3.10 Prior Period Adjustments and Retained Earnings

Prior Period Adjustments

• A prior period adjustment is a correction of an error that affected net income from a prior year.

Examples of Prior Period Adjustments

• Overstatement or Understatement of Inventory: This would misstate the cost of goods sold, leading to errors in the reported net income.
• Failure to Record Depreciation: This affects net income measurement; not considering salvage value leads to overstated depreciation.
• Failure to Record a Transaction or Event
• Material Math Error or Misapplication of Accounting Principle: An example includes the misapplication of a new revenue recognition standard.

Accounting Treatment

• Prior period adjustments are reported on the statement of retained earnings immediately after the beginning balance.
• Use the account title "Prior Period Adjustment."
• The adjustment can increase or decrease the beginning balance, depending on the nature of the error.
  • If net income was overstated, subtract the adjustment.
  • If net income was understated, add the adjustment.
• Adjustments must be reported on an after-tax basis because the beginning balance in retained earnings is reported after tax.

Retained Earnings Statement

• Retained earnings represent cumulative net income since the company's inception, less any dividends paid.
• It also represents the amount legally available for dividends.
• Shareholders have the right to share in the profits of the company.

Components of the Retained Earnings Statement

• Beginning Retained Earnings: Balance at the start of the year.
• Change in Accounting Principle: Restatement of the beginning balance due to a change in accounting methods (e.g., from LIFO to FIFO), on an after-tax basis.
• Prior Period Adjustments: Corrections of errors affecting prior year's net income, adjusted on an after-tax basis, to correct financial statements.
• Restated Beginning Balance
• Current Year's Net Income: Income for the current year, adjusted for any errors.
• Dividends: Subtracted from earnings for the current year.
• Ending Retained Earnings Balance: Corrected balance after all adjustments.

Appropriated vs. Unappropriated Retained Earnings

• Appropriated Retained Earnings: Portion of retained earnings restricted by the board of directors, unavailable for dividend distribution. It requires footnote disclosure only, with no journal entry needed and does not change the balance in the retained earnings account.
• Unappropriated Retained Earnings: Share of retained earnings available for dividend distribution.

Example Problem: Desert Incorporated

• Scenario: Equipment costing $10,000$ with a ten-year life and no salvage value was purchased on January 1, Year 1. The total cost was erroneously debited to miscellaneous expense; no depreciation was recorded.
• The error was discovered on December 29, Year 4, before net income and financial statements were prepared.
• Straight-line depreciation method with a 30% tax rate is used.
• The beginning retained earnings balance on January 1, Year 4, was $500,000$.
• Year 4 income before taxes and in error was $100,000$.
• Dividends of $20,000$ were declared in Year 4.

Requirements

1. Determine the correct net income for Year 4.
2. Prepare a retained earnings statement for Year 4.
3. Prepare the necessary journal entry to record the prior period adjustment.

Solution Steps

1. Determine Annual Depreciation Expense:
   • \frac{Original\,Cost}{Useful\,Life} = \frac{$10,000}{10} = $1,000
2. Correct Net Income for Year 4:
   • Net income before tax: $100,000$
   • Depreciation expense: $1,000$
   • Corrected income before taxes: 100,000 - $1,000 = $99,000
   • Tax rate: 30%
   • After-tax income: 99,000 \times (1 - 0.30) = $69,300

Analysis of Prior Year Errors

• Year 1: Recorded $10,000$ as miscellaneous expense instead of $1,000$ depreciation. Expenses overstated by $9,000$.
• Year 2 & 3: No depreciation recorded; expenses understated by $1,000$ each year.
• Total error for three prior years: Expenses overstated by $7,000$ (9,000 - $1,000 - $1,000). Pretax income understated by $7,000$.

After-Tax Adjustment to Retained Earnings

• Prior period adjustment (net of tax) = 7,000 \times (1 - 0.30) = $4,900
• This amount will be added to the beginning retained earnings because prior year's income was understated.

Retained Earnings Statement for Year 4

• Beginning Retained Earnings (January 1, Year 4): $500,000$
• Prior Period Adjustment (net of tax): $4,900$
• Restated Beginning Retained Earnings: $504,900$
• Net Income for Year 4 (corrected): $69,300$
• Dividends: $20,000$
• Ending Retained Earnings: 504,900 + 69,300 - 20,000 = $554,200

Journal Entry

• Debit Equipment: $10,000$
• Debit Depreciation Expense: $1,000$
• Credit Accumulated Depreciation: $4,000$ (4 years * $1,000$ per year)
• Credit Retained Earnings: $4,900$
• Credit Income Taxes Payable: $2,100$

Intra Period Tax Allocation

• Any addition or subtraction to that must also be on an after tax basis and that if it's a material amount, we must disclose the amount of the tax.
• Income from Continuing Operations: Separate disclosure of income tax expense.
• Discontinued Operations: Separate disclosure of the tax effect.
• Change in Accounting Principle
• Prior Period Adjustments: Disclose the effect of taxes when adjusting earnings from prior years.
• Comprehensive Income Items: Reported on an after-tax basis.
• Intra period tax allocation helps users understand the impact of income taxes on various income components.