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.

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's certain principles that we use when we keep track of our books, when when we're doing our record keeping the most common change of accounting principle. Pretty much the only one you're gonna see is a change in inventory methods. So that means you were using Fife oh but now you wanted to switch to the weighted average method or you wanted to switch to the life O method right? You're switching between different inventory uh 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 life oh this year. But last year's income statement is showing Fife oh well it's gonna show very different amounts for our inventory is going to show different amounts for 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 FIFA before on the old income statement, Well if we changed to life, oh we would change the old income statement as if we were using life. Oh 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 payments previous years. What they're gonna give you in this class, They're just gonna 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 gonna 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 FIFA 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. All right. 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 gonna have to tell you the amount of the increase and we know how to do an increase to inventory. Right? It's gonna 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 and it changed the values of our inventory and it changed the value of cause if you don't remember that specifically and you want a little more details. You could go back to a video. I think it was the financial statement effects of inventory costing methods and it will 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 Fifpro 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 gonna be the debit in this previous in this change in accounting principle. Well obviously the retained earnings has to be part of this right? This is 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 have always used the Fife o method. Right? So we're adjusting the inventory as if we had always been using Fife oh and we're adjusting retained earnings where our income would have been higher because cogs would have been lower. We would have had more 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 this can be a little tricky uh in 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.