Prior-period adjustments are modifications made to previously released financial statements. They can arise due to a variety of reasons, including errors, changes in accounting principles, changes in estimates, or corrections of prior period misstatements. Taxpayers must carefully evaluate the need for prior period adjustments and ensure that the changes are correctly recorded and disclosed in the financial statements.
The corporate tax provision could require a prior-period adjustment based on changes to the accounting results and/or changes to previous tax calculations — whether that is just the tax effect of any accounting changes or adjustments to the prior year’s income tax provision itself.
Is a Prior Period Adjustment Necessary?
Determining whether a prior period adjustment to the tax provision is necessary depends on many factors. The underlying causes of these adjustments typically reveal themselves upon audit of the financial statements, but they can also be discovered during routine review of general ledger activity or the tax calculations themselves. If a discrepancy is a possibility, the following steps should be followed:
- Identify the error or discrepancy: Is this an adjustment to pre-tax book income, or just to the income tax provision?
- Calculate the adjustment: Determine the impact of the error on the previous year’s income tax expense and deferred tax balances.
- Record the adjustment: This typically involves an adjustment to retained earnings and the deferred tax accounts.
- Disclose the adjustment: Provide appropriate disclosures about the nature and amount of the adjustment.
The key to whether an adjustment to the financial statements is necessary will be based on the materiality of the error — only significant adjustments should be recorded as prior period adjustments. Materiality is an ever-changing threshold and is the level at which an information omission or misstatement could significantly alter the financial picture of the company. In essence, the goal of a prior period adjustment is to correct the financial statements for the prior year to accurately reflect the actual tax position.
Let’s walk through the steps.
1. Identify the error or discrepancy
There are different types of prior period adjustments, including:
- Adjustments to prior year pre-tax book income calculation
- Error corrections: These are adjustments made due to an error in the previous period’s financial statements. For example, if a company made a mistake in calculating its depreciation expense, it could make a correction and adjust the financial statements of the previous period.
- Changes in accounting principles: Sometimes, companies change their accounting principles due to new accounting standards or regulations. In such cases, prior period adjustments are necessary to reflect the impact of these changes on the financial statements of the previous period.
- Changes in estimates: Companies use estimates to account for uncertain events, such as bad debts, inventory obsolescence, or warranties. If these estimates change in subsequent periods, prior period adjustments may be required to reflect the impact on the financial statements of the previous period.
- Corrections of prior period misstatements: Misstatements can occur due to fraud, error, or omission. These misstatements can be intentional or unintentional. If discovered, prior period adjustments may be necessary to correct the misstatements and adjust the financial statements of the previous period.
Based on the amount of these adjustments, it may be necessary to update the tax provision calculation as well. Again, materiality plays a key role in making this determination.
Adjustments only to the prior year’s income tax provision calculation
- Differences in tax rates: Changes in tax rates between the estimate used in the provision and the actual rate applied on the tax return.
- Example: A change in the corporate tax rate enacted during the year. Errors in tax calculations: Mistakes in calculating taxable income, deductions, or credits.
- Oversights or misinterpretations of tax laws.
- Differences in estimates for taxable Income: Discrepancies between estimated and actual taxable income.
- Example: Inventory valuation differences or depreciation methods.
- Uncertain tax positions: Resolution of tax positions that were uncertain at the time of the provision.
- Example: A tax audit resulting in a settlement different from the estimated provision.
2. Calculate the adjustment
This is pretty straightforward. Calculate the effect of the adjustments on the tax provision. Rerun the full tax provision calculation with the new/updated information. Compare to the original to determine the total effect.
3. Record the adjustment
One side of the tax journal entry will post the adjustment to the deferred tax asset or liability and the offset is to retained earnings.
4. Disclose the adjustment
When recording a prior period adjustment, the correction’s impact on every line item on the financial statement must be identified, including any affected per-share amounts, and the total impact of the change in retained earnings. Present the prior period results as if the error never happened. Restate interim periods to reflect the impact of the adjustment if applying a prior period adjustment to an intermediate period of the current accounting year.
The disclosure of the adjustment should include the type of inaccuracy, the amount of correction for each prior period presented, a description of the facts that gave rise to the problem, as well as how and when the error was fixed.
Disclosure of adjustments need not be repeated in financial statements for succeeding quarters. Disclosing only in the period discovered and booked is sufficient.
How does an Adjustment Differ from a Restatement?
While a prior period adjustment is a big deal, it is not the same as a restatement. A restatement is a more comprehensive revision of financial statements that involves correcting errors or omissions that affect multiple periods. It often requires restating the financial statements for all periods presented and may involve changes to other financial statement items besides retained earnings.
Prior period adjustments and restatements are generally seen quite negatively by the company’s management and stakeholders, who assume that the company’s accounting and/or tax system is flawed. Unless an error or omission is of such magnitude to be material to the financial statements, they should be avoided.
As a final note, it’s interesting that ASC 740 has no provisions for prior period adjustments. There is no formal accounting standard for this issue. Therefore, consult with your advisors to determine the proper strategy.
