Retained Earnings: Prior Period Adjustments - Online Tutor, Practice Problems & Exam Prep

Prior period adjustments in retained earnings occur due to errors or changes in accounting principles. Errors, such as unrecorded expenses or revenues, necessitate adjustments to correct overstated or understated retained earnings. For instance, a missed legal expense would require a debit to retained earnings. Changes in accounting principles, like switching inventory methods, also impact retained earnings. The cumulative effect of such changes must be reflected, often resulting in adjustments to both inventory and retained earnings. Understanding these adjustments is crucial for accurate financial reporting and maintaining comparability across periods.

Prior Period Adjustment: Errors

So let's talk about a special entry that gets made in retained earnings, a prior period adjustment. This is a rare case, but sometimes GAAP will require us to adjust the beginning balance of retained earnings and it's going to be for two main reasons. It's either going to be for an error or for a change in accounting principle. Let's start here with an error. If there was an error in a previous period, say we forgot to record an expense or forgot to record a revenue or something like that, and it could make a big deal to the investors. Well, we need to fix that balance and since it's related to a previous period's net income, remember that net income from previous periods, it's already in retained earnings. So we just need to fix our retained earnings balance and fix those income statements from previous years. So what we're going to do is if we have an unrecorded expense or a loss from a previous period, well that means we're going to overstate the retained earnings balance. We're overstating the retained earnings because the unrecorded expense means we overstated net income, right? Because if we didn't have enough expenses, if we didn't show all our expenses, well that would've made our net income too high, right? Because expenses reduce our net income and we forgot to record one, so we would have overstated our net income which in turn would have overstated our retained earnings. And the opposite happens with a revenue. If we forgot to record a revenue, then we would have understated retained earnings, right? We would have understated retained earnings for the same logic, we forgot to record this increase to net income, so we would have understated our net income and then we would have understated retained earnings as well.

Okay. So let's see how this works and how the journal entry works in this example. The accountant at Overlook Corporation discovered a $40,000 legal fee that was capitalized into the prepaid expenses account. However, the legal fees were related to a court case that was settled during the previous year. So the journal entry that we missed, let's do our missed journal entry over here. Last year, what we should've done, we should've debited legal expense for the $40,000 in last year's income statement and we would have credited the prepaid expense account, right, to get rid of that prepaid expense asset and reduce the prepaid expense. But we didn't make that entry, so when we showed our income statement, our income would've been overstated because we didn't take this expense, we had fewer expenses than we should have on our income statement, we should have had an extra expense which would have lowered our net income and that would have lowered our retained earnings balance. So what we need to do at this point is we need to fix our retained earnings balance. Right now our retained earnings balance is too high because we didn't take that expense, and we're not going to take that expense this year, we don't want to show that expense as this year's cost that was related to last year. It wouldn't make sense for us to now say this year we have a legal expense of $40,000. That's not correct. It's related to last year. So what we need to do is fix our retained earnings which is right now too high. We need to fix it with a debit, debits to retained earnings reduce it because it's an equity account. Equity accounts have a credit balance and we reduce it with this debit and that would be the $40,000. So by reducing it by this $40,000, now it shows the correct amount of retained earnings as if we had taken that legal expense last year. Now, what's the other side of this entry? What do we need to credit? We need to credit the prepaid expense account, our asset. We just looked in our books and we saw this legal fee that was in our prepaid expenses account that it shouldn't have been there. We need to rid of this prepaid expense that's sitting as an asset that we already used up. So since it's an asset, we need to credit it to get rid of it. Prepaid expenses were too high and now we fix it by this credit to retained earnings.

These are pretty tough because you have to kind of think logically about what should have been done correctly and then apply it to the retained earnings account this year. So remember if we need to increase our retained earnings, we would do it with a credit, but in this case, we needed to decrease our retained earnings because of this extra expense, so we would decrease it with a debit.

Cool? Alright. So this is what would happen if we had an error that we discovered that was related to a previous year. Now let's say it was related to this year and we discovered, oh back in February we should have made this entry. Well, if we haven't released the financial statements or anything, we would just make this entry. We would just make the entry that we needed to make and everything would be okay. We would show the correct amount of legal expense, whatever, but since it's related to a previous period, well we can't just put the legal expense on our income statement because it's not related to this period, it wouldn't be correct. We need to adjust our retained earnings account and that's that prior period adjustment. So we're adjusting for a prior period error in our retained earnings account. Let's go ahead and see the other reason why we would have a prior period adjustment in the next section.

Prior Period Adjustment: Change in Accounting Principle

So we would also have a prior period adjustment to retained earnings when we have a change in accounting principle. So what does that mean to have a change in accounting principle? Well, there are certain principles that we use when we keep track of our books, when we're doing our record keeping. The most common change of accounting principle, pretty much the only one you're going to see is a change in inventory methods. So that means you were using FIFO, but now you wanted to switch to the weighted average method or you wanted to switch to the LIFO method, right? You're switching between different inventory costing methods. So this is a change in accounting principle and remember, one of the main things that makes information useful to the investor is that it's comparable across periods. So if we were going to show this year's income statement and we're using LIFO this year, but last year's income statement is showing FIFO, well it's going to show very different amounts for our inventory, it's going to show different amounts for the cost of goods sold and that could affect decision-making for the users of the financial statement. So what we do is we restate those previous years as if we were always using the new method. So if we were using FIFO before on the old income statement, well, if we change to LIFO, we would change the old income statement as if we were using LIFO at that point. Now those calculations do get tricky and it's beyond the scope of this class to have to make those calculations of how we restate those previous payment, previous years. What they're going to give you in this class, they're just going to give you they'll say something like the cumulative effect. Okay? So the cumulative effect of this change in principle is the amount that you need to restate, okay? And they're going to give you how that works. So let's see it in this example. The inventory company has consistently used the weighted average method to account for inventory and COGS. During the current year, the company decided to switch to the FIFO method. The cumulative effect of the change in accounting principle was a $40,000 increase to inventory. Okay? So this meant that if we had been using inventory all along, well then our inventory would have been $40,000 higher this year. Alright? So, what does that tell us? We need to increase our inventory by $40,000, right? So it's pretty easy in this class when we deal with this because they're going to have to tell you the amount of the increase and we know how to do an increase to inventory, right? It's going to be a $40,000 increase to inventory. Well, that would be a debit to inventory of $40,000. Okay? And remember, when we use different costing methods, it changed the values of our inventory and it changed the value of COGS. If you don't remember that specifically and you want a little more detail, you could go back to a video, I think it was the financial statement effects of inventory costing methods, and it'll show you why the different ones have different ending balances of cogs and inventory, but that's just how we allocate, our purchases and our inventory balances between what we sold and what we didn't sell. In this case, if we had used the FIFO method all along, it meant that we would have had inventory balances $40,000 higher and that meant the COGS balances would have been $40,000 lower, right? So if we would have had lower expenses, well that means we would have had more income. Right? So that would have increased our retained earnings and that's why we see that retained earnings would increase with this credit here. Now, you don't have to think of so much logic. If you just know that the inventory is going to be the debit in this previous change in accounting principle, well obviously the retained earnings have to be part of this, right? This is why we always address retained earnings when we do a prior period adjustment or a change in accounting principle and that's exactly what we're doing here. We're adjusting as if prior periods had always used the FIFO method, right? So we're adjusting the inventory as if we had always been using FIFO and we're adjusting retained earnings where our income would have been higher because COGS would have been lower, we would have had more in inventory rather than in COGS. Okay? So this is the entry we would have had to make. This is going to adjust the beginning balance of retained earnings and it's going to adjust our inventory up to the correct amount of this cumulative effect of the change. Okay? So these can be a little tricky in the logic, but you just have to think about what should have been done correctly and then you just affect the retained earnings account accordingly. Cool? Alright. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What are prior period adjustments in retained earnings?

Prior period adjustments in retained earnings are corrections made to the beginning balance of retained earnings due to errors or changes in accounting principles from previous periods. Errors might include unrecorded expenses or revenues, which can overstate or understate retained earnings. Changes in accounting principles, such as switching inventory methods, also necessitate adjustments. These adjustments ensure accurate financial reporting and comparability across periods.

How do you correct an error in retained earnings from a previous period?

To correct an error in retained earnings from a previous period, you need to adjust the beginning balance of retained earnings. For example, if an expense was unrecorded, you would debit retained earnings to reduce it, reflecting the expense that should have been recorded. Conversely, if a revenue was unrecorded, you would credit retained earnings to increase it. This ensures that the retained earnings balance accurately reflects past financial performance.

What is the impact of changing accounting principles on retained earnings?

Changing accounting principles, such as switching inventory methods, impacts retained earnings by requiring adjustments to reflect the cumulative effect of the change. For instance, if a company switches from FIFO to LIFO, it must restate previous periods as if LIFO had always been used. This adjustment often involves debiting or crediting retained earnings to account for differences in inventory and cost of goods sold (COGS) values, ensuring comparability across periods.

Can you provide an example of a prior period adjustment due to an error?

Sure! Suppose a company discovered a $40,000 legal fee that was mistakenly capitalized as a prepaid expense in the previous year. The correct entry should have been a debit to legal expense and a credit to prepaid expense. To adjust for this error, the company would debit retained earnings by $40,000 to reduce it and credit prepaid expense by $40,000 to remove the incorrect asset. This corrects the overstated retained earnings and ensures accurate financial reporting.

How do you account for a change in inventory methods in retained earnings?

When accounting for a change in inventory methods, such as switching from weighted average to FIFO, you must adjust retained earnings to reflect the cumulative effect of the change. For example, if the cumulative effect is a $40,000 increase in inventory, you would debit inventory by $40,000 and credit retained earnings by $40,000. This adjustment ensures that the financial statements are comparable across periods, reflecting the new inventory method as if it had always been used.