Prior period adjustments

Prior period adjustment is one of the special types of adjustments . Prior period adjustment is a restatement of the beginning balance of retained earnings because of a correction of an error . 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 :

• 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 .

• 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" .

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 .

Examples of Prior period adjustments

• A prior period adjustment is an adjustment made to the financial statements for an accounting period that has already ended. It can also refer to an adjustment made to the financial statements of a prior accounting period. Examples of prior period adjustments include correcting an error in the prior period financial statements or recognizing a previously unrecognized liability or asset that should have been recorded in a prior period.
• For example, if a company discovers an error in the reporting of its inventory in the previous year, it would make a prior period adjustment to correct the error and ensure the financial statement is accurate.
• Another example of a prior period adjustment is when a company has underreported its income or expenses in the prior period due to an oversight or mistake. To correct this, the company must make a prior period adjustment, which would result in a change in the income statement for the prior period.
• Additionally, a prior period adjustment may be necessary to recognize a liability or asset that should have been reported in the prior period, but was not. For instance, if a company discovers that an asset has been undervalued in the prior period, a prior period adjustment is required to adjust for the difference.

Advantages of Prior period adjustments

Prior period adjustments are useful for ensuring accuracy in financial reporting. The following are the advantages of prior period adjustments:

• Prior period adjustments allow for reconciliation of financial statements by correcting errors and omissions of the prior period, enabling the company to present a true and fair view of its financial position.
• They help to ensure that the company's accounting records are consistent and accurate across multiple accounting periods.
• They also help to ensure the integrity of the financial statements by reducing the chances of material misstatements.
• Prior period adjustments ensure that the company's financial statements comply with applicable accounting standards and regulations.
• They also help to reduce the risk of overstatement or understatement of financial performance.
• Lastly, prior period adjustments can help to improve the quality of financial reporting, providing investors and other stakeholders with reliable information about the company's financial performance.

Limitations of Prior period adjustments

Prior period adjustments are special types of adjustments that are used to correct errors or omissions in financial statements. However, there are several limitations that must be taken into consideration when making prior period adjustments. These limitations include:

• The adjustments must be made in accordance with the Generally Accepted Accounting Principles (GAAP) and other applicable accounting standards.
• The adjustments must not be used to correct errors or omissions that occurred in the current period.
• Prior period adjustments must be applied to all related financial statements, such as the balance sheet and the income statement, in order to maintain consistency.
• The prior period adjustment must be properly documented and disclosed in the financial statements.
• The adjustment must also be able to be verified and, if necessary, audited by an independent third party.
• The adjustment must be made in accordance with the accounting period of the financial statements in which the error or omission occurred.

Prior period adjustments — recommended articles

Opening entries — Consistency principle — Management representation letter — Closing the accounts — Accounting Convention — Accrual method — Closing entries — Materiality principle — Change in accounting estimate

References

• Anderson L. K. (2019), Accounting for Government Contracts--Cost Accounting Standards, LexisNexis.
• Benesh B. K., Bryant M. K. (2019), Depreciation Handbook, LexisNexis.
• Nikolai L. A., Bazley J. D., Jones J. P. (2010), Intermediate Accounting, Cengage Learning, USA.
• United States of America Federal Energy Regulatory Commission (1984), Accounting and Reporting Requirements for Oil Pipeline Companies, U.S. Federal Energy Regulatory Commission.

Footnotes

Author: Gabriela Wojtaszek