What Is an Error of Principle in Accounting?

An error of principle is an accounting mistake that occurs when a transaction is recorded using an incorrect account, violating a fundamental accounting rule. This is a conceptual error, not a mathematical one, that happens when the person recording the transaction misunderstands an accounting principle. This results in the entry being placed in the wrong category, even if the dollar amount is correct. These mistakes can distort a business’s financial reports.

The Foundation of Accounting Principles

Financial accounting in the United States is governed by Generally Accepted Accounting Principles (GAAP). This framework provides the rules for how economic events should be recorded and reported, ensuring financial statements are consistent and reliable. Understanding these principles is necessary for preventing and identifying errors.

A common area for these errors involves the distinction between capital and revenue expenditures. Capital expenditures are funds used to acquire or upgrade physical assets like buildings or equipment and are recorded as assets on the balance sheet. Revenue expenditures are the day-to-day costs of running a business, such as repairs or utilities, and are recorded as expenses on the income statement.

Another guiding concept is the matching principle, which dictates that expenses should be recorded in the same period as the revenue they helped generate. For example, the cost of a delivery truck is a capital expenditure. Its cost is spread over its useful life through depreciation, matching the expense of using the truck with the revenue it helps earn over several years.

Identifying an Error of Principle

This type of error involves posting a transaction to the correct side of the ledger—a debit or a credit—but to the wrong type of account. This means an asset might be incorrectly recorded as an expense, or vice versa. Because the debits and credits in the accounting system still balance, these errors can be difficult to detect through a simple review of a trial balance.

For example, suppose a company buys a machine for $50,000 that is expected to last for ten years. This is a capital expenditure and should be recorded as an asset. If the bookkeeper instead records the entire $50,000 as an “Equipment Repairs” expense, an error of principle has occurred, violating the rule of capitalizing long-term assets.

Another instance involves the business entity concept, which requires keeping a business’s finances separate from its owner’s. If the owner uses company funds for personal car insurance and records it as a “Business Vehicle Expense,” this is an error of principle. The payment is a personal draw, not a business expense, violating the separation rule.

Impact on Financial Statements

An error of principle distorts a company’s financial statements, affecting its reported performance and financial position. The misclassification triggers a chain reaction that alters key financial metrics.

Using the example of the $50,000 machine, incorrectly recording it as an expense overstates the company’s total expenses by $50,000. This causes the reported net income to be understated by the same amount. Consequently, on the balance sheet, total assets are understated because the machine is not listed, and owner’s equity is also understated due to the reduced net income.

Similarly, if an owner’s personal payment is recorded as a business expense, the company’s expenses are overstated, and net income is understated. This reduction in net income flows to the balance sheet, decreasing owner’s equity. This misrepresents both the business’s profitability and the owner’s withdrawals from the company.

Correcting the Error

Correcting an error of principle requires a specific accounting action known as a correcting journal entry. This entry is used to reverse the incorrect transaction and record it properly, ensuring the accounting records are accurate before financial statements are finalized.

To illustrate, revisit the $50,000 machine purchase incorrectly recorded as a repair expense. The original entry wrongly debited Repair Expense instead of the Machinery asset account. The correcting journal entry moves the amount from the wrong account to the right one. It requires a debit to the Machinery (Asset) account for $50,000 and a credit to the Repair Expense account for $50,000. This correction places the asset on the balance sheet and removes the incorrect expense.