Financial statement errors may be due to several factors, such as mathematical mistakes, inaccurate application of accounting rules or incorrect interpretation of facts. One or more prior-period financial statements may have to be restated to correct errors, in addition to an adjustment in the assets, liabilities and retained earnings accounts in the current period. According to John Carroll University professor Robert Bloom and Cleveland State University professor Jayne Fuglister, you must state the nature of the error and disclose the changes made to correct the error.
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Change the appropriate assets and liabilities accounts to reflect the cumulative effect of prior-period errors. If you forgot to record the depreciation expense for a new piece of equipment in a prior period, credit or increase the accumulated depreciation account in the current period to correct the error. If there was an ending inventory overstatement or understatement in the prior period, decrease or increase the beginning inventory balance in the current period, respectively.
Acquisition costs for fixed assets that are in service for more than a year are allocated over their useful lives rather than in the year of purchase. This is known as depreciation. The accounting entries are to debit or increase depreciation expense and credit or increase accumulated depreciation, which is a contra account that reduces the book value of fixed assets.
Adjust the beginning retained earnings balance in the current period to reflect prior-period errors. Errors in sales and expense transactions could affect the net income amount, which affects retained earnings because net income (less dividend payments) is added to it.
For example, if you missed a depreciation expense of £6,500 last year, debit or decrease the beginning retained earnings balance by £6,500 and credit accumulated depreciation by the same amount. If the beginning retained earnings balance was £65,000, enter a separate line that says something like "Less adjustment for prior-period depreciation error" followed by £6,500. Insert another line that says something like "Corrected beginning retained earnings" followed by £58,500 ($100,000 - £6,500).
Restate the prior-period financial statements. If you are presenting comparative financial information, such as side-by-side quarterly statements, the correct amounts must be reflected on the statements along with a note describing the correction.
To conclude the depreciation example, increase bad debts expense and reduce net income on the prior-period income statement by £6,500 each. Increase accumulated depreciation by £6,500, reduce net fixed assets and total assets by £6,500 each, and reduce retained earnings by £6,500 on the balance sheet. If there is a separate statement of retained earnings, decrease the net income and ending retained earnings balances by £6,500 each.
Tips and warnings
- Do not correct prior-period errors by making a compensating error in the current period. For the depreciation example, do not debit depreciation expense and credit accumulated depreciation by £13,000 ($10,000 x 2) each in the current period to correct a missed depreciation entry from a prior period.
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