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Accounting Information > Accounting and Terminology > Correction of Errors
Correction of Errors

Everyone makes mistakes. This means that virtually every company will at some time discover that they have made an error. There are several different types of accounting errors that are normally seen in practice.

 

One example of an accounting error is changing from an accounting principle that is not generally accepted to a generally accepted accounting principle, such as changing from the cash basis to the accrual basis of accounting. Another example is a mathematical error, such as incorrectly adding up several inventory tally sheets, thereby reporting the wrong total for inventory. Another example of an accounting error is a change in estimate where the original estimate was not made in good faith, such as using an unrealistic rate of depreciation. Still another example is simply an oversight, like missing the accrual or deferral of an asset or liability at the end of a period. Another example is a misuse of facts, such as failing to deduct the salvage value when determining the basis of a depreciable asset for straight-line depreciation. One more example of an accounting error is incorrectly classifying a cost as an expense instead of an asset, or vice versa.

The accounting profession has clear guidelines on how to handle the correction of an error. Errors must be corrected immediately when found. The errors are corrected by posting the correct entries and reporting them in the financial statements. The corrections must be reported in the year they are discovered. They must be treated as prior period adjustments, and be shown as an adjustment to beginning retained earnings. When presenting comparative statements, any prior periods affected must be restated.

If only one period is being presented in the financial statements, the error is reported as an adjustment to beginning retained earnings of the year the error was found. When comparative financial statements are being presented, adjustments must be made in order to correct any accounts affected that are reported for all of the periods being presented. The amounts for all years presented must be restated to the correct amounts, with any catch-up adjustments reported as a prior period adjustment to the retained earnings balance of the earliest period being shown. Required disclosures for the financial statements would be a footnote about the restatement of any prior periods, and disclosing the effect of the correction on income before extraordinary items, net income, and earnings per share.

Normally, large corporations have sufficient internal controls to avoid most material errors. However, smaller companies may not have the necessary internal controls in place. When an error is discovered, the company or accountant needs to determine if there is a material effect on the financial statement presentation. If there is not, the error is generally not corrected. This would normally be the case when a small accrual is missed by a large corporation with a large amount already recorded in the related expense, and a high net income figure. When it is determined that an error should be corrected, the guidelines discussed above come into play.

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