Prior Period Adjustment
In accounting, a Prior Period Adjustment refers to the correction of an error that was made in the financial statements of a previous period. Errors may arise from mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time the financial statements were prepared.
When such an error is discovered, it is corrected through a prior period adjustment, which retrospectively adjusts the opening balances of assets, liabilities, and equity of the earliest period presented. The effect of the error on prior periods is removed, and the comparative financial statements are restated as if the error had never occurred.
The correction of the error is reported in the current period’s financial statements in the statement of retained earnings (or a statement of equity, if presented), not in the income statement. That’s because the error relates to a prior period, not the current one.
It’s important to note that prior period adjustments are different from changes in accounting estimate or changes in accounting policy, which are prospective in nature and do not affect prior periods. Prior period adjustments specifically deal with errors.
The specific treatment of prior period adjustments may vary under different accounting standards, such as U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). So, it’s always important to refer to the most current standards or consult with an accounting professional.
Example of a Prior Period Adjustment
Imagine a company, ABC Ltd., which has been depreciating a piece of machinery using the straight-line method over an estimated useful life of 10 years. After the third year, it’s discovered that due to a clerical error, the useful life was incorrectly input as 20 years instead of 10 in the calculation for the depreciation expense. This means that for the first three years, the company has been under-depreciating the machinery, leading to an overstatement of net income and retained earnings.
To correct this error, ABC Ltd. would calculate the correct depreciation expense for each of the three years, then determine the total amount of the error. If the cumulative depreciation was supposed to be $90,000 (i.e., $30,000 per year for 3 years), but the company only reported $45,000 (i.e., $15,000 per year for 3 years), the understatement of the depreciation expense (and overstatement of net income and retained earnings) is $45,000.
ABC Ltd. would then make a prior period adjustment. This means that the opening retained earnings of the earliest period presented would be reduced by $45,000, reflecting that this income was overstated in the past due to the error. The net book value of the machinery would also be decreased by $45,000 to reflect the higher accumulated depreciation. In the notes to the financial statements, ABC Ltd. would disclose the nature of the error and the impact of the correction.
This corrects the previous error and ensures that the financial statements present a more accurate picture of the company’s financial position and performance.
