A prior period adjustment can be one of the following two items:
- The correction of an error in the financial statements that were reported for a prior period; or
- Adjustments caused by the realization of the income tax benefits arising from the operating losses of purchased subsidiaries before they were acquired.
Since the second situation is both highly specific and rare, a prior period adjustment really applies to just the first item - the correction of an error in the financial statements of a prior period. An error in a financial statement may be caused by mathematical mistakes, mistakes in the application of GAAP, or the oversight or misuse of facts that existed at the time the financial statements were prepared.
You should account for a prior period adjustment by restating the prior period financial statements. You do so by adjusting the carrying amounts of any impacted assets or liabilities as of the first accounting period presented, with an offset to the beginning retained earnings balance in that same accounting period.
If you are presenting the results of a prior period alongside the results of the most recent accounting period, and the prior period adjustment impacts the prior period being presented, you must present the results of the prior period as though the error had never occurred.
If you are making a prior period adjustment to an interim period of the current accounting year, then you should restate the interim period to reflect the impact of the adjustment.
Finally, when you record a prior period adjustment, you should disclose the effect of the correction on each financial statement line item and any affected per-share amounts, as well as the cumulative effect on the change in retained earnings.
Investors and creditors tend to view prior period adjustments with deep suspicion, assuming that there was a failure in a company's system of accounting that caused the problem. Consequently, it is best to avoid these adjustments when the amount of the prospective change is immaterial to the results and financial position shown in the company's financial statements.
Prior Period Adjustment Example
The controller of ABC International makes a mistake when calculating depreciation in the preceding year, resulting in depreciation that is $1,000 too low. He finds the error in the following year, and corrects the error with this entry to the beginning balance of retained earnings:
These changes result in the disclosure of the following alteration of ABC's beginning retained earnings balance:
|Retained earnings, January 1, 20X1||150,000|
|Prior period adjustment:|
|Correction of depreciation error||(1,000)|
|Adjusted retained earnings, January 1, 20X1||149,000|