Financial Reporting

Error Correction

Students studying corporate reporting papers at any level will come across the term ‘prior period adjustment’.  This article looks at prior period adjustments which are contained within the provisions of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

The provisions in IAS 8 define a prior period error as:

Omissions from, and misstatements in, the entity’s financial statements for one or more periods arising from a failure to use, or misuse of, reliable information. 

Humans make mistakes and accountants are no different.  So how do we deal with an error in the financial statements that occurred last year?

Consider the following example:

Grantham Inc is preparing their financial statements for the year ended 31 March 2009.  During the course of the preparation of the 2009 financial statements it was found that a fundamental error had occurred when calculating the payroll costs for the year to be included in the statement of comprehensive income. The error was the omission of the final months payroll. Extracts from the financial statements for the year ended 31 March 2008, before the error had been discovered are as follows:

Profit before tax: $100,000
Retained earnings: $300,000

Details of the payroll which had been omitted are as follows:

Gross pay $40,000
Tax $8,800
Employee NIC $4,000
Employer NIC $5,120
Net pay $27,200

Required

We are required to restate the prior years financial statements to take account of the above omission.

Solution

The first thing we need to do is to consult the provisions in IAS 8 that deal with errors.  IAS 8 says that the correction of error should be applied retrospectively therefore we have to revisit the 2008 financial statements and correct them.

The impact of the error is that profit before taxation is overstated by the value of the gross pay and employers national insurance, so $40,000 + $5,120 = $45,120.  Net assets are also overstated.

First we need to consider the journals that would have been done had the error not been made, these would have been:

DR statement of comprehensive income $45,120
CR PAYE/NIC liability account $17,920
(tax and gross national insurance)
CR Net wages liability account $27,200

In the 2008 financial statements, we need to uplift the balance on the PAYE/NIC liability account by $17,920 and the net wages liability account by $27,200 – this sorts out our statement of financial position in terms of liabilities.  The debits that would have been sent to the statement of comprehensive income had the error not been made will go to the retained earnings account.  By debiting retained earnings account we are essentially restoring the balance on the retained earnings account to the amount that would have been transferred to this account had the error not occurred.

Extracts of the financial statements following the correction of the error are as follows:

Grantham Inc
Statement of Financial Position (extract)
As at 31 March 2008

$,000
(as restated)

Current liabilities
Trade and other payables $45,120

Equity
Retained earnings ($300,000 - $45,120) $254,880

In addition to the numbers, the entity would be required under IAS 8 to make a disclosure in their financial statements concerning the error and the impact that it has had on the financial statements so the user is aware of the error.

The above example is a simple example of how an entity should deal with error correction in their financial statements that have been issued in older periods.  The principles, whether complex or straightforward, regarding IAS 8 and prior period errors are the same. 

Students often find this area of studying complicated because it involves going back to the earliest period reported in the financial statements and correcting the opening position.  However, with lots of practice in this area it should all soon become a familiar exercise.

Steve Collings FMAAT ACCA DipIFRS is Audit and Technical Manager at Leavitt Walmsley Associates (http://www.lwaltd.com).  He is also a partner in AccountancyStudents.co.uk and is the author of ‘The Core Aspects of IFRS’ copies of which can be purchased from http://www.accountancystudents.co.uk