Question

Read the following Communication Case prompt:

"I don't understand," complained Chris, who responded to your bulletin board posting for tutoring in introductory accounting. The complaint was in response to your statements that recording adjusting entries is a critical step in the accounting processing cycle, and the two major classifications of adjusting entries are prepayments and accruals.

After reading the above prompt, respond to Chris:

When do prepayments occur? Accruals?

Describe the appropriate adjusting entry for prepaid expenses and for unearned expenses. What is the effect on net income, assets, liabilities, and shareholders' equity of not recording a required adjusting entry for prepayment?

Describe the required adjusting entry for accrued liabilities and for accrued receivables. What is the effect on net income, assets, liabilities, and shareholders' equity of not recording a required adjusting entry for accruals?

Answer 1

Prepayments occur when excess payment is made for a particular expenditure than required. For example in case the period for which financial statements are being prepared is of 12 months and the insurance premium has been paid for a period of 18 months. In such case the 6 months insurance premium is the prepayment and to be recorded accordingly in the books of accounts.

Accruals on the other hand are the expenditures that are due but has not been paid yet. Thus, in short these are expenditures outstanding.

Date	Account titles and explanations	Debit ($)	Credit ($)
For prepaid expenses	Prepaid expenses	$$$
	Expenses		$$$
For unearned expenses	Unearned expense	$$$
	Expenses		$$$

In case an adjusting entry for prepaid expenses is not recorded than the followings effects will be seen in the financial statements:

Effect on net income:

Net income will be understated by the amount of prepaid expenditures.

On assets:

The current assets will be understated by the amount of prepaid expenditures.

On liabilities:

Though there will be no effect on liabilities but the total of liabilities and equity will be understated by the amount of prepaid expenditures.

On shareholders’ equity:

Shareholders’ equity will be understated by the amount of prepaid expenditures as the net income is understated.

Date	Account titles and explanations	Debit ($)	Credit ($)
For accrued liabilities	Expenses	$$$
	Accrued liabilities		$$$
For unearned expenses	Accrued receivable	$$$
	Receivables		$$$

In case an adjusting entry for accrual expenses is not recorded than the followings effects will be seen in the financial statements:

Effect on net income:

Net income will be overstated by the amount of accrual expenses.

On assets:

There will be no impact on the assets.

On liabilities:

Current liabilities will be reduced by the amount of accrual expenses.

On shareholders’ equity:

Shareholders’ equity will be overstated by the amount of accrual expenses as the net income is overstated.