Compensating error definition
/What is a Compensating Error?
A compensating error is an accounting error that offsets another accounting error, resulting in no net impact in an organization’s financial statements. These errors can be difficult to spot when they occur within the same account and in the same reporting period, since the net effect is zero. A statistical analysis of an account may not find a compensating error.
These errors may also appear in different accounts, so that the trial balance totals for total debits and credits are correct, but different account balances are incorrect. For example, the wages expense could be too high by $2,000 due to one error, while the cost of goods sold could be too low by $2,000 due to a compensating error. Or, the revenue account balance could be too low by $5,000, but it is offset by a compensating error in the same amount in the utilities expense account.
Examples of Compensating Errors?
Here are several examples of compensating errors:
Overstated sales and overstated purchases. A company mistakenly records a sale as $5,000 instead of $4,000, overstating revenue by $1,000. At the same time, it records a purchase as $3,000 instead of $2,000, overstating expenses by $1,000. In this case, the trial balance remains correct, but both sales and purchases are overstated.
Understated salaries and understated rent expense. The salary expense for employees should be $8,000, but it is mistakenly recorded as $7,500 (understated by $500). Similarly, the rent expense should be $6,000, but it is recorded as $5,500 (understated by $500). In this case, the total debits and credits remain balanced, but both salary and rent expenses are understated.
Overstated cash and overstated accounts payable. A business incorrectly records a cash balance of $15,000 instead of $14,000 (overstated by $1,000). At the same time, it records accounts payable as $6,000 instead of $7,000 (understated by $1,000). In this case, the trial balance appears correct, but the individual accounts are misstated.
Problems with Compensating Errors
The presence of compensating errors might not have an immediate impact on the bottom-line accuracy of a reporting entity’s income statement. Nonetheless, they present several issues, which are as follows:
Credibility. When it becomes known that there are several compensating errors in an organization’s accounting records, this increases the external auditor’s doubt that the firm’s accounting system is functioning properly. This may result in more extensive audit tests in the future, which also increases the cost of the audit.
Correction problems. When compensating errors are present, it can be exceedingly difficult to track down and correct them - especially when it is not entirely clear that there are errors at all.
Systemic issues. The presence of compensating errors indicates that a business has problems with its recordation of business transactions, which must be corrected. If not, then the system will continue to produce errors in the future.