It's January 2024 and you found a new CPA for your annual review for 2023. You hand the new CPA the 2022 year end review with financial statements to your new CPA and off you go. Upon analyzing the 2022 financial statements, your new CPA identifies an error on the prior year WIP schedule.
For some reason the formula for calculating over/underbillings was broken on the financial statements and underbillings of $250,000 were recorded instead of $54,429 (difference of $195,571). Assuming the job closed in 2023, the $250,000 underbilling reversed, leaving gross profit of $108,000.
Diagram: The incorrect calculation is shown below along with the correct calculation and the differences between the two.
Now we all know that's wrong because we used the WIP template to calculate what underbillings should've been. The error caused a significant decrease in gross profit in 2023. The new CPA considers it material and records a prior period adjustment for $195,571 to ensure the opening balances are free from material misstatment. As a result, retained earnings is reduced along with underbillings for that amount. You ultimately recognized too much revenue in 2022 by mistake. That revenue is decreased in 2023 by reducing the opening balance in retained earnings and underbillings to ensure an accurate presentation of the 2023 financial statements.
Why is this important? Because I've seen it happen before but for much larger dollar amounts. When users of financial statements (underwriters/bankers/etc.) see prior period adjustments, they get nervous and start asking multiple questions which can delay the process of getting bonds or loans.
The moral of the story is to ALWAYS check the mathematical accuracy of your WIP. It's easy to override a formula, so recalculate WIP to make sure you're recognizing revenue correctly. This should help minimize the risk of having a prior period adjustment.