Prior period adjustments

Prior period adjustments
See also

Prior period adjustment is one of the special types of adjustments [1]. Prior period adjustment is a restatement of the beginning balance of retained earnings because of a correction of an error [2]. Sometimes a company may make an error in the financial statements of one accounting period that is not detected until a later period. The error may be due to [3]:

  • a mathematical mistake
  • the incorrect use of existing facts
  • an oversight
  • the use of an accounting principle that is not ordinarily accepted
  • fraud

Fundamental approaches to account for the effect of corrections

Under generally accepted accounting principles, three fundamental approaches are attainable to account for the effects of corrections and changes: the restatement method, the cumulative effect method, and the current and prospective method. Materiality is an issue that affects which method to use or whether to ignore the need for an adjustment. Only material adjustments should be made [4].

  • The restatement method involves a retroactive adjustment to one or more prior years. This approach presents the prior years involved in a more precise light. Completed and closed contracts may not make this method the most practical plan of dealing with the adjustments.
  • The cumulative effect method assigns the adjustment to the current cost accounting period. The cumulative effect of the adjustment is determined as of the beginning of the cost accounting period in which the adjustment becomes necessary and treated as an expense of the actual period. This method is used for adjusting preceding depreciation upon disposition of an asset under CAS 409. An important advantage of this approach is that the effects of the event are totally accounted for in the year when adjustment becomes necessary.
  • In the current and prospective method, the cumulative effects are spread over the current and future cost accounting period. Using this approach, errors in depreciation would be revised and reflected in the undepreciated balance and the undepreciated balance becomes the basis for the depreciation expense of the actual and future periods.

Entering prior period adjustments

"Adjustments occurring in the current accounting period, relating to events or transactions which occurred in a prior period the accounting effects of which could not be determined with reasonable assurance at that time, shall be reported as prior period adjustments. A prior period adjustments, after income tax effect, should be reported by restating the beginning balance of retained income of the current year and correspondingly adjusting related prior year balances presented for comparative purposes" [5].

Accounting rules permit a company to enter the change on the current year's financial statement by describing a prior period adjustment in the equity section of the balance sheet. The balance sheet will show the balance in retained earnings at the beginning of the year, followed by the prior period adjustment to that balance [6].

References

Footnotes

  1. L. K. Anderson 2019
  2. L. A. Nikolai, J. D. Bazley, J. P. Jones 2010, p. 226
  3. L. A. Nikolai, J. D. Bazley, J. P. Jones 2010, p. 218
  4. L. K. Anderson 2019
  5. United States of America Federal Energy Regulatory Commission 1984
  6. G. A. Perry 2006, p. 347

Author: Gabriela Wojtaszek