How to Report an Error Correction
When an error is discovered in your company’s financial statements, it should be corrected promptly. The accounting treatment for an error correction depends on the nature of the error and when it is discovered.
According to the US GAAP (Generally Accepted Accounting Principles), prior period errors are adjusted against the opening balance of retained earnings in the period in which the error is discovered. This adjustment is done retrospectively.
If the error is immaterial, it might be corrected in the financial statements of the period in which it is discovered, without restating prior periods.
For material errors, financial statements of prior periods should be restated. Comparative financial statements should also be adjusted to correct the error.
Example of How to Report an Error Correction
Imagine your company sells machinery and you discover in June 2023 that you overstated your sales revenue in December 2022 by $15,000 due to a recording error. This is a significant amount, and you need to correct the error.
Here are the steps you’d take:
- Record a Prior Period Adjustment: Since this is a material error from a prior period, you’ll need to adjust your retained earnings at the beginning of the current period. You’d decrease Retained Earnings by the overstated amount of $15,000 and decrease Accounts Receivable (assuming the sale was on credit) or increase Cash (if the sale was a cash sale and you already reduced cash due to the customer return or refund) by the same amount. Here’s how that might look if the sale was on credit:
|Jan 1, 2023
This journal entry corrects the error by reducing your beginning retained earnings and reducing your accounts receivable for the overstated sales.
- Disclose the Error in Your financial statements: In your financial statements for the period when the error was discovered (2023 in this case), you should add a note that explains the nature of the error, its impact on previous financial statements, and how it was corrected.
Remember, it’s important to correct errors as soon as they’re discovered, and to be transparent about these corrections. It may also be prudent to review your internal controls to understand why the error occurred and how similar errors can be prevented in the future. In such cases, it’s usually a good idea to consult with an accounting professional or auditor to ensure that the error is corrected appropriately.