Definition
The financial accounting term prior period adjustments refers to either a correction to a prior period's financial statement, or the realization of a tax benefit resulting from an operating loss of a subsidiary before it was acquired.
Explanation
Prior period adjustments is one of several categories of irregular items that may appear as line items on one or more of the company's financial statements. As outlined by the Financial Accounting Standards Board, the following two items would be excluded when determining net income in the current period:
Correction of an error appearing in a prior period's financial statement.
Income tax benefits derived from the operating loss of a purchased subsidiary that occurred before it was acquired.
If an error is found in a prior period's financial statement, this should result in a retroactive restatement of the company's report. An adjustment would then be made to retained earnings in the current period.
While the correction of an error appearing in a prior financial statement is more common than income tax benefits derived from operating losses of a purchased subsidiary, corrections are typically viewed with caution by readers of these statements. Errors are usually regarded as a failure in the company's financial controls or accounting processes.
Example
Company A discovered an error which resulted in the understatement of depreciation by $100,000 in the prior accounting period. This error affected both Company A's income statement as well as its tax return for that year. The journal entry to record this transaction would be:
| Debit | Credit | |
| Accumulated Depreciation | $100,000 | |
| Taxes Payable | $40,000 | |
| Retained Earnings | $60,000 |
While the disclosure of the error in retained earnings would be:
| Retained Earnings, January 1, 20XX | $35,500,000 | |
| Prior Period Adjustments: | ||
| Understatement of Depreciation Expense | ($60,000) | |
| Adjusted Retained Earnings, January 1, 20XX | $35,440,000 |
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