Chapter4: The Income Statement and Statement of Cash Flows
Correction of Accounting Errors
Errors occur when transactions are either recorded incorrectly or not recorded at all. We briefly discuss the correction of errors here as an overview and in later chapters in the context of the effect of errors on specific chapter topics. In addition, Chapter 20 provides comprehensive coverage of the correction of errors.
Accountants employ various control mechanisms to ensure that transactions are accounted for correctly. In spite of this, errors occur. When errors do occur, they can affect any one or several of the financial statement elements on any of the financial statements a company prepares. In fact, many kinds of errors simultaneously affect more than one financial statement. When errors are discovered, they should be corrected.
Most errors are discovered in the same year that they are made. These errors are simple to correct. The original erroneous journal entry is reversed and the appropriate entry is recorded. If an error is discovered in a year subsequent to the year the error is made, accounting treatment depends on whether or not the error is material with respect to its effect on the financial statements. In practice, the vast majority of errors are not material and are, therefore, simply corrected in the year discovered.
Prior Period Adjustments
After its financial statements are published and distributed to shareholders, Roush Distribution Company discovers a material error in the statements. What does it do? The correction of material errors is considered to be 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..41 A prior period adjustment 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).
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 is corrected. 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 of shareholders' equity (or statement of retained earnings) avoids this confusion.
In addition to reporting the prior period adjustment to retained earnings, previous years' financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction. Also, a disclosure note communicates the impact of the error on income.
41 FASB ASC 250–10–45–23: Accounting Changes and Error Corrections—Overall—Other Presentation Matters (previously “Prior Period Adjustments,” Statement of Financial Accounting Standards No. 16 (Norwalk, Conn.: FASB, 1977)).