Journal Entry for Prior Year Adjustment
Prior year adjustment is the accounting entry that company record to correct the previous year’s transactions.
A financial statement is a formal document that shows financial health, business performance, and many more. It includes a balance sheet, income statement, and cash flow statement. They can be used to track a company’s progress over time or to compare it to other businesses. A financial statement is an important tool for business owners and investors.
The balance sheet is a report that measures the assets, liabilities, and owner’s equity of the company at a specific point in time. It shows what resources an organization can access to generate revenue. The balance sheet lists all of the financial resources of the business such as cash, debts owed by others, investments in marketable securities, and property (land or buildings). The assets side of the balance sheet is arranged in order of liquidity: cash comes first, then other investments such as stocks and bonds, accounts receivable, inventory, and equipment. Liabilities are the next item on the list, they represent the amount that company owes to the creditor and other parties. The last component is the equity which presents the amount of owner investment into the company.
The income statement measures how well the business is doing over a period of time. It shows all revenue and expenses incurred during that period, along with the difference between the two figures. Revenue is listed first, then subtracting any costs associated including the cost of goods sold, compensation expense, etc. Operating expenses are next on the list, and they include rent, utilities, borrowing costs, etc. The final figure is the bottom line, whether the business earned a profit or incurred a loss for that period.
At the end of accounting period, the profit or loss from the income statement will move to the retained earning which is the equity component on the balance sheet. It is called the year-end closing which will reset all the accounts on the income statement to zero. After that, we will not be able to record the prior year’s income statement. The revenue and expense accounts that are recorded into the new year will impact the new year income statement.
In order to record, the revenue and expense for the prior year, we need to use the retained earning account instead. As we know that the revenue and expense of the prior year will impact the retained earnings. So if we want to increase or decrease the prior year’s profit, we can do so by recording the retained earnings.
Journal Entry for Prior Year Adjustment
When the company finds some error in the prior year and they wish to correct it. However, if the mistake is related to the revenue and expense, it will be tricky to correct them. As we know, we cannot adjust the income statement account. When we record the revenue and expense, it will reflect with current year’s performance, not the prior year. The income statement of last year is already closed and all revenue/expense accounts reset to zero at the beginning of the new year.
If we want to adjust the prior year’s income or expense, we have to adjust with retained earning account instead. The prior year profit or loss is already reflected in the retained earnings on the balance sheet.
When we want to record the prior revenue, it will increase the profit, so it will increase the retained earnings as well. The other side may impact assets account. The journal entry is debiting assets and credit retained earnings.
| Account | Debit | Credit |
|---|---|---|
| Assets | $$$ | |
| Retained Earnings | $$$ |
If we want to record expenses, it will decrease the prior year’s profit as well as the retained earnings. So we have to debit retained earnings and credit the liability.
| Account | Debit | Credit |
|---|---|---|
| Retained Earnings | $$$ | |
| Liability | $$$ |
Example
ABC has already prepared last year’s financial statement. However, they found some mistakes, and the accounting system does not allow posting backdate. There are two errors as follows:
- Company has forgotten to record revenue of $ 5,000 which is sold on credit and is still not collected.
- Company also forget to record expenses of $ 2,000 which is still payable to the supplier.
Please prepare the journal entry for the prior year’s adjustment.
The company forgets to record revenue of $ 5,000, which means that last year’s revenue is understated. The profit is also understated, it is the same as the retained earnings. We have to record this revenue to increase the retained earnings as the prior year’s income statement is already closed.
The journal entry is debiting accounts receivable of $ 5,000 and credit retained earning $ 5,000.
| Account | Debit | Credit |
|---|---|---|
| Accounts Receivable | 5,000 | |
| Retained Earnings | 5,000 |
Moreover, company also understates expenses by $ 2,000. It means the profit is overstated as well as the retained earnings. When we record this expense, it will reduce the retained earnings. The journal entry is debiting retained earning $ 2,000 and credit accounts payable $ 2,000.
| Account | Debit | Credit |
|---|---|---|
| Retained Earnings | 2,000 | |
| Accounts Payable | 2,000 |