Prior Period Error
A Prior Period Error refers to an omission from, or misstatement in, an entity’s financial statements for one or more prior periods due to a failure to use, or misuse of, reliable information that was available and could reasonably be expected to have been obtained and taken into account in the preparation of those financial statements.
These errors include both mathematical mistakes and mistakes in applying accounting policies. The errors can result from oversight or misinterpretation of facts, as well as fraud.
When a prior period error is identified, it is typically corrected retrospectively in the first set of financial statements authorized for issue after its discovery by restating the comparative amounts for the prior period(s) in which the error occurred.
In other words, the financial statements are revised to reflect what the results “should have been” if the error had not occurred. This could impact reported assets, liabilities, equity, net income, or cash flows of the prior period(s).
The detailed treatment and disclosure requirements for prior period errors can vary under different accounting standards, such as U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). As of my knowledge cutoff in September 2021, it’s always best to refer to the most current standards or consult with an accounting professional when dealing with prior period errors.
Example of a Prior Period Error
Let’s consider a company called XYZ Corp.
Suppose that in 2022, XYZ Corp. discovered that they had made an error in their 2021 financial statements. They had incorrectly recorded a $500,000 expense as revenue due to a misunderstanding. This means that their net income for 2021 was overstated by $1,000,000 ($500,000 that should have been an expense was recorded as revenue, hence the income was overstated by the sum of these two amounts).
To correct this prior period error, XYZ Corp. would need to restate their 2021 financial statements. The restatement would involve reducing 2021’s revenue and net income by $1,000,000 to correct for the error.
In the restated 2021 income statement, revenue would be decreased by $1,000,000 and the expense would be increased by $500,000. As a result, net income would be decreased by $1,000,000. The retained earnings balance at the beginning of 2022 (which reflects the cumulative net income of prior years) would also be decreased by $1,000,000.
XYZ Corp. would disclose this adjustment in the notes to their 2022 financial statements, explaining the nature of the error and the impact of the correction on their 2021 revenue, expenses, net income, and retained earnings. This transparency allows users of the financial statements to understand the adjustments and make more informed decisions.
It’s important to note that this example is simplified and the actual process of correcting prior period errors would be subject to the specific rules and regulations of the relevant accounting standards.