A company is preparing its financial statements and discovers that it failed to record accrued salaries of $50,000 at the end of Year 1. The error was discovered in Year 2 before the Year 2 financial statements were issued. The company uses a calendar year-end. What is the appropriate accounting treatment for this error in Year 2?
- ARecognize the $50,000 as an expense in Year 2.
- BRestate the Year 1 comparative financial statements to correct the error.
- CAdjust Retained Earnings at the beginning of Year 2.
- DDisclose the error in the notes to the Year 2 financial statements only.
Show answer & explanationAnswer & explanation
Correct answer: B. Restate the Year 1 comparative financial statements to correct the error.
The failure to record accrued salaries in Year 1 is a prior period error that affects a prior year's financial statements. Since the Year 2 statements have not yet been issued, the company must restate the Year 1 comparative financial statements to correct the error. This involves adjusting the beginning balance of retained earnings for Year 1 (if the statements are presented comparatively) and correcting the affected accounts for Year 1.
Why the other options are wrong
- A. Incorrect. This would misstate Year 2 income by including an expense that pertains to Year 1.
- C. Incorrect. While retained earnings are adjusted, the primary action for comparative statements is restatement, which implicitly includes adjusting the beginning balance of retained earnings for the earliest period presented.
- D. Incorrect. Disclosure alone is insufficient; the financial statements must be corrected.
Prior Period Adjustment (Error Correction)
A correction of an error in the financial statements of a prior accounting period. These adjustments are reported by restating the prior period's financial statements presented for comparative purposes.
- Applies to errors in prior periods.
- Requires restatement of comparative financial statements.
- Adjusts beginning retained earnings for the earliest period presented.
- Must be disclosed in the notes to financial statements.
Memory trick: Error's Past, Restate Fast! Don't let old mistakes haunt new reports.