Question

Explain the appropriate adjusting entry for prepaid expenses and for deferred revenues. What is the effect on net income, assets, liabilities, and owner’s equity of not recording a required adjusting entry for prepayments? Please include an example.

Answer 1

Prepaid expenses refer to expenses paid in advance and which is yet to be incurred For example, insurance paid for two years for $2,400 is a prepaid expense. At the end of year only expenses for a year will be recognized in income statement and rest will be carried forward as an asset in balance sheet Thus, when paid an asset is created as and when expense is incurred a portion of it is recognized as expense Effect of not recording Net income               - overstated Assets                         - overstated Liabilities                    - no effect Owner’s equity         - overstated Deferred revenues are income received in advance for which services are yet to be performed. Thus, a liability is created when the advance is received as and when services are performed portion of it is recognized as revenue from the liability account. For example, rent revenue received in advance is carried on balance sheet as a liability as and when the services are performed the liability account is extinguished and revenue is recognized under rent revenue account Effect of not recording Net income               - understated Assets                         - no effect Liabilities                    - overstated Owner’s equity         - understated