase of new equipment. However, instead of recording the loan as a liability in the Loans Payable account, an employee mistakenly records it as revenue in the Sales account.
In this case, the error of principle occurs because the transaction is not recorded in accordance with the revenue recognition principle, which states that revenue should be recognized when it is earned. The loan received from the bank is not revenue but a liability that needs to be repaid in the future.
How to correct this error?
To correct the error of principle, the transaction should be reversed in the Sales account and recorded accurately in the Loans Payable account as a liability. This ensures that the financial statements reflect the correct financial position of the company and comply with the fundamental accounting principles.
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Areas where Error of Principle in Accounting may occur
1. When company mention revenue expenditure as capital expenditure
When a company wrongly categorises revenue expenses as capital expenses, it results in a fundamental error. For example, when a company chooses to include its marketing expenditures as part of its fixed assets rather than recognising them as operating expenses, it can distort the income statement and balance sheet. This issue of Error of Principle in Accounting may arise in situations where there is uncertainty in differentiating between revenue and capital expenditures.
To correct the error of capitalizing revenue expenses, the company needs to reclassify the incorrectly capitalized expenses back to operating expenses. Let’s assume the company incorrectly capitalized $10,000 of advertising expenses. The correcting entry would be:
Debit: Accumulated Depreciation (or Depreciation Expense) $10,000
Credit: Advertising Expense $10,000
2. When principle of disclosure isn’t followed
Failure to reveal transactions between associated parties can result in a significant error, which can have serious consequences. For instance, if a company sells goods to its subsidiary at a much lower price than to an unrelated party without proper disclosure, it would be considered a violation of the principle of arm’s length transactions. This error can arise in situations where there is a lack of comprehension or ignore for the principle of full disclosure.
To rectify the error of non-disclosure of related-party transactions, the company needs to disclose the transactions appropriately in the financial statements. Let’s assume $20,000 of sales were made to a subsidiary without proper disclosure. The correcting entry would be:
Debit: Sales Revenue $20,000
Credit: Related-Party Sales Disclosure $20,000
3. Realisation of revenue before its earned
When revenue is recognised before it is actually earned or realised, it can result in a fundamental error. For example, a company might record revenue from a long-term contract before finishing the work, which goes against the principle of revenue recognition. This Error of Principle in Accounting can occur in situations where there is a strong incentive to boost revenue or a lack of clarity regarding the criteria for recognising revenue.
To correct the misapplication of revenue recognition, the company needs to adjust the recognized revenue to match the actual completion of the work. Let’s assume $50,000 of revenue was recognized prematurely. The correcting entry would be:
Debit: Unearned Revenue (or Deferred Revenue) $50,000
Credit: Revenue $50,000
4. When personal expenses are treated as business expenses
When private expenses are incorrectly recorded as business-related expenses, it is considered an error of principle. For instance, when a business owner includes personal travel expenses in the company’s records, it skews the accuracy of financial statements. This error can arise in situations where personal and business finances are not properly separated or when there is inadequate oversight.
To rectify the inclusion of personal expenses as business expenses, the company needs to reverse the incorrect expense and reduce the owner’s equity accordingly. Let’s assume $5,000 of personal travel expenses were charged to the company. The correcting entry would be:
Debit: Owner’s Drawings (or Owner’s Equity) $5,000
Credit: Travel Expense $5,000
5. Unable to record accrual related liabilities
Not properly accruing liabilities can result in a fundamental mistake. As an expert in financial analysis, it is important to note that if a company neglects to record accrued salaries at the end of an accounting period, it will result in an understatement of expenses and an overstatement of profits. This error can arise in situations where there is a lack of focus on aligning expenses with revenues or a misinterpretation of accrual accounting principles.
To correct the failure to accrue liabilities, the company needs to recognize the accrued expenses in the current period. Let’s assume $30,000 of accrued salaries at the end of the period. The correcting entry would be:
Debit: Salary Expense $30,000
Credit: Accrued Salaries $30,000
