These exceptions mainly relate to prior period adjustments and are accounted for by an adjustment to the beginning balance of retained earnings.
There has been, however, considerable controversy about what causes an event to qualify as a prior period adjustment.
Only two events are considered prior period adjustments:
- Correction of an error in the financial statements of a prior period.
- Adjustments that result from realization of income tax benefits of pre-acquisition operating loss carryforwards of purchased subsidiaries.
Because the realization of tax benefits is a specialized topic, we will examine only prior adjustments that relate to error corrections.
Occasionally, a firm will discover a material error in a prior year’s financial statements. However, material errors are very rare, especially when a firm’s financial statements are audited by a CPA firm.
When they do occur and are discovered, the manner in which the error is corrected depends on whether the firm publishes single-year or comparative financial statements and on the year in which the error was made.
When single-year statements are published, the error is corrected by adjusting the beginning balance of retained earnings on the retained earnings statement.
To demonstrate accounting for prior period adjustments in a single-year statement, we will assume that during the audit of its 2019 statements, the Mondrian Corporation discovered that depreciation in 2018 had been understated by $100,000, ignoring taxes. Because this is a material error, a prior period adjustment is required.
The following journal entry is made at year-end to correct this error:
The 2019 statement of retained earnings would appear as follows:
In addition, the prior period adjustment is explained in the footnotes to the financial statement.
When comparative financial statements are presented, the procedure is different.
If the error is in an earlier financial statement that is being presented for comparative purposes, that statement should be revised to correct the error.
As a result, net income will be corrected, and after that corrected net income figure is reflected on the retained earnings statement, no further adjustment is required.
If the error is in a year for which the financial statements are not being presented, the correction is made through a prior period adjustment to the earliest retained earnings balance presented.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.