Question

Failure to make a necessary adjusting entry for accrued interest on a note payable would result in which of the following?

A.) Net income would be overstated and assets would be understated.

B.) Net income would be understated and liabilities would be understated.

C.) Liabilities and stockholders' equity would both be understated.

D.) Net income and stockholders' equity would be overstated and liabilities would be understated.

Answer 1

Solution:

Option D is the correct answer "Net income and stockholders' equity would be overstated and liabilities would be understated"

Explanation:

Accrued Interest represents that portion of  Interest that has occurred, but has not been paid as of a balance sheet date.

Impacts will be

1. Overstated Income:

Reason: As per the accrual basis of accounting, this interest expense must be debit to Interest Expense in the statement of profit and loss. This expenditure belongs to the current year irrespective of the fact that it is not paid yet. If this interest expense not recorded will lead to an overstatement of profit.

2. liabilities would be understated"

Reason: This accrued Interest must be credited to the current liability Interest Payable. This will be shown under the current liabilities in the statement of Financial Position or Balance sheet. If this expense is not credited to interest payable account will result would be understated liabilities.

3.  stockholders' equity would be overstated

Reason: As the profit earned by the entity will increase the balance of stockholder equity in the balance sheet. Any under or overstatement of profit will have a direct impact on shareholder equity. As in the present case if the profit is overstated then stockholder equity balance will also be overstated at the end to the year.