The two types of prior period adjustments are: (1) Correction of an error that was made in a previous year; and (2) Recognition of a tax loss carryforward benefit arising from a purchased subsidiary. How are prior period adjustments handled? Through this post, I am going to quickly demonstrate ways to handle several prior period adjustments with easy—to—follow examples. Enjoy!
When a single year is presented, prior period adjustments adjust the beginning balance of retained earnings.
The presentation follows:
Retained earnings—1/1 Unadjusted
Prior period adjustments (net of tax)
Retained earnings—1/1 Adjusted
Add: Net income
Have I made the point? Not yet, you said. I am going to show you in clearer manner with some case examples, shortly. So, read on…
Errors may arise from mathematical mistakes, misapplication of accounting principles, or misuse of facts existing when the financial statements were prepared. Furthermore, a change in principle from one that is “not GAAP” to one that is “GAAP” is an “error correction“. Disclosure should be made of the nature of the error and the effect of correction on profit.
When comparative statements are prepared, a retroactive adjustment for the error is made to prior years. The retroactive adjustment is disclosed by showing the effects of the adjustment on previous years’ earnings and component items of net income.
Case Example-1 [Misclassification]
In 2009 a company incorrectly charged furniture for promotion expense amounting to $30,000. The error was discovered in 2010. The correcting journal entry is:
[Debit]. Retained earnings = $30,000
[Credit]. Furniture = $30,000
Case Example-2 [Expenses were not Accrued]
At the end of 2010 a company failed to accrue telephone expense that was paid at the beginning of 2011. The correcting entry on 12/31/2011 is:
[Debit]. Retained earnings = $16,000
[Credit]. Telephone expense = $16,000
Case Example-3 [Revenue was not Deferred]
On 1/1/2010 an advance retainer fee of $50,000 was received covering a five-year period. In error, revenue was credited for the full amount. The error was discovered on 12/31/2012 before closing the books. The correcting entry is:
[Debit]. Retained earnings = $30,000
[Credit]. Revenue = $10,000
[Credit]. Deferred revenue = $20,000
Case Example-4 [Repairs Expense Was Charged]
A company bought a machine on January 1, 2012, for $32,000 with a $2,000 salvage value and a five-year life. By mistake, repairs expense was charged. The error was uncovered on December 31, 2015, before closing the books. The correcting entry is:
[Debit]. Depreciation expense = $6,000
[Debit]. Machine = $32,000
[Credit]. Accumulated depreciation = $24,000
[Credit]. Retained earnings = $14,000
Accumulated depreciation of $24,000 is calculated below:
= [$32,000 – $2,000]/5
= $6,000 per year × 4years
The credit to retained earnings reflects the difference between the erroneous repairs expense of $32,000 in 2012 versus showing depreciation expense of $18,000 for three years (2012–2014).
Case Example-5 [Salvage Value Was not Charged]
At the beginning of 2013 a company bought equipment for $300,000 with a salvage value of $20,000 and an expected life of 10 years. Straight-line depreciation is used. In error, salvage value was not deducted in computing depreciation. The correcting journal entries on 12/31/2015 follow.
Depreciation taken $300,000/10 × 2 years $60,000
Depreciation correctly stated
$280,000/10 × 2years $56,000
[Debit]. Depreciation = $28,000
[Credit]. Accumulated depreciation = $28,000
(Note: To recognize depreciation for current year)
[Debit]. Accumulated depreciation = $4,000
[Credit]. Retained earnings = $4,000
(Note: To correct prior year depreciation misstatement)