Correcting a prior-period accounting error: method and impact

Several months after the year-end close, you discover that an invoice was never recorded, that depreciation was miscalculated, or that revenue was booked twice. The period is closed, the accounts are approved, sometimes filed with the registry. The question is not whether you can correct it, but how to do so cleanly, without reopening a frozen period and without triggering an avoidable tax reassessment.

This article explains how to correct an accounting error relating to a prior period, how to distinguish it from a change in accounting method, and how to manage its impact on retained earnings and on tax.

A prior-period error is never corrected by reopening the closed accounts. The correction is recorded in the current period. If the error is material, it is charged to retained earnings (equity), not to profit or loss. For tax purposes, the symmetrical balance-sheet correction theory and the intangibility of the opening balance sheet of the first non-time-barred period (article 38-4 bis of the French tax code) govern how the corrected profit is allocated. An amended tax return is often required.

The treatment depends entirely on how the issue is qualified. The two notions are often confused, and that is the first source of dispute with the tax authorities and the auditor alike.

• An error: an omission or the wrong application of a rule to a fact that was already known and available at the date the accounts were drawn up. Examples: a forgotten invoice, double posting, the wrong depreciation rate, an expense allocated to the wrong period.
• A change in accounting method: moving from one acceptable method to another acceptable method (for example a change in the depreciation pattern or in the inventory valuation method), at the entity's initiative or imposed by a new rule.

The boundary is not always clear-cut. A rule misapplied from the outset is an error, not a change in method. Conversely, deciding today to value differently an item that was correctly treated yesterday is a change in method.

What the French GAAP (PCG) provides#

For a change in accounting method at the entity's initiative, article 122-2 of the PCG sets the dual condition: it is only possible if a rule permits it, or if it leads to better financial information (for example because the change provides a truer and fairer view).

It is then article 122-3 of the PCG that sets the calculation mechanism. The effect, after income tax, of the new method is calculated retrospectively, as if it had always been applied. The impact of the change, determined at the opening date and after the tax effect, is charged to retained earnings as of the opening of the period, unless, owing to the application of tax rules, the entity has to record the impact of the change in profit or loss.

For the correction of a material error, the logic is similar: the corrective entry runs through retained earnings rather than through the period's profit or loss, so as not to distort current performance with the catch-up of past items.

Materiality is assessed against the true and fair view (article L123-14 of the French Commercial Code): an error is material if it is liable to influence the judgement of a reader of the accounts.

There is no universal legal percentage. In practice, the threshold is built around the size of the entity, the nature of the line item and the recipients of the accounts (banks, shareholders, investors). The same 5,000 euro error is trivial for a group and major for a young company in a fundraising round.

This is often where files go off track. Correcting the bookkeeping cleanly is not enough: the corrected profit must be allocated to the right tax period.

The symmetrical balance-sheet correction theory requires the error to be corrected both in the closing balance sheet and in the opening balance sheet of each period concerned, as long as the period is not time-barred. But this symmetry is capped by the intangibility of the opening balance sheet of the first non-time-barred period (article 38-4 bis of the French tax code): you cannot go back indefinitely to neutralise an old error.

The concrete consequence: depending on whether the error overstated or understated past profit, its correction may give rise to additional tax (hence an amended return and possible penalties) or, conversely, to an overpayment to be recovered. The direction of the error changes everything.

No, you do not reopen filed accounts. The correction is reflected in the accounts of the current period. The prior-period accounts already filed remain as they are. Continuity is ensured through retained earnings and, where applicable, through the disclosure in the notes explaining to the reader the origin and amount of the correction.

This correction should not be confused with the reversal technique, used at the start of a period to cancel a cut-off entry (prepaid expenses and income, accrued invoices not yet received). The reversal is a cut-off mechanism, not a tool for correcting an error from a closed period.

1. Qualify: error or change in method. This is the structuring decision.
2. Assess materiality in light of the true and fair view and the recipients of the accounts.
3. Record the entry in the current period: retained earnings for a material error, profit or loss for a non-material error, with the after-tax impact calculation documented.
4. Handle the tax aspect: apply the symmetrical correction, check the intangibility of the opening balance sheet, file an amended return if the tax due has changed.
5. Document and disclose: disclosure in the notes for a material correction, retention of the audit trail, information to the statutory auditor and the shareholders where relevant.

In catch-up files, the most frequent sticking points are not accounting issues but tax issues: a technically correct balance-sheet correction can trigger unanticipated additional tax because no one looked at the direction of the error or at the time bar. Before recording any entry, we always reconstruct the chronology of the error across the open periods. It is this upstream work, more than the entry itself, that avoids unpleasant surprises.

The natural reflex, when a forgotten expense is found, is to book it as an expense in the current period to reduce this year's tax. For a material error, this is doubly risky: the period's performance is distorted, and the tax authorities may consider that the expense relates to a prior period and therefore disallow it for the current year. The right reflex is retained earnings and tax allocation to the correct period.

• Check the qualification: confusing an error with a change in method remains the leading cause of mistreatment.
• Reconstruct the time bar before any correction: the intangibility of the opening balance sheet (art. 38-4 bis of the tax code) limits what can be corrected for tax purposes.
• Do not neutralise a material correction by booking it through profit or loss to smooth the tax charge.
• Document the after-tax impact and the disclosure in the notes: that is what an auditor or an inspector will look at.