You are a tutor for introductory financial accounting. You tell your students "Recording adjusting entries is a critical step in the accounting cycle, and the two major classifications of adjusting entries are prepayments and accruals". Chris, one of the students in the class, says, "I don't understand".
Required:
1. When do prepayments occur? When do accruals occur?
2. Describe the appropriate adjusting entry for (a) prepaid expenses, (c) deferred revenues.
3. What is the effect on (a) net income (b) assets (c) liabilities (d) stockholders' equity of not recording a required adjusting entry for prepayments? For each item, indicate clearly whether the effect will be an Increase, a Decrease, or No Effect. Please present your answers using the template below. I have done Net income as an example. Item Increase Decrease No Effect Net income x Assets Liabilities Stockholders' Equity
4. Describe the appropriate adjusting entry for (a) accrued expenses (c) accrued revenues.
5. What is the effect on (a) net income (b) assets (c) liabilities (d) stockholders' equity of not recording a required adjusting entry for accruals? For each item, clearly indicate whether the effect will be an Increase, a Decrease, or No Effect. Please present your answers using the template below. Item Increase Decrease No Effect Net income Assets Liabilities Stockholders' Equity

On June 30, you are preparing the financial statements for the first 6 months of operations. Since 6 months have already passed since you purchased insurance, then you have to accrue 6 months worth of insurance expense:

June 30, adjustment entry

Dr Insurance expense 600

Cr Prepaid insurance 600

3. What is the effect on (a) net income (b) assets (c) liabilities (d) stockholders' equity of not recording a required adjusting entry for prepayments? For each item, indicate clearly whether the effect will be an Increase, a Decrease, or No Effect.

E.g. prepaid insurance is an asset account, and if you do not adjust it in order to determine insurance costs, then your net income will be overstated. Your balance sheet will also be overstated, since assets and retained earnings will be higher than they should be.

(a) net income ⇒ increase

(b) assets ⇒ increase

(c) liabilities ⇒ no effect

(d) stockholders' equity ⇒ increase

4. Describe the appropriate adjusting entry for (a) accrued expenses (c) accrued revenues.

Since I already used a prepaid account as an example, I will now us a deferred revenue account. Suppose that you are the insurance company, and you sell a 1 year policy on January 2.

January 2, sales revenue

Dr Cash 1,200

Cr Deferred revenue 1,200

Deferred revenues are liabilities, since you collected money in exchange for providing future services.

Again on June 30, you are preparing the financial records for the first 6 months. you notice that 6 months have already passed since you sold the policy, so you accrued 6 months worth of revenue.

June 30, adjustment entry

Dr Deferred revenue 600

Cr Revenue 600

5. What is the effect on (a) net income (b) assets (c) liabilities (d) stockholders' equity of not recording a required adjusting entry for accruals? For each item, clearly indicate whether the effect will be an Increase, a Decrease, or No Effect.

(a) net income ⇒ decrease

(b) assets ⇒ no effect

(c) liabilities ⇒ increase

(d) stockholders' equity ⇒ decrease