Retained Earnings: Prior Period Adjustments: Videos & Practice Problems

In accounting, a prior period adjustment is a necessary correction made to the retained earnings balance due to either an error or a change in accounting principle. This adjustment is crucial because it ensures that the financial statements accurately reflect the company's financial position and performance over time.

Errors can occur when a company fails to record an expense or revenue in a previous period. For instance, if an expense is unrecorded, it leads to an overstatement of net income, which in turn inflates the retained earnings balance. Conversely, if revenue is omitted, it results in an understatement of both net income and retained earnings. Understanding this relationship is essential for accurate financial reporting.

To illustrate, consider a scenario where an accountant discovers a $40,000 legal fee that was incorrectly recorded as a prepaid expense instead of an expense in the previous year. The correct journal entry would have involved debiting legal expense and crediting prepaid expenses. Since this entry was missed, the retained earnings balance is now overstated. To correct this, a prior period adjustment is made by debiting retained earnings to reduce it by $40,000, reflecting the accurate amount that should have been reported if the expense had been recorded correctly. The corresponding credit would be made to the prepaid expense account to eliminate the asset that was incorrectly recorded.

It is important to note that if the error were discovered in the current period and the financial statements had not yet been released, the company could simply record the necessary entry without affecting retained earnings. However, when the error pertains to a prior period, the adjustment must be made to retained earnings to maintain the integrity of the financial statements.

In summary, prior period adjustments are essential for correcting errors that impact retained earnings, ensuring that the financial statements provide a true and fair view of the company's financial health. Understanding how to identify and correct these errors is a vital skill for accountants and financial professionals.

When a company changes its accounting principle, such as switching inventory costing methods, it must adjust its retained earnings to reflect this change. The most common scenario involves transitioning between methods like FIFO (First-In, First-Out), LIFO (Last-In, First-Out), or the weighted average method. This adjustment is crucial because it ensures that financial information remains comparable across different periods, which is essential for investors and stakeholders making informed decisions.

For instance, if a company has been using the weighted average method and decides to switch to FIFO, it must restate previous financial statements as if FIFO had always been used. This process involves calculating the cumulative effect of the change, which represents the necessary adjustments to prior periods. In our example, if the cumulative effect indicates a $40,000 increase in inventory due to the switch to FIFO, this means that the inventory balance would have been $40,000 higher if FIFO had been used consistently.

The accounting entries for this adjustment would include a debit to inventory for $40,000, reflecting the increase in inventory. Correspondingly, the cost of goods sold (COGS) would decrease by the same amount, leading to an increase in net income and, consequently, retained earnings. This is because lower COGS results in higher income, which directly impacts retained earnings. Therefore, the adjustment to retained earnings is made to reflect the higher income that would have been reported if FIFO had been used in prior periods.

In summary, when a company changes its accounting principle, it must restate prior financial statements to maintain comparability. The cumulative effect of the change is recorded as an adjustment to both inventory and retained earnings, ensuring that the financial statements accurately reflect the company's financial position and performance over time.