Prior Period Adjustments

Prior period adjustments are adjustments made to periods that are not a current period but already accounted for because there are a lot of metrics where accounting uses approximation. However, approximation might not always be an exact amount, and hence they have to be adjusted often to make sure all the other principles stay intact.

Stakeholders of the company tend to view the Prior Period error and adjustments in a negative notion, assuming that there was a failure in the company's accounting system. Although, it is best to avoid such adjustments when the amount of prospective change is immaterial to portray a fair view of a company's performance and its financial position.

Prior Period Adjustments are made in the financial statements to correct the incomes or expenses that arise in the current year due to omissions or errors in the preparation of financial statements of one or more periods in the past.

• These adjustments are also used in the case of "Realization of an Income Tax Benefit" arising from the operating losses of a purchased subsidiary (before they were acquired). Although it is clearly defined and rare, a prior period adjustment is implied in the above scenario.
• The term doesn't include any other adjustments that have been necessitated by the circumstances linked to prior periods adjustments but are determined in the current period, for example, arrears payable to employees as a revision in their salaries with retrospective effect during the current year.

Errors in the preparation of financial statements could be caused due to the following reasons:

• Mathematical mistakes
• Mistakes in applying accounting policies
• Misinterpretation of facts and figures
• Failure to accrue or defer certain expenses or revenues
• Oversights
• Fraud or misuse of facts existed at the time financial statements were prepared;

Following are a few examples of Prior Period Errors/adjustments along with their Adjustment entry to rectify them-

Example 1 – Stein Mart, Inc

In the year 2017, MSA Company incorrectly charged furniture and fixtures for advertisement expenses amounting to Rs. 50,000. The error was identified in the year 2018. The journal entries passed to correct the same will be

It is a misclassification error.

In 2017, ABC Company did not accrue the telephone expenses paid at the beginning of 2018. The correcting for the same would be

In the above error, the expenses were not accrued.

source: sec.gov

• The previous year's financial statements of Stein Mart contained errors in inventory markdowns, leasehold improvement costs, compensated absences (paid vacation), etc.
• Therefore, Stein Mart restated its annual report on 10K based on the audit committee's recommendation and in consultation with the management.

Example 2 - Practical Case-Study

While preparing the statements in the Financial Year 2018, XYZ limited got to know that they had committed a mistake in accounting for the depreciation of an office building acquired in the preceding year. As a result, there was an error in calculating the depreciation, and they shortchanged the depreciation by Rs.50,00,000/- in the books of accounts. Assuming this error to be material, the company has decided to incorporate required prior period adjustments.

Before that, let's understand the implication of short charging the depreciation: –

1. Net Income got to be higher since the operating costs were computed on a lower side.
2. Assuming that the company pays dividends from its retained earnings, it has also affected the Dividends.
3. It will affect the company's tax obligations, as the profits tend to go up.

The rectification of the error would be done by passing the following entry in the opening balance of retained earnings:

Following changes will result in the disclosure of the adjustments in the opening balance of Retained Earnings: –

Accounting for prior period adjustments is a crucial affair as even a minor mistake could lead to invalid or false net income figures. As a result, it is important to be accurate while figuring out such adjustments. The need for such adjustments arises when companies make a mistake and record prior period transactions in the records meant for the current period. This might be due to calculation error, accounting treatment mistake or completely wrong recording of the financial information obtained.

To understand how to record such adjustments, there are certain things that one must make sure of. The first is that the corrections get reflected in all related financial statements, as each one of them are studied for better and wiser decision-making, be it the management or investors.

Secondly, the prior period adjustments to retained earnings must be ensured. This means that the change in revenue and expense must be exhibited with respect to the retained earnings of the current year.

To achieve this, it needs to be noted that the income statement of the prior year gets carried forward to the retained earnings account automatically. Hence, the carry forward of the adjustments to the current year can be guaranteed only when one focuses less on the income statement and more on the retained earning account for making changes.

An entity shall correct material prior period adjustments/errors retrospectively in the first set of financial statements approved for issue after their discovery either by the following ways:

• Restating the comparative amounts for the prior period(s) in which the error occurred
• If the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities, and equity for the earliest prior period presented

Provided that the prior period error/adjustment shall be corrected by retrospective restatement except that it is impractical to determine either the period-specific effects or the cumulative effect of the error. Only where it is impractical to determine the cumulative effect of an error, only then prior periods of error can be rectified by the entity prospectively.

In disclosing so, the entity should mention the following: –

• The nature of the prior period error
• For each prior presented, to the extent practicable, the amount of correction:
  • For each financial statement line item
  • For each prior period presented, to the extent practicable.
• The amount of the correction at the beginning of the earliest prior period
• If retrospective restatement is impracticable for a particular prior period, mention the circumstances that led to the existence of that condition and a description of how and from when the error has been corrected.
• Financial statements of subsequent periods need not repeat these.

This article has been a Guide to what are the Prior Period Adjustments. Here, we explain the concept along with the examples, how to record them, and disclosures. You also have a look at the following related articles for a better understanding of the topic:

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• How to make a Pro Forma Cash Flow Statement?
• Pro-Forma Earnings Formula