Which one of the following statements is FALSE concerning adjusting journal entries for prepaid expenses?

• A. If adjusting entries for prepaid expenses are omitted, expenses will be understated and assets will be overstated.
• B. Adjusting entries for prepaid expenses increase both assets and expenses.
• C. Prepaid expenses are initially recorded as assets and expensed over time as they are used.
• D. Adjusting entries for prepaid expenses decrease assets and increase expenses.

Answer: (B)

Verified step by step guidance

1. Understand the concept of prepaid expenses: Prepaid expenses are payments made in advance for goods or services that will be consumed or used in the future. Initially, these payments are recorded as assets because they represent future economic benefits.
2. Recognize the purpose of adjusting entries for prepaid expenses: Adjusting entries are made at the end of the accounting period to allocate the portion of the prepaid expense that has been used or consumed during the period. This ensures that expenses and assets are accurately reported.
3. Analyze the impact of adjusting entries for prepaid expenses: When an adjusting entry is made, the asset account (e.g., Prepaid Insurance) is decreased to reflect the portion of the asset that has been used, and the expense account (e.g., Insurance Expense) is increased to record the cost incurred during the period.
4. Evaluate the false statement: The statement 'Adjusting entries for prepaid expenses increase both assets and expenses' is false because adjusting entries decrease assets and increase expenses, not both. This adjustment aligns the financial statements with the accrual basis of accounting.
5. Conclude the reasoning: If adjusting entries for prepaid expenses are omitted, expenses will be understated (because the cost incurred is not recorded), and assets will be overstated (because the used portion of the prepaid asset is not reduced). This highlights the importance of making proper adjustments.