Errors in the financial statements occur as a result of mistakes, improper application of Generally Accepted Accounting Principles (GAAP), or other omissions or misuse of information when the financial statements were prepared. Errors are different from fraud because fraud is an intentional act with the purpose of deceiving investors whereas errors are unintentional.

Financial Accounting Standard Board (FASB) and the International Accounting Standards Board (IASB) are developing common grounds with respect to handling accounting errors; the goal is to achieve uniformity and comparability. SFAS 154, Accounting Changes and Error Corrections, is very similar to IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors.

The following are errors commonly found in financial statements:
a) Estimates based on unreasonable assumptions. For example, in a manufacturing company, the cost of goods sold is based on unrealistic rates very different from those used in the same industry.
b) Recording erroneous amounts for assets and equities. If incorrect footing of inventory totals would cause inventory to be misstated in the balance sheet.
c) Failure to record prepaid and accrued expenses. For instance, a company pays its six-month insurance on January 1st, then that amount should be allocated among six months rather than charging the total to the month of January.
d) Improper classification of assets as expenses and vice versa. Patty’s Inc. purchased a new machine for its facility and recorded it as an expense rather than as a fixed asset.

Change from an accounting principle that is not generally accepted to one that is generally accepted. The classical example here is a change from the direct write-off method to the allowance method of accounting for uncollectible accounts. According to the FASB an entity shall report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application requires the following:
a. The cumulative effect of the change to the new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
b. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
c. Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle.

If it is impracticable to determine the cumulative effect of applying a change in accounting principle to any prior period, the new accounting principle shall be applied as if the change was made prospectively as of the earliest date practicable.

Accounting errors may be classified by the time of discovery or according to their effect on the balance sheet, income statement or both.
a) Occurrence and discovery in different periods. In this case, the cumulative effect of each error on periods prior to the period of discovery must be calculated and recorded as a direct adjustment to the beginning balance of retained earnings.
b) Occurrence and discovery in same period. Reversing the incorrect entry and recording the correct one achieve the correction. It also can be corrected by bringing the accounts’ balances to the correct amount in a single entry.
c) Effect on balance sheet. If only balance sheet accounts are affected, when the error is discovered an entry is recorded to correct the accounts’ balances. For example if the cash account is recorded when a purchase of equipment is made on credit. The correct account should be notes payable.
d) Effect on income statement accounts for the period. If office expense is charged instead of shop supplies. As a result of this error, the amounts on the income statement for these accounts will be misstated, although the net impact on the net income for the period will be zero. This error can be corrected with an entry to bring the account balances to actual if it is discovered before the year-end closings. If the error is discovered in a subsequent period no correction is necessary, however, the restatement of comparative financial statements is required.

Errors although unintentional have implications that must be closely assessed and corrected as soon as they are discovered. Strive to be error-free and save yourself the hassle of correcting mistakes and what goes with it.