BAFS Study Notes: Correction of Errors

Hello! Welcome to your study notes for one of the most practical topics in accounting: Correction of Errors. We're all human, and that means mistakes happen, even for accountants! This chapter is all about becoming an 'accounting detective'. You'll learn how to find mistakes in the books, understand what kind of mistakes they are, and most importantly, how to fix them properly.

Mastering this is super important because accurate financial records are the foundation of any healthy business. Don't worry if it seems tricky at first; we'll break it down step-by-step. Let's get started!


First, A Quick Refresher: The Trial Balance

Remember the Trial Balance? It's a list of all the debit and credit balances from the general ledger. Its main job is to check if the total debits equal the total credits.

$$ \text{Total Debits} = \text{Total Credits} $$

If they don't match, you know for sure there's an error. But here's the tricky part: even if the Trial Balance balances, there could still be hidden errors! This is the key idea for this chapter.

Identifying the Types of Accounting Errors

We can sort all accounting errors into two main groups, based on whether the Trial Balance catches them or not.

Group 1: Errors NOT Revealed by the Trial Balance (The 'Sneaky' Errors)

These errors are clever. They follow the double-entry rule (a debit and a credit of equal value are made), so the Trial Balance still balances. But the entries are wrong!

Memory Aid: POOCCE

Use the mnemonic POOCCE to remember these six sneaky errors:

  • P - Principle
  • O - Omission
  • O - Original Entry
  • C - Commission
  • C - Compensating
  • E - Entry (Complete Reversal of)
1. Error of Omission

This is the simplest error: a transaction was completely forgotten and was not recorded at all. No debit, no credit. Since nothing was entered, the books still balance.

Example: A cash sale of $500 was made, but the bookkeeper forgot to record it entirely.

2. Error of Commission

Here, the correct amount is posted to the correct class of account, but the wrong account. Think of it as sending a letter to the right street, but the wrong house number.

Example: A payment of $1,000 was made to a supplier, J. Chan. The bookkeeper correctly credited Cash but debited the account of another supplier, P. Chan, by mistake. Both are trade payables, so the Trial Balance isn't affected.

3. Error of Principle

This is a big one! It happens when a transaction is recorded in the wrong class of account, violating a fundamental accounting principle. Most often, it's mixing up an asset and an expense.

Example: The company bought a new air conditioner (a non-current asset) for $8,000 cash. The bookkeeper debited 'Repairs and Maintenance Expense' instead of 'Equipment'. The double-entry is complete (a debit and a credit), but it breaks the rule of capital vs. revenue expenditure.

4. Error of Original Entry

The error happens right at the start. The wrong amount is recorded in the book of original entry (like the sales journal), and this wrong amount is then correctly double-entered.

Example: A credit sale of $980 was made to a customer. The bookkeeper accidentally wrote it down as $890. They then correctly debited Trade Receivables with $890 and credited Sales with $890. The debit equals the credit, so it balances.

5. Compensating Errors

This is when two or more separate, unrelated errors are made that, by pure coincidence, cancel each other out.

Example: The Sales account was overstated by $100 (a credit), and the Rent Expense account was also overstated by $100 (a debit). The extra debit for rent is cancelled out by the extra credit for sales, so the Trial Balance totals are correct, but both account balances are wrong.

6. Complete Reversal of Entries

The correct accounts are used, and the correct amount is used, but the accounts that should have been debited and credited are swapped.

Example: Received $200 cash from a customer. The correct entry is Debit Cash, Credit Trade Receivables. The bookkeeper made a mistake and did Debit Trade Receivables, Credit Cash. The Trial Balance still balances.


Key Takeaway for Group 1 Errors

These errors are tricky because the Trial Balance gives you a false sense of security. They don't throw the totals off balance. To fix them, you need to make a journal entry that involves the two accounts that were originally affected.

Group 2: Errors That ARE Revealed by the Trial Balance

These are the more obvious errors because they break the double-entry rule. They cause the total debits and total credits in the Trial Balance to be unequal. These are the errors that require a Suspense Account.

Examples include:

  • Posting to one account but not the other (a one-sided entry).
  • Posting the correct debit amount but the wrong credit amount.
  • Posting on the correct side of one account but the wrong side of the other (e.g., two debits).
  • Calculation errors when balancing an account or listing balances in the trial balance.

The Suspense Account: A Temporary Fix

When the Trial Balance doesn't balance, we need a way to make it balance temporarily so we can prepare draft financial statements while we investigate. This is where the Suspense Account comes in.

Analogy: Think of a suspense account as a temporary 'mystery fund' or a 'holding area'. You put the difference from the trial balance into this account to force it to balance. Your goal is then to find the errors and empty this 'mystery fund' until its balance is zero.

How to Use a Suspense Account: Step-by-Step

Step 1: Find the difference in the Trial Balance.
Example: Total Debits = $50,200; Total Credits = $50,000. The difference is $200.

Step 2: Open a Suspense Account.
Enter the difference on the smaller side to make it balance.
In our example, the credit side is smaller. So, we make a credit entry of $200 in the Suspense Account.

Step 3: Find the Error(s).
Now, you play detective and find the mistake that caused the $200 difference.
You discover that a payment for Telephone Expense of $200 (a debit) was correctly credited from the Cash account, but was never debited to the Telephone Expense account.

Step 4: Prepare a Correcting Journal Entry using the Suspense Account.
The correcting entry will fix the wrong account and clear the suspense account.
To fix our error, we need to debit Telephone Expense by $200. The other side of the entry will be to the Suspense Account.

Correcting Journal Entry:
Dr. Telephone Expense $$ \$200 $$
    Cr. Suspense Account $$ \$200 $$
(To record omitted debit for telephone expense)

After this entry, the Suspense Account has a $200 debit and a $200 credit. Its final balance is ZERO! Mission accomplished.


Quick Review Box

Errors NOT affecting Trial Balance (POOCCE):
- Corrected with a journal entry between the affected accounts.
- No Suspense Account needed.

Errors AFFECTING Trial Balance:
- A Suspense Account is opened with the difference.
- Corrected with a journal entry between the affected account and the Suspense Account.

Correcting Errors and the Effect on Profit

Fixing errors isn't just about making the numbers balance; it often changes the company's calculated net profit for the year.

The Golden Rule: An error correction will only affect the net profit if it involves an account that appears in the Income Statement (i.e., a revenue or expense account).

  • Correcting errors in asset, liability, or capital accounts does NOT affect the current year's profit.

How to Determine the Effect on Profit

Think about how your correcting journal entry changes incomes or expenses:

If your correction... | ...the effect on Net Profit is... --- | --- Increases an expense (e.g., debiting Rent Expense) | Profit Decreases Decreases an expense (e.g., crediting Rent Expense) | Profit Increases Increases an income (e.g., crediting Sales) | Profit Increases Decreases an income (e.g., debiting Sales) | Profit Decreases

Let's look at an Error of Principle example:
Original Error: Purchase of a motor van ($50,000) was wrongly debited to Motor Expenses.
Draft Profit was overstated. Why? Because expenses were too high ($50,000 too high). Oh wait, let's re-think that. Yes, expenses were overstated, so profit was understated. My mistake. Let's fix this explanation.

Let's look at an Error of Principle example (Corrected Explanation):
Original Error: Purchase of a motor van ($50,000) was wrongly debited to Motor Expenses.
Effect of error: The 'Motor Expenses' account is $50,000 too high. Since expenses reduce profit, the originally calculated profit is $50,000 too low (understated).

The Correcting Journal Entry:

Dr. Motor Vehicles (Asset) $$ \$50,000 $$
    Cr. Motor Expenses $$ \$50,000 $$
(To capitalise purchase of van wrongly treated as an expense)

Analysis of Correction: This entry reduces (credits) an expense account. According to our table, decreasing an expense will INCREASE the net profit. Therefore, we must add $50,000 back to the originally calculated profit to find the correct profit.


Final Key Takeaway

The process of correcting errors is systematic. First, identify the type of error to see if it affects the Trial Balance. Then, use a journal entry to fix it, involving a suspense account if necessary. Finally, always consider if your correction has changed the final net profit. Keep practising, and you'll become a pro at finding and fixing any mistake!