Corrections to prior period retained earnings can result from several factors, such as math errors or incorrect applications of generally accepted accounting principles. Retained earnings reflect the company's accumulated net income or loss, less cash dividends paid, plus prior period adjustments. Companies must exclude the effect of prior period adjustments from current financial statements, since the changes have no relationship to the current statement period. Prior period adjustments can only be made to correct errors and certain tax-related adjustments.
Find the prior period error. There could be an incorrect application of depreciation rules, an expense incorrectly recorded as an asset or a mathematical error. For example, if a scheduled $5,000 depreciation expense was not recorded in the prior year, then it will impact the net income and retained earnings numbers. Fixed assets are usually depreciated over their useful lives rather than being expensed in the year of purchase.
Make the appropriate adjustments. In the example, credit accumulated depreciation -- a balance sheet account that is used to reduce the book value of assets over their useful lives -- and debit retained earnings by $5,000. Write a brief note stating that the entry is to reverse a prior year error.
Correct the beginning retained earnings balance, which is the ending balance from the prior period. Record a simple "deduct" or "correction" entry to show the adjustment. For example, if beginning retained earnings were $45,000, then the corrected beginning retained earnings will be $40,000 (45,000 - 5,000).
Restate prior period earnings statements if you are releasing them with your current statements. The restated results must be reflected on the income statement, balance sheet and cash flow statement. In the example, the depreciation expense, net income, total assets and operating cash flow amounts for the prior period will be changed to reflect the error.
Tip
Under International Accounting Standards 8, or IAS 8, disclosures relating to prior period errors must include the nature of the prior period error, the amount and extent of the correction and, if a restatement is not practical, an explanation and description of how the error has been corrected.
