Errors: Definitions, Reasons and Types
Chapter Seven
Syllabus topic 2, "Errors & Frauds – Definitions, Reasons and Circumstances, Types of Error, Types of frauds, Risk of fraud and Error in Audit, Auditors Duties and Responsibilities in case of fraud."
Pages 16 to 18 of 98
In one line
An error is an unintentional mistake in the books or the statements, and it is classified by how it was made rather than by how much it was for.
Definition
An error is an unintentional misstatement in the financial statements, including the omission of an amount or a disclosure. Intention is the whole of the difference from fraud, and it is also what makes an error harder to conceal: a person who did not mean to do it did not cover it up.
The reasons and circumstances
| Reason | Example |
|---|---|
| Ignorance of accounting principle | Capital expenditure charged to revenue by a clerk who does not know the distinction |
| Carelessness | A figure transposed, a total added wrong |
| Ignorance of the client's system | A new clerk who does not know a particular ledger exists |
| Pressure of work and haste | Month-end and year-end concentrations |
| A weak or absent internal control | Nothing checks the entry, so nothing catches the slip |
| Mechanical or software failure | A wrong formula, a broken interface, a corrupted import |
The four types
1. Errors of omission. A transaction is not recorded at all, or not fully.
| Sub-type | What happened | Trial balance |
|---|---|---|
| Complete omission | The entry is missing from both accounts. A credit sale never entered anywhere | Agrees; both sides are equally short |
| Partial omission | One side entered and not the other. A purchase posted to the supplier and not to purchases | Disagrees |
2. Errors of commission. The transaction is recorded, but wrongly.
| Sub-type | Example | Trial balance |
|---|---|---|
| Wrong amount in both accounts | Rs 5,400 entered as Rs 4,500 in both | Agrees |
| Wrong amount in one account | Rs 5,400 debited and Rs 4,500 credited | Disagrees |
| Wrong account of the same class | Sale to Ram posted to Shyam's account | Agrees |
| Posting to the wrong side | A credit posted as a debit | Disagrees |
| Casting or carry-forward error | A column added wrong | Disagrees, usually |
3. Errors of principle. The entry is made in a way that breaks an accounting principle, most often by confusing capital with revenue.
| Example | Effect |
|---|---|
| Purchase of a machine debited to repairs | Profit understated, fixed assets understated |
| Repairs to a machine debited to the machinery account | Profit overstated, fixed assets overstated |
| Wages paid to erect a machine charged to wages | Profit understated, asset understated |
| Depreciation not provided | Profit and assets both overstated |
The trial balance agrees in every one of them, because both entries are of the right amount and on the right sides; only the account chosen is wrong in principle. These are the errors that matter most to an auditor, because they distort the profit and the position and nothing arithmetical reveals them.
4. Compensating errors. Two or more errors that cancel out.
Errors: Definitions, Reasons and Types
Ram's account is debited Rs 900 short and Shyam's account is credited Rs 900 short. The trial balance agrees, and both accounts are wrong.
The trial balance test, stated properly
| Type of error | Does the trial balance disagree? |
|---|---|
| Complete omission | No |
| Partial omission | Yes |
| Wrong amount in both accounts | No |
| Wrong amount in one account | Yes |
| Wrong account of the same class | No |
| Wrong side | Yes |
| Errors of principle | No |
| Compensating errors | No |
Five of the eight rows leave the trial balance agreeing. So an agreed trial balance proves that the two sides of the postings are equal, and nothing else. That sentence is a whole answer to "does an agreed trial balance prove the books are correct".
What the auditor does about errors
| Step | |
|---|---|
| 1 | Assess the internal control, because errors are a symptom of weak control |
| 2 | Test check transactions and balances, with more testing where control is weak |
| 3 | Use analytical procedures: a ratio out of line, an expense out of proportion, points at an error |
| 4 | Follow up every difference, however small, until its cause is known |
| 5 | Have material errors corrected, and where they are not, qualify the report |
Step four is the professional rule. A small unexplained difference may be the visible edge of a large error, and treating it as immaterial because of its size is the mistake.
What it does NOT mean
An immaterial error is not ignored; its correction is not insisted on. The auditor notes it, considers whether it points at a system weakness, and moves on.
An error is not a fraud even if it is large. Intention decides, and the auditor who finds a large error must consider whether it was intentional, which is where section 143(12) can begin.
Quick revision
| Definition | An unintentional misstatement, including an omission |
| Four types | Omission, commission, principle, compensating |
| Omission | Complete leaves the trial balance agreeing; partial does not |
| Principle | Capital against revenue; the trial balance always agrees |
| Compensating | Two errors cancelling; the trial balance agrees |
| What an agreed trial balance proves | That the postings balance, and nothing more |
| The auditor's rule | Follow up every difference to its cause, however small |
Test yourself
- Define an error and say what separates it from a fraud.
- Name the four types with one example each.
- Which types leave the trial balance agreeing?
- A machine is bought and debited to repairs. Which type, and what is the effect?
- Does an agreed trial balance prove the books are correct?
Answer in one sentence
1. An unintentional misstatement in the financial statements, including an omission, distinguished from a fraud by the absence of intention.
2. Omission, as where a credit sale is never entered; commission, as where Rs 5,400 is entered as Rs 4,500; principle, as where a machine is debited to repairs; and compensating, as where two errors of Rs 900 cancel each other.
Errors: Definitions, Reasons and Types
3. Complete omission, a wrong amount entered in both accounts, posting to the wrong account of the same class, errors of principle, and compensating errors.
4. An error of principle, which understates the profit and understates the fixed assets, and the trial balance still agrees.
5. No, it proves only that the debit and credit postings are equal, and five of the eight kinds of error leave it agreeing.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.