A prior year adjustment in accounting is a correction of errors in a company's financial statements for the previous year. For example, if XYZ Limited reported a lower depreciation amount, an adjustment is made by debiting the retained earnings account and crediting the accumulated depreciation account in the current year.
XYZ Limited should include the adjusted retained earnings as part of its disclosures at the beginning of the year. A prior year adjustment also refers to the adjustment of entries in financial statements to reflect income tax benefits from losses incurred by acquired subsidiaries in the previous year, which is rare.
Errors on financial statements are typically caused by mathematical errors, wrong application of GAAP standards and the oversight of facts during the preparation of the financial statements. A company should disclose the effect of prior year adjustments on each line item affected; it should also disclose the impact of such adjustments on its retained earnings.
Accountants should avoid making prior period adjustments if the amounts involved do not affect a company's financial position as reported in its financial statements. Investors are usually suspicious of any prior period adjustments, which according to them, are caused by the failure of accounting systems within a company.