Question

Topic: You are a teacher 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

Answer 1

1) Prepayments

  Prepayments occur when company has paid in advance for expenses which are not incurred yet. It is also called advance.

Accruals

Accruals are those expenses which are already incurred by the company but the supplier invoice is not yet received. It is also called outstanding expense.

2) Journal Entry Debit Credit

a) Prepaid Expense

Prepayment XXX

Cash XXX

b) Defered Revenues

Accounts Receivable XXX

Deferred Revenue Account XXX

3) Items Increase Decrease No effect

Assets overstated

Net income overstated

Liablities overstated   

Stockholder's Equity   overstated

4) Journal Entry Debit Credit

a) Accrued Expenses

Expense XXX

Accrued Expense XXX

b) Accrued Reveues

Accrued revenue XXX

Revenue XXX

5) Items Increase Decrease No effect

Assets   overstated

Net income    overstated

Liablities   understated

Stockholder's Equity overstated