In an ideal world, the books are closed, financial statements are published, and adjustments to prior periods are not necessary. However, despite our best intentions, this does not always happen. What are prior period adjustments and when are they appropriate? Adjustments to prior periods require going back into a closed accounting period to correct errors related to missing, incomplete, or inaccurate transactions. The purpose of these adjustments is to rectify the accuracy of the financial statements for a given period of time so they are not misleading. The type of business sector, public vs. private, should be determined along with the materiality of the proposed adjustment. If you are in the public sector, the guidelines are much stricter and you should consult your auditor to approve the adjustments and determine the documentation requirements to ensure compliance with Generally Accepted Accounting Principles (GAAP). If you are in the private sector, determine the materiality of the change and footnote the financials regarding the adjustment. Note that if you are in the private sector but operate under the contingency of going public, assume the rules of the public sector.
What situation could result in a prior period adjustment, how does it occur, and how can it be avoided? To illustrate, a payment to an insurance company is booked directly to the Income Statement as an “expense” as opposed to an “other asset” account on Balance Sheet. The books are closed and financial statements are published. The related insurance policy eventually arrives in the mail. After further review, you realize the payment made actually covers 12 months and the policy premium should have been expensed evenly over that time period. Your financial statements are misstated. On the Income Statement, insurance expense is overstated and net income is understated. On the Balance Sheet, other current assets and retained earnings, if it spans into prior year, are understated. In this case, the transaction was posted without proper source documents. Misapplying the terms of source documents is one of the leading causes of errors in financial statements. To avoid this issue going forward make sure you request and review all source documents timely and carefully. Once the error has been identified, a decision should be made based on compliance with GAAP and the materiality of this error as to whether an adjustment needs to be posted and prior period financial statements restated.
It is important to remember that most companies have internal controls in place to reduce errors in the accounting system and minimize the need for prior period adjustments. For example, routine account reconciliations help ensure the completeness and accuracy of transactions. Utilizing functions like password protecting closed periods in the accounting system ensure entries are not posted to prior periods without proper approval.
If you need help determining materiality or restating prior period financials, contact a professional accounting firm like TGG Accounting for help. Not only will we correct the error and deliver correct financial statements, we will implement processes and controls to prevent mistakes in the future.Written by: Andrea Murray TGG Accounting