A correction of an error--also referred to as a prior period adjustment--is sometimes necessary. But when should such a correction be made? And are there situations where a prior period adjustment is improper?
Below I explain what a correction of an error is, when it's appropriate, disclosure requirements, and implications for auditors.
Correction of an Error
In comparative statements (when two or more years are presented), the correction of a prior period error affects the prior period financial statements and opening balances in the current year. In single-year statements, the correction affects opening balances. Here's an example.
If Mountain Bikes, Inc. failed to accrue it's last two weeks’ payables in the prior year, a correction might be needed. Why do I say might? Well, if the amount is not material, then the correction of the error may not be required. If the amount is material, then a correction is necessary.
Suppose you are auditing the financial statements of Mountain Bikes, Inc. for the year ended December 31, 2019, and you discover an error made in the December 31, 2018 financial statements. December 31, 2018 payables of $1 million were not accrued (and the amount is material). In this example, the invoices supporting the $1 million error existed and were on hand during last year’s audit, but, for whatever reason, the amount was not accrued. And the misstatement was not detected by the audit. Now, it's necessary to make a prior period adjustment.
If Mountain Bikes, Inc. provides comparative financial statements, the restated 2018 numbers must reflect the additional $1 million in payables and expenses. This adjustment will of course decrease net income for 2018 and retained earnings. So opening retained earnings (January 1, 2019) will decrease $1 million. The adjustment should not affect net income in 2019.
Before suggesting any corrections, discuss them with your audit client.
Discuss the Error with Management
It’s time to discuss the error with management or the owners. Why? You want to make sure the error is real. If management disagrees, they will tell you, and they will provide an explanation. But if management agrees, it’s time to propose a prior period adjustment (technically referred to as a restatement in the FASB Codification).
Correction of Error Defined
FASB defines a correction of an error as follows:
An error in recognition, measurement, presentation, or disclosure in financial statements resulting from:
- mathematical mistakes,
- mistakes in the application of generally accepted accounting principles (GAAP), or
- oversight or misuse of facts that existed at the time the financial statements were prepared.
Correction of an Error Disclosures
If Mountain Bikes, Inc. presents single year financial statements, the prior period adjustment affects just the opening balance of retained earnings (January 1, 2019, in this example). The company should still provide a disclosure explaining the prior period adjustment.
What should be in the note?
Provide a description of the nature of the error. For example, "The Company failed to record $1 million in payables as of December 31, 2018."
When comparative statements are provided, disclose the prior year numbers compared to the corrected numbers for each affected financial statement line items. (Consider displaying three columns: the uncorrected numbers as stated previously, the corrected numbers, and the difference.) FASB specifically requires disclosure of changes to retained earnings or other equity accounts for each prior period presented.
If a single period financial statement is issued, disclose the effects of the restatement on beginning retained earnings and net income from the preceding period.
Correction of Errors and Auditing
If you are the auditor, consider whether the error was intentional (fraudulent). What if, for example, the recording of the 2018 payables would have adversely affected the company's compliance with debt covenants? Then the understatement of payables may have been intentional.
Regardless, now that the misstatement is known, a prior period adjustment is necessary. Either management makes (accepts) the adjustment or you will need to qualify your opinion. Or, depending on the facts, withdrawal might be necessary. If the prior period adjustment is not made, you may need to contact your attorney and insurance company.
Additionally, if fraud is suspected in the prior period (2018, for example), it will have a bearing on the current year planning and risk assessment. You may be thinking, “But what if I discovered the error while performing the 2019 audit?” In other words, this potential fraud was not known during your 2019 audit planning. What then? Return to your audit plan and adjust accordingly. The audit plan is not static. It is living. The plan should reflect the facts, regardless of when they are discovered—in the early stage of the engagement or later.
If you believe the prior year misstatement was intentional (fraudulent), then incorporate this element in your current year audit planning and responses.
When a Prior Period Adjustment is not Merited
Sometimes there is no error as defined above. If so, a prior period adjustment should not be made. For example, suppose the allowance for uncollectibles as of December 31, 2018 was adequate based on the facts that existed when the financial statements were created. However, in August 2019 (after the issuance of the 2018 statements) the company realizes it will not collect a material 2018 receivable, one that was previously believed to be collectible. Now what? Well, the allowance for uncollectibles should be adjusted in August 2019. A prior period adjustment should not be made. Changes in estimates are prospective.
Sometimes a company might desire a prior period adjustment though one is not merited. Why? It’s a way to sweep problems under the rug. Consider the example in the prior paragraph. If the company incorrectly records the bad debt as a restatement of the January 1, 2019 retained earnings, the expense does not appear in the 2019 income statement. Now, if a single-year presentation is provided, the bad debt expense does not appear in the 2018 or 2019 income statements. (A correction of an error disclosure is required. But some companies don’t mind as long as net income isn't adversely affected.)
Consider that bonuses may be based on net income. If so, this slight of hand could result in extra (fraudulent) compensation. A prior period adjustment might be desired for other reasons as well. Maybe the owners are sensitive to net income or management doesn’t want the embarrassment of declining net income. Whatever the reason, a correction of error should be made only when required by generally accepted accounting principles.