Financial Reporting and Concepts

Special Reporting Situations

In earlier book chapters, it was noted that the accounting profession uses an "all inclusive" approach to measuring income. Virtually all transactions, other than shareholder related transactions like issuing stock and paying dividends, are eventually channeled through the income statement. However, there are certain situations where the accounting rules have evolved in sophistication to provide special disclosures. The reason for the added disclosure is to make it easier for users of financial statements to sort out the effects that are related to ongoing operations versus those that are somehow unique. Specifically, the following discussion will highlight the correct handling of (1) error corrections, (2) discontinued operations, (3) extraordinary items, (4) changes in accounting methods, and (5) other comprehensive income items.

Corrections of Errors

Errors consist of mathematical mistakes, incorrect reporting, omissions, oversights, and other things that were simply handled wrong in a previous accounting period. Once an error is discovered, it must be corrected.

The temptation is to simply force the books into balance by making a compensating error in the current period. For example, assume that a company failed to depreciate an asset in 20X4, and this fact is discovered in 20X5. Why not just catch up by "double depreciating" the asset in 20X5, and then everything will be fine, right? Wrong! While it is true that accumulated depreciation in the balance sheet would be back on track at the end of 20X5, income for 20X4 and 20X5 would now both be wrong. It is not technically correct to handle errors this way; instead, generally accepted accounting principles dictate that error corrections (if material) must be handled by "prior period adjustment." This means that the financial statements of prior periods must be subjected to a restatement to make them correct - in essence the financial statement of prior periods are redone to reflect the correct amounts.

Correcting financial statements of prior periods entails reissuing financial statements with the necessary corrections. However, what journal entry is needed, given that revenue and expense accounts from earlier years have already been closed? Suppose that, in 20X5, a journal entry is needed to record the depreciation for 20X4 that was previously omitted in error:

This entry reveals a debit to Retained Earnings (reducing the beginning of year balance) for the depreciation expense that should have been recorded as an expense and closed to retained earnings in the prior year. The credit to Accumulated Depreciation provides a catch up adjustment to where the account would have been, had the deprecation been correctly recorded in 20X4.

Importantly, if comparative financial statements (i.e., financial statements, side by side, for two or more years as illustrated in the next chapter) are presented for 20X4 and 20X5, depreciation would be reported at the correct amounts in each years' statements (along with a note indicating that the presentation of prior years' data have been revised for an error correction). If an error related to prior periods for which comparative data are not presented, then the statement of retained earnings would be amended as follows:

Shareholders generally take a dim view of prior period adjustments as they tend to undermine confidence in management and financial information. But, GAAP takes the position that accountants must own up to their mistakes and reissue corrected financial data. As a practical matter, some accountants give way to the temptation to find creative ways to sweep errors under the rug. But, be wary of falling into this trap, as many a business person has found themselves in big trouble for trying to hide erroneous accounting data!