Prior Period Adjustment

Prior period adjustments are discussed in SFAS 16, (as amended in SFAS 109 and SFAS 154), and aim to separate economic events that affected prior years from those events that affect the current financial statements.

Corrections to financial statements can result from mathematical errors, an incorrect application of GAAP, or the oversight or misuse of facts at the time the company issues financial statements for the period.

Before Statement 16, companies could increase current income by burying prior period adjustments that would have corrected understated income in a prior period somewhere in current operating income. If the adjustment would have corrected an income overstatement for a prior period, companies could then make entries directly into retained earnings that would have otherwise decreased net income for the current period. Under Statement No. 16, companies must exclude the effect of prior period adjustments from current financial statements since the changes have no relationship to the current statement period.

SFAS 16 was further amended to narrow prior period adjustments to only two items:

Prior Period Adjustments are limited to the following events: The correction of an error in the financial statements for a prior period.
Under very limited circumstances per FAS 141(R), adjustments that result from the realization of income tax benefits of preacquisition operating loss carryforwards of purchased subsidiaries.

For example, if Sunny forgot to record $2,360 of straight line depreciation after issuing the financial statements for the prior year, he would make the following entry to correct the overstatement of net income in the prior year:

Prior Period Adjustment, Depreciation Expense To record annual depreciation expense of company vehicle for prior year.

Since income and expenses are closed to retained earnings at the end of the period through closing entries, additional expenses that were incorrectly omitted from the financial statements are directly debited to retained earnings.

Sunny would also adjust the statement of retained earnings to show the prior period adjustment as follows:

Beginning Retained Earnings (as originally stated)Deduct: Adjustment for Prior Period: DepreciationRestated Beginning Retained Earnings

If the company issues prior period financial statements with current statements for comparison purposes, then those statements must be restated to report the correct amounts that would have been reported had the error not occurred.

If only current statements are issued, the adjustment is required to beginning retained earnings of the current year (above) as well as to the net income of the most recent prior accounting period.