Definition
A Prior Period Adjustment (PPA) is an accounting technique used to correct errors made in previous financial statements. These errors might include mathematical mistakes, incorrect application of accounting principles, or overlooked expenditures or incomes. Prior period adjustments ensure that the financial data accurately reflects the historical financial health of the organization and aligns the financial records with Generally Accepted Accounting Principles (GAAP).
Key Points:
- Correction of Errors: Prior period adjustments are primarily used to fix mistakes from previous accounting periods.
- Impact on Retained Earnings: Adjustments are generally made by altering the beginning retained earnings balance of the earliest period presented.
- Compliance with Standards: Accountants must follow guidelines provided by the Financial Accounting Standards Board (FASB) for making these adjustments.
Examples
- Inventory Adjustment: Suppose a company discovers that it incorrectly reported its inventory balance the previous year, leading to an overstatement of income. A prior period adjustment would be made to correct the inventory balances and adjust the retained earnings accordingly.
- Litigation Settlement: If a company settles a lawsuit that relates to an event from a past accounting period, the payment should be accounted for as a prior period adjustment if it wasn’t adequately recorded when the event occurred.
Frequently Asked Questions
Q1: When should a prior period adjustment be made?
A1: A prior period adjustment should be made when a significant error affecting prior financial statements is discovered. Materiality and relevance are key factors in determining the need for an adjustment.
Q2: Will a prior period adjustment affect current year earnings?
A2: No, a prior period adjustment should not affect current year earnings. The correction is usually reflected in the retained earnings account from the earliest period presented.
Q3: Where are prior period adjustments recorded in financial statements?
A3: Prior period adjustments are typically recorded in the statement of retained earnings, which is part of the Statement of Changes in Equity, and are prominently disclosed in the notes to the financial statements.
Related Terms
- Retained Earnings: The cumulative amount of net income that a company retains rather than distributing it to shareholders as dividends.
- Restatement: The process of revising previously issued financial statements to correct an error.
- Materiality: The significance of financial statement information to influence the economic decisions of users.
- GAAP (Generally Accepted Accounting Principles): A collection of commonly followed accounting rules and standards for financial reporting.
Online References
- Financial Accounting Standards Board (FASB)
- SEC Staff Accounting Bulletin: No. 99 – Materiality
- Investopedia – Prior Period Adjustment
Suggested Books for Further Studies
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- Financial Accounting Theory and Analysis: Text and Cases by Richard G. Schroeder, Myrtle W. Clark, and Jack M. Cathey
- Accounting Principles by Jerry J. Weygandt, Donald E. Kieso, and Paul D. Kimmel
Fundamentals of Prior Period Adjustment: Accounting Basics Quiz
### What is a primary reason for making a prior period adjustment?
- [x] To correct errors in previously issued financial statements.
- [ ] To allocate a current year’s expense.
- [ ] To increase retained earnings for stockholder distribution.
- [ ] To adjust future projections.
> **Explanation:** Prior period adjustments are made to correct errors from previous financial statements, ensuring accurate historical data.
### How does a prior period adjustment affect retained earnings?
- [ ] It decreases retained earnings for the current period.
- [x] It adjusts the initial retained earnings balance for the earliest period presented.
- [ ] It has no effect on retained earnings.
- [ ] It increases retained earnings for the current period.
> **Explanation:** Prior period adjustments modify the initial retained earnings balance of the earliest period presented to correct for past errors.
### Can prior period adjustments be made for immaterial errors?
- [ ] Yes, always.
- [x] No, typically only for material errors.
- [ ] Only if approved by auditors.
- [ ] Yes, if the board of directors agrees.
> **Explanation:** Prior period adjustments are usually made for material errors that could impact the decision-making of financial statement users.
### Which body provides guidelines for making prior period adjustments?
- [ ] Internal Revenue Service (IRS)
- [ ] International Monetary Fund (IMF)
- [x] Financial Accounting Standards Board (FASB)
- [ ] Securities and Exchange Commission (SEC)
> **Explanation:** The Financial Accounting Standards Board (FASB) lays down the guidelines for how prior period adjustments should be made.
### Are prior period adjustments reflected on the income statement?
- [ ] Yes, always.
- [x] No, they are reflected in the retained earnings.
- [ ] Only in the supplementary notes.
- [ ] Yes, but only in a separate section.
> **Explanation:** Prior period adjustments are generally reflected directly in the retained earnings and not on the current income statement.
### Should prior period adjustments be disclosed in the financial statements?
- [x] Yes, along with detailed explanations.
- [ ] No, just adjusted.
- [ ] Only if requested by shareholders.
- [ ] Yes, but only in quarterly reports.
> **Explanation:** Disclosure of prior period adjustments in the notes to financial statements is necessary to provide full transparency to the stakeholders.
### What document is primarily affected by prior period adjustments?
- [ ] Cash Flow Statement
- [ ] Balance Sheet
- [ ] Income Statement
- [x] Statement of Retained Earnings
> **Explanation:** Prior period adjustments typically affect the Statement of Retained Earnings, altering the beginning balance.
### Which of the following would *not* require a prior period adjustment?
- [x] Allocation of current year marketing expenses.
- [ ] Correction of a past year’s revenue misstatement.
- [ ] Adjusting overlooked past expenditure.
- [ ] Rectifying misclassified past liabilities.
> **Explanation:** Allocation of current year marketing expenses pertains to the current period and does not necessitate a prior period adjustment.
### If a material error is found in a recent accounting year's financial statements, when should the adjustment be made?
- [ ] In the next year’s financial statement.
- [ ] Never disclose it.
- [ ] Only during fiscal audits.
- [x] Corrected immediately and restated in the next issued financial statements.
> **Explanation:** Material errors should be corrected and restated in the next available financial statement to maintain accuracy and compliance.
### Are opening balances influenced by prior period adjustments?
- [ ] No, they remain the same.
- [x] Yes, they are adjusted to reflect the accurate financial condition.
- [ ] Only on auditors' request.
- [ ] No, it affects only future records.
> **Explanation:** Opening balances are adjusted to accurately reflect the financial condition by correcting previous errors.
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