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Chapter20: Accounting Changes and Error Corrections

Prior Period Adjustments

Before we see these steps applied to the correction of an error an adjustment a company makes due to an error made., one of the steps requires elaboration. As discussed in Chapter 4, the correction of errors is the situation that creates prior period adjustments. A prior period adjustment addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity due to a correction of an error. refers to an addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity (or statement of retained earnings if that's presented instead).

   In an earlier chapter we saw that a statement of shareholders' equity is the most commonly used way to report the events that cause components of shareholders' equity to change during a particular reporting period. Some companies, though, choose to report the changes that occur in the balance of retained earnings separately in a statement of retained earnings. When it's discovered that the ending balance of retained earnings in the period prior to the discovery of an error was incorrect as a result of that error, the balance must be corrected when it appears as the beginning balance the following year. However, simply reporting a corrected amount might cause misunderstanding for someone familiar with the previously reported amount. Explicitly reporting a prior period adjustment on the statement itself avoids this confusion. Assume, for example, the following comparative statements of retained earnings:

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A statement of retained earnings reports the events that cause changes in retained earnings.

   Now suppose that in 2011 it's discovered that an error in 2009 caused that year's net income to be overstated by $20,000 (it should have been $330,000). This means retained earnings in both prior years were overstated. Because comparative financial statements are presented and the current year is the year in which the error was discovered, the prior year would include a prior period adjustment as shown below:

p. 1153

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The incorrect balance as previously reported is corrected by the prior period adjustment.

   At least two years' (as in our example) and often three years' statements are reported in comparative financial statements. The prior period adjustment is applied to beginning retained earnings for the year following the error, or for the earliest year being reported in the comparative financial statements when the error occurs prior to the earliest year presented.16

16The retained earnings balances in years after the first year also are adjusted to what those balances would be if the error had not occurred, but a company may choose not to explicitly report those adjustments as separate line items.

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