Definition: A prior period adjustment is the correction of an accounting error that occurred in the past and was reported on a prior year’s financial statement, net of income taxes. In other words, it’s a way to go back and fix past financial statements that were misstated because of a reporting error.
What Does Prior Period Adjustment Mean?
Prior period adjustments are used to fix mathematical errors, improper accounting methods, and overlooked facts in past periods. Since balance sheet and income statement effects of these errors have already occurred, the adjustment should be made to the retained earnings or equity account on the statement of retained earnings. This adjustment will change the carrying balance of retained earnings and adjust it as if the accounting was done properly in past periods.
Let’s take a look at some examples.
Many adjustments happen because improper accounting treatments were used in prior periods. This was the case for a lot of early 2000’s company that were involved in accounting scandals. Enron is one of the main examples. For years, the company was recording special purpose entities as separate businesses without consolidating their activities on the main set of financial statement. In form, entities were originally set up to hedge risky commodities and deals that Enron was doing at the time, but in substance the only real purpose was to shift debt from the main company to the smaller subsidiaries. Because proper ownership and capitalization structures were not maintained, Enron was actually supposed to consolidate these activities.
This past improper accounting treatment led to the massive prior period adjustments and financial statement restatements that eventually bankrupted the company.
Obviously, this is a major adjustment, but there are plenty of examples of smaller one. For example, a math error might have been made on a prior year’s income statement that increased the reported expenses and lowered the reported income. If this mistake was material, the adjustment could be made on the statement of retained earnings to adjust the equity account to the proper balance.