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Prior Period Adjustment: Errors

Brian Krogol
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So let's talk about a special entry that gets made in retained earnings, a prior period adjustment. So this is a rare case, but sometimes gap will require us to adjust the beginning balance of retained earnings and it's gonna 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 since it's related to a previous periods, net income, we'll 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 uh income statements from previous years. So what we're gonna do is if we have an un recorded expense or loss from a previous period, well, that means we're going to overstate the retained earnings balance right? That we're overstating the retained earnings because the expense, the un recorded expense means um we overstated net income right? Because if we didn't have enough expenses, if we didn't show all our expenses, well, that would have 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 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, right? We forgot to record a revenue. We forgot to record this increase the 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. So if we last year missed entry, what we should have done, we should have done a debit to 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 right. So when we showed our income statement, while our income would have been overstated, right, because we didn't take this expense, we didn't, we had less 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 right? So what we need to do at this point is we need to fix our retained earnings balance right now are retained earnings balance is too high because we didn't take that expense right? And we're not gonna take that expense this year. We don't want to show that expense as this year's cost that was related to last year. Right? It wouldn't make sense for us to now this year say, oh 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. So we need to fix it with a debit, right? Debits to retain earnings, reduce it right? Because it's an equity account. Equity accounts have that 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 of retained earnings as if we had taken that legal expense last year. Right now, what's the other side of the century, what do we need to credit? We need to credit the prepaid expense account, right? 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 right? We need to get 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 retain earnings. Okay so 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. Okay So remember if we need to increase our retained earnings we would increase 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, what 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. Alright let's do that in the next.