What are Prior Period Adjustments?
Prior period adjustments are adjustments made to periods that are not current period, but already accounted for because there is a lot of metrics where accounting uses approximation and 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.
Prior Period Adjustments are made in the financial statementsThe Financial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. to correct the incomes or expenses arisen in the current year as a result of 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 “Realisation 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 scenario mentioned above.
- The term doesn’t include any other adjustments which have been necessitated by the circumstances, that are 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 policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.
- Misinterpretation of facts and figures
- Failure to accrue or defer certain expenses or revenuesRevenuesRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.
- Fraud or misuse of facts existed at the time financial statements were prepared;
Examples of Prior Period Adjustments/Errors
Following are few examples of Prior Period Errors/adjustments along with their Adjustment entry to rectify it-
MSA Company, in the year 2017, 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 the year 2017, ABC Company did not accrue the telephone expenses, which was paid at the beginning of 2018. The correcting for the same would be
In the above error, the expenses were not accrued.
Example – Stein Mart, Inc
- Previous year’s financial statements of Stein Mart contained errors made in inventory markdowns, leasehold improvement costs, compensated absences (paid vacation), etc.
- Therefore Stein Mart restated its annual report on 10K is based on the recommendation of the audit committeeAudit CommitteeA company's audit committee is a group of non-executive directors who are in charge of ensuring the integrity of internal controls, auditing, and financial reporting procedures. It works under the supervision of the Board of Directors and strives to sustain the corporate governance system. and in consultation with the management.
In the Financial Year 2018, XYZ limited while preparing the statements got to know that they have committed a mistake to account for the depreciation of an office building that was acquired in the preceding year. 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: –
- Net Income got to be on the higher side since the operating costs were computed on a lower side.
- Assuming that the company pays dividends from its retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company., it has also affected the Dividends.
- It will affect the tax obligations of the company, as the profits tend to go up.
The rectification for the error would be done by passing the following entry in the opening balance of retained earnings:
Following changes will result in the disclosure by the adjustments in the opening balance of Retained Earnings: –
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 restatementRestatementA restatement is the revision of already issued financial statements of one or more companies to correct errors with material inaccuracy due to non adhering and complying with the GAAP, accounting mistakes, fraud, or clerical errors affecting part of the entire financial statement requiring a completely new audit. except to the extent 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 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.
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 system of accountancySystem Of AccountancyAccounting systems are used by organizations to record financial information such as income, expenses, and other accounting activities. They serve as a key tool for monitoring and tracking the company's performance and ensuring the smooth operation of the firm. and doubt the competency of its auditors. 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.
This article has been a guide to what are Prior Period Adjustments. Here we discuss the Prior Period error adjustments examples and practical case studies, including the disclosures required for such errors.