Meaning of Compensating Error
This is a type of accounting error where a debit side mistake compensates or offset a credit side error. This means that the value of error in the debit side is equal to the value of error in the credit side. In such a case, the trial balance will definitely have equal amounts on both sides.
A type of accounting error. There are six types of mistakes that wouldn’t affect a trial balance. Compensating error is one of them. Others are commission, omission, principle, complete reversal of entry and original entry errors.
It compensates or offset. The error affects different accounts on the debit and credit sides of the business books of accounts. And the amounts on both sides are the same. This implies that if an error of N20,000 is on the debit side of various accounts also, the same amount is on the credit side of a single account or multiple accounts.
Overcasts and undercasts. Overcast means the amount in an account is more than what is supposed to be there. And undercast is the value in the account is less than the original amount. In compensating error, both sides can either be undercast or overcast.
The debit side cannot be undercast with an amount and overcast in the credit side of another account. In this case, the trial balance will have different figures on both sides. And therefore the mistake cannot be corrected by offsetting it.
Correction of Profit Statement. Compensating error affects profit statements. It can either overstate or understate profit. For example, if sales is undercast along an asset a/c with the same amount, it means that revenue earned for the period had been understated. Therefore, misleading users of the statement.
Examples. Various examples can ensue here. Sales was undercast by N58,000 so is a furniture account with the same figure. The commission paid account is overcast by N7,000 and insurance policy a/c by N15,000 so is Account Payable account by N22,000. The list goes on.
How to identify Compensating Error
There is no lay down rule on how to identify compensating errors. As long as the amount on the debit side offset the amount on the credit side of the books of accounts of the business in question, then such mistakes can be labeled compensating error.
How to correct Compensating Errors
This depends on if the mistake is overcast or undercast. For overcast, you will have to subtract the amount from the accounts affected. However, you will need to add the amount undercast to correct it in the accounts.
Example of Compensating Errors
Sales was undercast by N58,000 so is a furniture account with the same figure. In this example and as explained, you will need to add the amount to the sales and furniture account. Therefore the entry shall be:
Dr: Furniture account
Cr: Sales account
With the amount. That is N58,000.
The commission paid account is overcast by N7,000 and insurance policy a/c by N15,000 so is Account Payable account by N22,000. Here, the amount will be subtracted.
To subtract an amount on the debit side, you record that amount on the credit side and vise versa. Commission paid and insurance policy accounts are expenses. So, it is normally debited to record an entry. While Account Payable is always credited. To comply with the rule, to correct the overcasts, you will need to record the amount in he opposite sides, thus:
Dr: Account Payable A/c with N22,000
Cr: Commission Paid A/c with N7,000
Cr: Insurance Policy A/c with N15,000
Why it doesn’t affect trial balance
This error won’t affect trial balance. As explained in previous sub headlines, the mistake occurs in both sides of multiple accounts. And with the same value. Since it affects both sides, it can be said that it doesn’t affect a trial balance.
Compensating Error and Profit Statement
If a business discovers errors after preparing a trial balance, such errors may affect the profit statement. In such a case, it is necessary to correct the profit to a more accurate figure. The simple rules to correct it are:
Add undercast income and overcast expenses and subtract overcast income and undercast expenses.
From the above example, assume the profit for the month is N49,500. Then the corrected profit statement shall be as follows:
In summary, the mistake tends to compensate for another error. When it occurs, it can either overcast or undercast the debit and credit sides of the books of accounts of the business. Also, this error does affect the profit statement.