Correct Financial Statement Errors
When an error is discovered in financial statements that have already been issued, it must be corrected to reflect the true financial position and performance of the company. The appropriate method for correcting the error depends on when the error is discovered and the nature of the error.
According to the generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), companies should follow these steps:
- Identification: The first step is to identify the error, which might be discovered through a routine audit, during the preparation of the subsequent year’s financial statements, or through an internal review process.
- Assessment: Once an error is discovered, it needs to be assessed to determine its impact on the financial statements. This includes assessing whether the error is material or immaterial. Material errors have a significant impact on the understanding of the financial statements, while immaterial errors do not.
- Correction: The process for correcting the error depends on its nature:
- Prior period errors: These are material errors that relate to prior period financial statements. These should be corrected retrospectively by restating the comparative amounts for the prior period(s) in which the error occurred. This often involves adjusting the opening balances of assets, liabilities, and equity for the earliest period presented.
- Immaterial errors: These can typically be corrected in the financial statements of the period in which they are discovered. They do not require restatement of prior period financial statements.
- Disclosure: When prior period errors are corrected, the nature of the error and the impact of the correction on each financial statement line item affected should be disclosed in the notes to the financial statements.
- Internal Control Review: After the correction of the error, it’s important to review the internal controls that failed to prevent or detect the error and to take necessary steps to improve these controls.
It’s important to remember that accounting standards can vary by country and by the type of organization, so organizations should follow the specific guidance provided by the accounting standards that they adhere to.
Example of Correct Financial Statement Errors
Let’s consider a fictional company, “ElectroGadgets Inc.”, that discovered an error in its previous year’s financial statements.
In the fiscal year 2022, ElectroGadgets Inc. mistakenly expensed $100,000 worth of equipment that should have been capitalized and depreciated over its useful life of 10 years. This error was discovered in 2023 while preparing the 2023 financial statements.
Here’s how ElectroGadgets Inc. might correct the error:
- Identification: During the preparation of the 2023 financial statements, the company’s accountants notice that a large purchase of equipment was incorrectly classified as an expense in the previous year.
- Assessment: They determine that the error is material because it significantly understates the company’s assets and net income for 2022.
- Correction: The company corrects the error by restating the 2022 financial statements. The equipment is removed from expenses and added to the property, plant, and equipment (PPE) account with a value of $100,000. Accumulated depreciation for 2022 is increased by $10,000 (assuming straight-line depreciation), and retained earnings are increased by $90,000 (the net value of the equipment after one year’s depreciation). The net income for 2022 is increased by $100,000.
- Disclosure: In the notes to the 2023 financial statements, ElectroGadgets Inc. discloses the nature of the error, the impact of the correction on the 2022 financial statements, and the fact that the 2022 financial statements have been restated.
- Internal Control Review: The company reviews its capitalization policy and provides additional training to its accounting staff to ensure this type of error doesn’t occur in the future.
This example simplifies a complex process, but it gives an idea of how a company might correct a prior period error in its financial statements.
